In one of the worst weeks in financial history since the 2008 Financial Crisis, the Fed chose an awfully bad time to go into a blackout period. But sometimes it's best not to say anything, hoping that by the time you can, there won't be a need.
Such is the wishful thinking behind the US Federal Reserve and their failed policies dating back to 2000. Failed policies being a rather contentious topic, as policies have failed economically speaking, not in terms of asset price growth, or put more eloquently, generating wealth inequality.
Fifteen years after the first financial crisis, today the banking sector faces another crisis of confidence as the Swiss regulator rushed to get everyone to meet over the weekend to find a suitable suitor for Credit Suisse (CS) . The most obvious candidate was UBS (UBS) , but given past experiences, they would only agree if the price was pennies on the dollar and were given various provisional backstops in case their real assets get marked down lower in due course. Surely the bankers would not have had time to go through the books properly.
The sad irony is that the US economy is actually in decent shape, so this crisis is not a liquidity crisis as it is about banks once again taking undue risk in positions that were not hedged properly. After the Covid induced stimulus surge in 2020, inflation was more than transitory that caused the Fed to embark on one of the tightest rate hiking campaigns in history, raising interest rates by 500bps + in less than 12 months. Unheard of! History has shown us that every rate hiking cycle causes a hiccup of some sort, and this one would be no different.
The issue today with these regional banks is that as their deposits increased, they held back on raising the interest rate to match the current Fed rate, leaving depositors unhappy as they could get better rates in money markets. In addition to this, they bought bonds and various securities (unhedged in some cases) as no one ever thought the Fed would raise rates so fast leading bonds to collapse as higher yields got priced.
This surge caused massive marked to market losses on the books. Now we know the ECB and the Fed are sitting on these same losses, but they can afford to shove them underneath the carpet and keep changing the law and accounting rules to suit. But banks and listed entities cannot as they have their shareholders to answer to. When deposit outflows combine with the asset side showing severe losses, therein lies your banks going bankrupt.
As was the case in 08, today many banks still do not know the extent of the losses on the books making the equity worth questionable. Hence the resistance of the big banks to buyout these smaller banks for now. But Credit Suisse was a counterparty risk, so "too big to fail."
Which Crisis Is Worse?
After a year of getting it entirely wrong, the Fed has been trying to undo its mistake by raising rates to combat inflation which is coming down slowly, but Core CPI is still averaging around 5.5%. There are various sticky parts of the index like shelter and rent and services that refuse to come down as much as goods prices have. Even the Fed's preferred Core CPI measure ex shelter is still averaging north of 5%.
The Fed was hopeful that it could continue raising rates to get it back to their 2% goal, especially given the tight and resilient labor market. But today it battles with raising rates to put the inflation genie back inside the bottle lest it see a repeat of the 70s, or risk having a financial sector break down. Which crisis is worse?
Banks continue to take more and more risks each cycle around because they know their central bank will come to their rescue, and it has! This one-sided risk profile has incentivized CEOs and CFOs to continue investing in risky assets with no accountability whatsoever. The Fed message was clear all throughout 2022: they would not hold back on inflation, yet these banks kept holding onto these bonds that suffered as yields rose.
After the move lower in goods prices, inflation will move lower, but services inflation is embedded into the system and shows no signs of rolling over yet. Central banks have been able to carry on with their MMT (magic money tree) experiment as inflation was never an issue, but today it is an entirely different matter.
The Fed is playing with fire as it goes into the FOMC this Wednesday, but it's better to be consistent than appear out of control as it was only the week before when Fed Powell was extremely hawkish saying there was still so much work to do. It would be unwise and rather risky to walk back now, especially as the equity market will wonder what it is the Fed knows that they don't. Control or at least the illusion of control is everything.
