Transcript
Speaker: Hello and welcome back to another conversation with Ben.
Speaker: It's difficult to believe that only five weeks ago we were recording a podcast about a shortage of deposits, issues with mark-to-market in the bank securities portfolios and
Speaker: hypothesizing this could cause the banking system a few problems and by implication the economy a problem in the second quarter.
Speaker: And yet here we are, still 17 days short of the second quarter and the problems are very much in front of us.
Speaker: I think Silicon Valley Bank has proved to be
Speaker: perhaps the tip of what looks to be quite a disturbing iceberg.
Speaker: I have to say, I think we did think that something would go wrong.
Speaker: It's not very often you see the weakest rate of deposit growth in the US banking system since the Great Depression.
Speaker: I think we have to go back to 1934 to see a similar contraction.
Speaker: in the bank's deposit base.
Speaker: For the mega banks, that's an issue.
Speaker: For the smaller banks, that's potentially an existential crisis, as we're seeing.
Speaker: Certainly, things have moved quickly.
Speaker: What do you think, Ben?
Speaker: Yeah, like you, we discussed about the problems of deposit outflow or deposit beaters, as we discussed them, we'll call them in the banking industry.
Speaker: I have been
Speaker: shocked at how quickly things have unfolded, particularly at Silicon Valley Bank and the fact that in less than 48 hours they basically lost their deposit base, which is one of the key things I think is also worth highlighting since the last crisis has been the rise of digital banking.
Speaker: So no longer are you in the classic it's a wonderful life type scenario.
Speaker: We have to be in the branch and there's a big long queue or even I remember in Moorgate in London watching Northern Rock with QC out the door that actually you can do it from home on your app.
Speaker: And it's very, very efficient about getting money out the door.
Speaker: As you know, we discussed a number of names offline that I thought were of high interest.
Speaker: SVB was one I'd looked at, but we didn't discuss.
Speaker: I
Speaker: would like to see how the others are going to perform over the next few weeks and maybe months, I still think they have significant issues to deal with.
Speaker: Certainly.
Speaker: I think there's more shoes to drop.
Speaker: The two banks that have failed have very, I suppose, slightly niche-like in terms of their business.
Speaker: Three.
Speaker: Three, yeah.
Speaker: Sorry, three.
Speaker: Three now.
Speaker: It's easy to lose track these days.
Speaker: But I think we've probably got
Speaker: more concerns about banks with the deposit shortage, more concerns with banks with mark to market.
Speaker: But also I think we're probably now entering a period of pretty significant credit losses.
Speaker: I mean, once credit conditions start to tighten, as they undoubtedly are, we've seen a
Speaker: a collapse in lending to the private sector by the US banking system that of course will crystallize all sorts of problems.
Speaker: Although the US corporate sector is notionally cash flow positive, really it's a few big companies that generate a pile of cash.
Speaker: The rump of the corporate sector is cash flow negative.
Speaker: They have a funding requirement for their working capital.
Speaker: There are now doubts whether the banks will meet that requirement and that will produce further casualties.
Speaker: In particular, I'm thinking of the commercial property sector.
Speaker: The banks have about $3 trillion worth of exposure there.
Speaker: Current delinquency rate is 0.6.
Speaker: A normal recession would be 10 times that.
Speaker: So there's clearly a potential for significant hits to the banking system's capital from that.
Speaker: And I think all of this is adding up into being quite a big
Speaker: or potential to be really quite a severe credit crunch at a very inopportune moment in the cycle.
Speaker: And not just domestically, I think the rest of the world is going to feel the backwash of this, not just reduced or the potential for reduced economic activity in the US, but rather unfashionably, I think the dollars become more important over recent years.
Speaker: Many of the European, Japanese banks sourcing dollars to lend into emerging markets, all of that threatens to dry up in this credit crunch.
Speaker: And this, I think, is a very significant event.
Speaker: Do you think I'm over-egging it, or does it feel like one of those moments for the memoirs?
Speaker: Very good question.
Speaker: I think there's an element of path dependency.
Speaker: And while all central bank support packages start off either the wrong size or the wrong design, and to my mind, there's a number of flaws with what the Fed's come out with,
Speaker: But I think on the current trajectory, I cannot see how this is going to get better.
Speaker: And I would highlight three or four key points.
Speaker: The first one is if you are a corporate treasurer, I cannot see many of them hanging around with a lot of the smaller banks.
Speaker: I think it is highly likely they are going to shift their business.
Speaker: And I'm not quite sure how you reversed that behavior without a proverbial bazooka of some description.
Speaker: You and I have obviously written numerous notes about the Eurodollar market and how it ends up in Asia or a big chunk of it lurks in Asia.
Speaker: I would be extremely surprised to see that market staying robust and liquid over the next few quarters.
Speaker: I think there is a high chance with tightening US financial conditions, offshore dollars will become even more scarce.
Speaker: And absolutely correct on to my mind.
Speaker: I mean, obviously you had Dave on a few weeks ago, who's far more of an expert than I am on commercial real estate, but very crudely, the way I look at things is if you looked at the overall financial system as one giant aggregated balance sheet, they created a lot of deposits.
Speaker: Those deposits had to find assets.
Speaker: A lot of the assets were either created by the government sector, done at the wrong price.
Speaker: And some of those holds maturity securities.
Speaker: You can see that they were bought at the wrong price.
Speaker: Rates have now moved.
Speaker: They're offside.
Speaker: lot of other things that were created at price were offside and that includes a lot of the private sector assets including the commercial real estate so i think it is probable that that will continue to deteriorate the other issue you have as well is as this deposit movement carries on and it goes out of these smaller banks into the larger banks that will create a credit crunch in its own right so yes i i think we've got
Speaker: the start of a negative feedback loop.
Speaker: And that doesn't mean every sort of day is going to be terrible, but I have difficulty seeing how this is going to be reversed without quite serious policy intervention.
Speaker: As we saw in the global financial crisis, there's days of intense activity and then you do have quiet bits and then another thing occurs.
Speaker: I think that'll be the lesson for the second quarter.
Speaker: And it's difficult to see how that doesn't affect economic growth.
Speaker: I mean, I think this is the route to the recession that the Federal Reserve
Speaker: arguably wants to create.
Speaker: We could certainly see capacity utilization in the service sectors coming down.
Speaker: And that should at least have a beneficial effect on inflation towards the end of the year.
Speaker: Treasuries may or may not gain from that.
Speaker: I think we've probably got quite a volatile treasury market in front.
Speaker: We've got at some point a lot of issuance.
Speaker: We're still playing data roulette with the inflation prints.
Speaker: And the Federal Reserve may still raise interest rates in response to bad inflation data.
Speaker: I'm not really sure.
Speaker: I personally don't think that interest rates are the root cause of this.
Speaker: much of the media wants to talk about rising rates so something breaks and something is broken.
Speaker: I think this is much more a quantity event.
Speaker: It's the quantity of deposits, it's the quantity of funding available to the banks and the quantity of credit that the banks will provide the economy that I think is the most significant.
Speaker: And that, I guess, is
Speaker: going to frame the Fed's response to this.
Speaker: I mean, I could sort of see a sort of tightening stroke easing cycle here where the Fed maybe does go through with a hike in the Fed funds, but also signals that the days of quantitative tightening are numbered.
Speaker: I think, as we said in the last podcast, the system can't bear quantitative tightening.
Speaker: And I think the Federal Reserve may not have believed that a few weeks ago, but probably does now.
Speaker: What do you think?
Speaker: I agree with you.
Speaker: As I said on the last podcast, I had great difficulty seeing quantitative tightening going through, certainly by 2024, if not by the second half of this year.
Speaker: I think we're getting close to that point.
Speaker: And the question to me is certainly American banks going down will motivate the Fed.
Speaker: But what is a bigger question is what happens when it's foreign institutions?
Speaker: And obviously there's a couple that may well be in quite significant difficulty at the moment.
Speaker: what happens to them and will their local central banks bail them out?
Speaker: But I think QT is probably going to be suspended.
Speaker: A question I would have, and you're more of an expert on the issuance, but if they have to stop QT and they have to start providing giant central bank swap lines for everybody and then pumping the system through liquidity, isn't that getting back to something that's relatively inflationary?
Speaker: The key point I always come back to is, as we all know, monetary policy acts with long and variable lags.
Speaker: These mistakes were made in 2020 and most certainly in 2021.
Speaker: And the tightening now is going to manifest itself for a while longer.
Speaker: And it's very hard for them to deal with it.
Speaker: So do we get a very steep curve as the bond market realizes the Fed's kind of stuck?
Speaker: More QE-like activities start.
Speaker: and the bond market realizes actually inflation is here to stay and it may well be quite substantial for some period of time.
Speaker: In the short run, I fully accept that once the tightening catches up and a bank credit crunch happens, that is likely to certainly have a negative effect on the US economy.
Speaker: I should point out some banks will be doing very well at this.
Speaker: It is a different situation to 2008 to my mind, and some of the banks that have been prudent will do very well.
Speaker: And I think we could guess at some of those names and
Speaker: Obviously, I have a conflict of interest about potentially one of them.
Speaker: Yeah, no, I think we better leave actual names aside for now.
Speaker: This doesn't, of course, constitute tailored investment advice.
Speaker: But for bonds, I think, I mean,
Speaker: I can imagine the treasury market being quite choppy, which of course, as we were talking offline, has an implication for the valuation of assets.
Speaker: If we've got instability in the system's new mirror, it's going to be quite difficult to value anything.
Speaker: But yeah, a Federal Reserve suspension of quantitative tightening, maybe erring towards something that looks like a quantitative easing in some form, could raise long-term inflation expectations, particularly after experiencing the pandemic.
Speaker: Recession,
Speaker: flight to safety, all of that could be good for treasuries.
Speaker: I think we could find ourselves being whipsawed around in the bond market in the near term.
Speaker: And of course, I don't believe secular stagnation is over.
Speaker: Productivity growth isn't up.
Speaker: The world isn't really capable of growing any faster than it was before the pandemic, probably capable of growing at a slower rate.
Speaker: which has its implications for debt markets and debt sustainability.
Speaker: So I think the treasury market is going to be difficult to invest in, in all of this.
Speaker: Probably does end up steeper with yields at a higher level than we're used to, but I think we'll probably see most shapes on the way to that.
Speaker: The financial system, I think, as you said,
Speaker: you say is going to look very different the other side of this and this begs the question you know will we have to evolve um you know arguably this makes the case for a central bank digital greater use of central bank digital currencies um take some of the banking system out of this but how does that sit with the political agenda you know sort of centralization of power that's normally anathema to the us so
Speaker: I think this is going to be one of those moments that we do include in our memoirs and the effects will be quite far reaching.
Speaker: But in the near term, credit crunches in the US, I think, are highly likely to cause a recession that the Fed's been threatening.
Speaker: There is some disinflation in that, but other things will break.
Speaker: And I, like you, think some of those could all be outside the US and maybe some of the
Speaker: The themes we were running in Asia last year when credit conditions were tightening and how that affects those countries, particularly around China with a lot of dollar borrowings, we could revisit some of those things.
Speaker: So I think this clearly is a very significant moment in financial history, certainly in medium-term financial history.
Speaker: I agree.
Speaker: I think it's the end of an era.
Speaker: The three or four things, again, I would sort of focus on
Speaker: Some institutions will be fine, but I would say that perhaps overall we've allowed the economy, certainly in the Anglosphere, to become over-financialized, and I think that probably needs to reverse to a certain extent.
Speaker: The other thing as well that may well have to kind of be revisited is the thought of how easy it is to move capital around and move...
Speaker: funding around the world because I'm not necessarily certain that helps things.
Speaker: The classic Keynes quote was something along the lines of when your activities and long-term capital allocation become indistinguishable from a casino, don't be surprised when you get casino-like results.
Speaker: So I think that there's a good chance we're going to see a slightly different regulatory architecture.
Speaker: It's interesting you bring up CBDC because, as you know, I did quite a long paper on it, and it's always the source of, along with vaccines, 5G and chemtrails, about one of the great conspiracies.
Speaker: But there are, in fact, five models broadly of CBDC.
Speaker: You've obviously got one extreme model where, effectively, the government controls everything, and that seems to be the example that most people focus on.
Speaker: And then at the other end,
Speaker: You've got one where actually you give even more power to mega banks and their ability to effectively bypass the local banking system.
Speaker: And that would have certainly attractions to some of these institutions.
Speaker: It would have some attractions to some of the central banks.
Speaker: The ECB is an obvious example there where obviously pumping the money around their system and liquidity around the system is problematic because of the flaws in the general architecture.
Speaker: But there's definitely a model in between where you've got the ability to unpack a lot of the risk of the banking sector.
Speaker: And maybe that's something we have to investigate.
Speaker: And that is, as you know, I suggested in the model that you better match people that were providing liquidity to what they really wanted.
Speaker: You basically locked it in and you remove the whole problem that you have fundamentally with the current banking model of maturity transformation.
Speaker: And that's sort of really what causes the problem at the end of the day.
Speaker: Credit losses cause people to kind of change the funding or pull their deposits, as we're now seeing.
Speaker: But ultimately, it's that funding that tends to be more problematic.
Speaker: That's certainly the case.
Speaker: In the wearingly large number of crises I've covered in the last 30 years, it always comes down to funding at the end of the day.
Speaker: And I think possibly the big message from this is that the Fed underestimated the impact it was going to have on the financial system by doing even the modest amount of quantitative timing we've seen.
Speaker: I think that perhaps
Speaker: I think if we were to be critical, the Federal Reserve probably lost some of its back channel, some of its communication with the financial industry and perhaps got a bit left behind in how the system actually works.
Speaker: And in particular, how big the banks,
Speaker: had actually become where the off balance sheet items underestimated the impact of its quantitative tightening.
Speaker: And I think we've probably got a few months now where the Fed has to rethink many of its models, iterate as they did during the global financial crisis to a solution.
Speaker: And I suspect that solution is no quantitative tightening.
Speaker: which markets may not take terribly positively from the point of view of long-term inflation expectations, but I think quantitative tightening is probably going to give way to something they may not call quantitative easing, but has that type of effect on the system, possibly as soon as the second half of the year.
Speaker: But between now and then, we've probably got some more credit losses, some more funding events, and some more questions to ask of valuations.
Speaker: I couldn't agree more.
Speaker: And I'm going to say something that you may well disagree with.
Speaker: But I would like to see a lot less economists at central banks.
Speaker: And I would like to see a lot more people who have been in the financial system for a long period of time being empowered to have a common sense banker's type view about how the financial system works.
Speaker: rather than some model which may or may not work.
Speaker: And given my background, a model is something that should be able to produce results that are relatively accurate and can be repeated, rather than what we seem to see a lot of coming out of various parts of policymakers, which seems to be an opinion on a spreadsheet that often doesn't face any kind of, it doesn't seem to stand up to reality very well.
Speaker: I think if we were to write the history, I'd probably say that the Bill Dudley New York Federal Reserve was perhaps a little too close to the financial system.
Speaker: Maybe it should have disentangled itself after the GFC a bit faster than it did.
Speaker: But the Yellen version of the New York Fed or the Williams version of the New York Fed
Speaker: seemed to build itself an ivory tower and brick up the windows and went too far the other way.
Speaker: So there needs to be communication and I think understanding rather than both parties avoiding each other as they have been over the last few years.
Speaker: So that's something I would actually agree with you, but I wouldn't mind if the economists got to hold the conversations.
Speaker: We can discuss that offline.
Speaker: I think we should.
Speaker: But, you know, let's say significant times, I have a feeling it's going to get worse before it gets better.
Speaker: But central banks ultimately do know how to solve banking crises.
Speaker: They've had a worrying amount of practice over the last few decades.
Speaker: But I think it is going to take the Fed a while to iterate its way to a solution.
Speaker: And then in that period, I think we do see the economy slide into
Speaker: a recession and there's going to be some credit events in that, I think in particular in some of the commercial real estate space and maybe in some of the private markets.
Speaker: Sadly, I agree with you.
Speaker: I think you kind of have to divide it into two things.
Speaker: You've got the real economy where we're still looking at that for inflation data and a lot of that's obviously backward looking and we've got the financial economy which has obviously become
Speaker: so enormous and important over the last few years.
Speaker: And that's where things are really starting to struggle.
Speaker: And ultimately, there needs to be a long term sort of thought process about what the right balance between the two is.
Speaker: But I think it's getting to the point where people can probably agree there's too much financialization in the
Speaker: I think that's very much the case.
Speaker: Well, thanks, Zoha, for your time.
Speaker: I'm sure we'll be talking again because I think this situation will continue to evolve.
Speaker: But thank you again and speak soon.
Speaker: Thank you, Andrew.
