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Monday, March 13, 2023

Peanuts Brittle

What goes up, must come down?  Yesterday’s thunderbolt that the Federal Reserve will underpin deposits by loaning against Treasurys and other qualifying collateral at par following the demise of Silicon Valley Bank and Signature Bank loudly reverberates, not least in the short-term rates market.  
Two-year Treasury yields pancaked by as much as 60 basis points to 3.99%, extending beyond a 100-basis point, three-day decline for the largest such move since the October 1987 stock market crash.  Similarly, interest rate futures now price in a 4% policy rate by the end of the year, down from a 5.56% guesstimate last Wednesday as well as from the current 4.57% effective rate. 
That course correction follows dramatic structural changes ushered in by the Fed’s one-year-old tightening campaign. Citing data from CUSIP Global Services, The Wall Street Journal reports that investor demand for short-term certificates of deposit stands at its highest since the 2008 crisis, while money market funds sported $8.5 trillion in assets as of March 5 per the Federal Reserve Bank of New York, double that seen at the end of 2020. At the same time, the banking industry’s reluctance to pay up for customer funds is readily apparent, as the spread between S&P’s AAA-AA Money Market Rate and Bankrate’s average deposit rate towered at 395 basis points as of March 3 according to Bianco Research, up from 0.04% a year prior. “The fix is simple,” Bianco concludes. Lenders must “raise deposit rates. . . .”
More broadly, the banking system’s demonstrated vulnerabilities may serve to derail Fed chair Jerome Powell’s efforts at “normalization” following years of strenuous monetary easing. In fact, yesterday’s unveiling of the Bank Term Funding Program serves as a de facto reintroduction of the quantitative easing policy in force for large swaths of the post-2008 era, some believe. “The new BTFP facility is QE by another name,” strategists at Citi write. “Assets will grow on the Fed balance sheet, which will increase reserves. Although, technically, they are not buying securities, reserves will grow.” 
That prospective return to balance sheet expansion is ironic, considering that the Fed’s policy stance in the latter stages of the pandemic arguably laid the groundwork for the current snafu. Recall that the morning of June 10, 2021 brought news that headline CPI vaulted by 5% year-over-year in May, well above the 4.7% consensus and accelerating from a 1.7% annual pace just three months earlier.  That data point arrived a month after San Francisco Fed President Mary Daly declared that “it’s not yet time to start thinking about talking about relaxing the accommodation that we’ve given.”
Rather than pull back from the Covid-era policy pillars of near-zero interest rates and bountiful asset purchases, the Fed maintained the benchmark Funds rate at 0% to 0.25% while expanding Reserve Bank credit by $1.19 trillion over the subsequent nine months, despite the fact that measured price pressures increased in nearly every month during that stretch.  Even following 12 months of QT balance sheet runoff, the Fed’s holdings of interest-bearing assets remain at $8.3 trillion, roughly $400 billion north of the June 2021 level.
Indeed, that belated response to percolating inflation (along with the euphoric financial conditions that prevailed in 2021), is prologue to today’s difficulties, a recent analysis from Daly’s institution finds. Last month, the San Francisco Fed published Working Paper 2023-06, titled “Loose Monetary Policy and Financial Stability,” which concludes that “when the stance of monetary policy is accommodative over an extended period, the likelihood of financial turmoil down the road increases considerably.” Though some might consider that finding to be logically intuitive, the authors contend otherwise: “This study provides the first evidence that the stance of monetary policy has implications for the stability of the financial system.” See the current edition of Grant’s Interest Rate Observer dated March 10 for a counterpoint. 

Recap March 13

Intense curve steepening headlined today’s price action as the long bond remained at 3.7% while the two-year yields collapsed to 4.03% from 5.05% on Wednesday afternoon. Stocks managed to grind out a near-unchanged finish on the S&P 500 with the tech-heavy Nasdaq 100 rising 0.74%, though those indices finished well off their best levels of the afternoon, while gold ripped higher by nearly 3% to $1,919 an ounce and WTI crude slipped below $75 a barrel.  The VIX settled near 27, up two points on the day, after testing 31 this morning for its most elevated reading since October.   
- Philip Grant