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Rates and Crises

Consensus has converged around a +25bp hike tomorrow (Wed. 3/22). This after conceding that no one knows how deep the banking carnage is (or could be), primarily so the Fed can show markets they are both (a) standing firm in their fight against inflation and (b) not overly concerned about or moved by recent events.[1] The Fed's position would be such that sticking to another rate hike—even if down from +50bps priced in a couple weeks ago—as opposed to taking a brief wait-and-see approach, would be a display of confidence. In other words, the case is for the Fed to fool markets by assuming things are fine until proven otherwise. It is difficult to see markets buying into the idea that conditions are alright simply because the Fed arbitrarily continued their rate-hiking trajectory. After 40 years on the dot of declining interest rates[2] the pace of rate hikes has been so fast and furious that, as Jeffrey Gundlach pointed out last week,[i] neither the Fed nor anyone else yet grasps all the second-, third-, and fourth-order effects coming down the pike.


Some say the Silicon Valley Bank (SVB) et al. fall out is sparking conversations about diversifying accounts with more than the FDIC limit (250,000 USD) into multiple banks. Yet the top of the safety ladder, short-term treasuries, still yield as much or more than checking and savings accounts. An intended, or a priori understood, consequence of going from zero to five percent on the Fed funds rate was that fixed income and credit securities (a material portion of bank assets) would fall in value. An unintended consequence has been the number of savvy-ish depositors who have moved large amounts to short-term treasuries. For the California banks on the brink and those already under receivership, the combination of declining asset values, numerous cash-burning start-ups, and depositors' propensity to transition money to safer, higher-yielding treasuries was, in hindsight, an obvious nail in the coffin. Yet it wasn’t so clear. Nothing was done until it was too late. Things were fine until they weren’t—i.e., the 2-3 day period of the bank run.


The general narrative is that SVB and similar banks were mismanaged, underregulated, and/or undercapitalized. Though a thread of truth trickles through each allegation, they miss the mark for evading one of banking's first principles: a bank's existence is contingent upon the absence of a run on deposits. At the point of such a run, the business model ceases to be viable. An institution could have a fifth of deposits in reserves (i.e., immediately liquid). Still, a quarter of depositors demanding their cash in concert creates a problem. The bank would be unable to deliver all deposits to customers in a timely fashion, which is of course the purpose and implicit expectation of having a bank account—the ability to access the entire deposit when one desires.[3] Hence banking, levered as it is, is the most fragile of risky businesses, and why it lives in infamy for those sporadic yet perennial collapses.


 

[1] Another reason for backing a rate hike is the pervasive belief that the consumer is still “strong.” I continue to sense, as outlined in the last memo, that presumption is on shaky ground. [2] Rates peaked in September 1981 with the 1-year yield reaching 17.31%, a 5x increase from the March-1971 low of 3.48%. The recent record rapid rise began around September/October of 2021 and, to date, peaked on March 8, 2023 at 5.25%, a 131x increase from the low of 0.04% in May-2021. [3] This is a simplified example without government, tax-payer (FDIC), or Federal Reserve overnight backing. On the flip side, increasing said backstops, as we have seen, increases moral hazard in a non-linear fashion.

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2022 Investor Letter II (Fall)

A preview of our second investor letter for 2022. Click here to read the full letter. “In order to outperform, by definition, you have to depart from the crowd. You have to hold a different position.

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