Latest research reveals that, contrary to popular opinion, Silicon Valley Bank is not the primary concern. Yet, the concentration of risk in failed digital companies has caused the problem to spread and become a systemic concern, affecting policymakers, the Fed, the Treasury, and CEOs of large banks. The inverted yield curve indicates a problem in the financial system, and the crisis is spreading, with China decreasing rates due to concerns about California's monetary woes.
The issue is global, with inverted curves indicating the possibility of deflationary money all around the world. This is concerning since current economic data indicates that everything is great, but fear in the banking sector and steeply inverted curves indicate that a financial catastrophe is occurring. Even though the economy appears to be in good form, if actual issues develop, things could go worse.
During China's shutdown, the country suffered economic setbacks due to a drop in demand, as their companies rely significantly on US orders. Meanwhile, the European Central Bank unexpectedly boosted interest rates, and the Federal Reserve may follow suit next week. The possible economic effects are unknown, but there is troubling hard evidence, such as negative year-over-year industrial production in the United States, which could imply a recession.
The market is understanding the impact of deflationary money, and the pragmatic Chinese, unlike the hopeful Europeans, are bracing for trouble. As a result, massive hedging has happened this week, surpassing that of 2008. Although there have been problems with many banks throughout areas, experts believe the issue is one of inflation rather than a systemic financial crisis.
A banking crisis, on the other hand, can be deflationary and force customers to hoard their money, resulting in lower expenditure on non-essential products such as cars and restaurants. Policymakers may be underestimating the gravity of the crisis.
There are two major issues to consider in this severely deflationary climate. To begin with, consumer spending is down, and a recent University of Michigan survey found a dip in consumer mood, indicating that individuals are already experiencing the effects. This is concerning because consumer mood has been improving for months as a result of lower consumer price pressures.
Second, during a banking crisis, inflation is unimportant, as the markets have already indicated. Subsequent developments, such as the major credit or discount window's deflationary spasm, have confirmed the severity of the crisis.
The Federal Reserve uses this emergency financing window, and this week's funding request was 85 billion, which is equal to the amounts seen during the 2008 financial crisis. This implies that small banks were unable to receive money from wholesale markets, indicating a systemic problem.
Furthermore, smaller banks are losing their cash reserves to larger banks, demonstrating that the problem extends beyond Silicon Valley Bank. To avoid further problems, cash must be redistributed from larger to smaller institutions. This underlines the importance of addressing the issue's collateral consequences.
The current banking industry position, in which many banks rely on the Federal Reserve for funding, is unusual and has a negative connotation. There are clearly structural concerns at work that demand addressed at both major and small banks.
To overcome this issue, banks typically remove illiquid loans from their loan books and use them as collateral to borrow US Treasury bonds, which they then use to acquire short-term funding in the repo market. Nevertheless, this has not occurred, and the banks have forced to seek assistance from the Federal Reserve. These challenges are now more concerning to the market than they were previously.
Despite assurances from central bankers and politicians, existing systemic difficulties show that things are not well. Market volatility and collateral runs similar to those experienced in 2008 are concerning.
Additionally, the implications of this predicament will continue to mount in the following weeks and months, with the full scope of the impact yet to be determined. This is a simple explanation of what is going on in the market. Despite promises that everything is under control in the run-up to the Fed meeting, it remains unclear why the problem was not anticipated and why the discount window is still being used instead of other choices. The market is dubious of the premise that everything is OK, and the dollar futures curve shows that a rate hike will be followed by a rate decrease. This suggests that the market expects a rapid run of rate decreases, which is not a good indication.
Source:
Eurodollar University, 20 March 2023, "Severe consequences to expect months, weeks, even days ahead",