Is QE About to Make a Comeback?

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1:27Is QE about to make a comeback? Welcome to this live edition of Steno Signals. My name is Andreas Steno, the Senior Editor at Real Vision, and we are going to discuss today whether the deposit flight crisis is contained for now after the Federal Reserve meeting yesterday, and whether the Federal Reserve will need to do more to contain this crisis in the weeks ahead of us. But before we get to the potential solutions to this deposit flight crisis, I'd like to just take a look at the recent price action in interest rates to give you a flavor of how severe it's been relative to, for example, 9-11 and the post-crisis environment in 2008-2009 after the great financial crisis.

2:16If we look at the development in two-year bond yields in the US, I've labeled the chart nothing to see here since it kind of reveals the magnitude of the moves that we've seen in bond space relative to other crisis situations in US history. The one-week change in two-year bond deals in the US has been sort of double up of the move that we've seen post Lehman, post 9-11 and post the pandemic lockdowns. So this is a very severe move in the interest rate space and something that you should pay attention to in my humble opinion. So why have we seen such a big move? Is it all driven by expectations of rate cuts upcoming for the Federal Reserve or is it also driven by technical factors.

3:09I think it's a combination of the two. So first of all, this is obviously a market looking for rate cuts already in two, three, four months from now. And the market expects the Federal Reserve to commence a relatively severe cutting cycle already soon, all the way into 2024. And the question is whether the Federal Reserve will cave in to the demand from the yield curve because ultimately it is very very tricky to convince the market of another cause when the market screams as loud as it does right now but i also think there is a technicality that we need to discuss in relation to this move in the yield curve because credit swiss the swiss bank that essentially went bankrupt last weekend was one of the biggest players in terms of leveraged financing for hedge funds.

4:09And I have loads of clients in the space and I know that Credit Suisse is a big counterpart to many larger hedge funds and Credit Suisse has been one of the key players in this space in recent decades. And I wouldn't rule out that the lack of risk appetite from Credit Suisse heading into their de facto bankruptcy and after that takeover by UBS has been a part of these moves in the dollar bond space as well. Simply since a lot of these hedge funds were betting on higher interest rates in the US in leveraged positions. And as soon as the leveraged financing was pulled away from the market, they probably had to de-risk or square their positions in a very rapid way.

4:57And I think that sort of exaggerated the move in the bond space on top of the expectations forming of a cutting cycle commencing soon from the Federal Reserve. But let's have a look at whether the crisis is contained after this Federal Reserve meeting, because I essentially think the key to understanding asset allocation and investments in the months ahead of us will be to understand whether the deposit flight from banks is contained or not. And I find various ways of measuring whether the deposit base is leaving the banking sector or not. And if we look at the chart called the deposit flight continues first here, I'd like to point your attention to the relationship between the shape of the yield curve and the behavior of consumers and banks.

5:52So why do we see deposit flight right now? I think it is related to the inversion of the yield curve that we've seen in recent quarters in the US. The reason is that banks thrive when the yield curve is steep. Banks fund themselves in the front of the yield curve, for example, via deposits from customers, while they lend out the deposits with longer time horizons. and therefore they earn the spread between far-end yields and front-end yields. So when we have an inversion of the yield curve, it is typically something that spills over to weaker margins in banks and therefore they try to orchestrate their own yield curve and keep that yield curve steep by not raising interest rates on deposits to the same extent as we've seen interest rate hikes in the Fed funds.

6:52And if you look at the average deposit rate in the US, it's probably still about 0.5%, despite Fed funds reaching 5 % in the upper bound of the range yesterday, meaning that this spread between the Fed funds rate and the average deposit rate out there has been growing and growing and growing in recent months. And at some point, you're simply incentivized as a bank customer to move your money away from the bank and into a money market fund, which yields close to 5 % or into T-bills directly. Because it's essentially as safe, if not even safer than having a bank deposit, and it yields better. So I think this is the underlying root cause of the deposit flight from banks.

7:46And as long as the Federal Reserve hikes interest rates, this spread will basically continue to grow. And therefore, my overall conclusion after the Federal Reserve meeting yesterday is that they are not yet willing to admit to the root cause of this deposit flight, meaning that deposits will continue to flee banks in weeks ahead, despite measures taken by the U.S. Treasury and despite measures taken by the Fed to sort of ensure liquidity across the banking system. It doesn't really matter whether you have access to endless liquidity as a bank if clients keep pulling money out of the bank, because ultimately you need to find a viable business model, and it's not a viable business model to only lend via the Federal Reserve.

8:35So you need customers, and if customers continue to leave, it will eventually turn into an issue to more banks, for more banks than what we've already seen.

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9:47So if we look at why this deposit flight continues, I'd like to just briefly roll back time, say seven, eight days to the hearing of Janet Yelling in Congress. She was asked by a Republican member of Congress from Oklahoma whether Oklahoma banks would see the same kind of safeguarding from U.S. Treasury and the Federal Reserve should one of the local banks in Oklahoma get into trouble. And Janet Yellen obviously couldn't say yes to that question. She instead referred to an assessment of whether a bank is systemic or not. And one thing I know is that a small bank in Oklahoma would not be deemed systemically important by the end of the day.

10:42And therefore, the response from Janet Yellen basically ended up as a catalyst for further deposits leaving the banking system. And Jay Powell was asked similar questions yesterday and it was the exact timing of the sell-off post the press release that sort of coincided with these questions to Jay Powell when he was asked about the guarantee of deposits in smaller banks. He couldn't really give any guarantees and then the sell-off in equity markets started and likely also continued deposit flights followed. So So how do we measure the deposit flights on an ongoing basis now that it is the most important gauge at all for financial stability going forward?

11:30Well, first of all, we actually have a daily number to follow. And I think you should start doing so if you're not already following that. It is the daily usage of the so-called overnight reverse repo facility at Federal Reserve. It is used by money market funds in particular when they have excess capacity or excess liquidity that they need to find a home for. It usually happens when there are too few T-bills available from a supply perspective and then money market funds they decide to park their liquidity at the Fed in return for collateral in the form of a T-bill for example. And we've seen a spike in the usage of the overnight reverse repo of roughly 100 billion both yesterday and the day prior to that.

12:25Meaning that money market funds likely saw inflows after the Federal Reserve meeting yesterday or amidst it since they had to find a home for quite a few billions of dollars yesterday. If the search continues in this overnight reverse repo facility, I would consider that and early signal that the deposit flight in the banking system continues. We will get more clarity on the exact numbers in the money market system already later today. So the second way we can measure this deposit flight is to look into the actual flows into money market funds on a weekly basis. We get data from Wednesday to Wednesday released on Thursdays And the last print just a week ago showcased an inflow of more than 100 billion to money market funds.

13:20So basically bank clients taking up deposits from banks and putting them into money market funds, effectively into T-bills by the end of the day. And this number will be scrutinized week in and week out from here to assess whether the deposit flight continues. But we have a third thing that we need to watch now when it comes to the deposits. And that is the new lending program from the Federal Reserve, which was put in place just a couple of days after the bankruptcy of Silicon Valley Bank. and it is called the BTFP, so a term funding program for banks. And it is essentially a program designed to meet claims for deposits when they leave the banking system.

14:09It allows banking counterparties to post collateral at par, at the Federal Reserve in return for a one-year loan priced at Fed funds plus 10 basis points. And this facility was used quite a bit just since the inauguration a week ago. And if we get continued flight from banks, we should probably also expect some of these regional banks to utilize this program to post bonds underwater as collateral for new liquidity injected into the bank. And as you can see from the chart, it was a pretty decent spike. We've also seen spikes in other emergency lending programs from the Fed. And therefore, the question is now, is this some sort of new QE program in disguise by the Federal Reserve?

15:05I think the answer is both yes and no. From a practical perspective, it is clearly not QE since the Fed is not buying assets from the market. Instead, they hold assets as collateral temporarily, hopefully at least, while they lend out the new dollars to a financial institution. But let's assume that a bank takes up a loan in this new program, collateralized via bonds, and the bank goes bankrupt in a month or two from now. So then the Fed will basically seize these bonds and they've paid for it via the newly freshly added liquidity. And in such case, it would be de facto QE. It would even remove those bonds permanently from the private market and move them to the Fed balance sheet.

16:02So I think it is likely that at least parts of what we're seeing right now will eventually end up as de facto QE. And that is why I consider it fair to a certain extent that the market sees this as QE. It's not QE per se, but it is indirect QE, or at least it risks being indirect QE in not so long from now. Just a quick moment to remind you, today's Real Vision Daily Briefing is sponsored by CraneShares. Learn about their KRBN ETF at craneshares.com forward slash KRBN. Now back to today's analysis. And if we look at the overall question here, now that we are faced with the banking crisis, I think it's worthwhile looking into what I call credit standards by banks.

16:59The Federal Reserve even directly referred to lending standards, credit tightness in their statement yesterday. Powell was also referring to it several times through the press conference. And the question here is whether banks will now take very conservative decisions on the back of this liquidity slash deposit crisis in the system. And if we are to see even firmer or tighter credit standards from here, I feel relatively certain that it is the trigger for a recession, the recession that we've been talking about forever, it almost feels like. But we've always needed that trigger, and this deposit crisis could be that trigger if we get a very conservative decision-making from banks on the back of it.

17:50And if we, for example, look at credit standards right now, We've seen a clear move towards tighter lending standards by US banks in recent quarters. And if we get another move in that direction, we will be back at 2008 level in terms of credit standards relative to households and corporates. And to me, that is a very great or good predictor of future credit growth and future economic activity consequently. That will eventually lead to the recession. And therefore, I consider the recession, if not a done deal, then at least clearly the base case now after what we've seen over the past few weeks.

18:39And therefore, I also find it very likely that the Fed height interest rate for the last time yesterday. This was peak Fed funds. Looking at the banking system overall, I've received a bunch of questions on which banks to consider vulnerable, which are the sectors that you would watch out for in this current environment. And one of the things I've been looking into is whether regional banks have eligible collateral to post in this new lending program from the Fed on one hand. And then on the other hand, I've looked into the balance sheet of these banks to assess whether they have very risky exposures.

19:22So what I show on the chart call which banks are vulnerable is the cocktail of banks with eligible bonds to post in this new lending program relative to their exposure to commercial real estate. We know that real estate as an asset class is illiquid relative to liquid asset markets, which means that the price action in these assets typically follows the price action in liquid asset markets by a time lag of, say, 6 to 12 months, which is why the turmoil we saw last year is enough for me to sort of be convinced of weakness in both residential real estate, but in particular in commercial real estate.

20:09commercial real estate this year. And if we look at the regional banking space in the US, we find quite a few banks with a very large exposure to commercial real estate. That is on the one hand, you see up towards 40 to 50 % exposure of the total asset base of the bank towards this particular space in real estate, which is very concentrated risk, I'd say, if we see drawdowns on the pricing, which I find likely. And then if you pair that with a very weak bond book to post as collateral in these new lending programs, you have a potential very toxic cocktail for these banks. You can assess this entire list of banks in the slide deck that we will post after the show.

21:00We have the balance sheet data posted for each and every of the banks in the regional banking index in the US. At least I find a few very, very vulnerable targets should commercial real estate continue to suffer. And going forward, I think this is the key question to assess now. Will banks with a risky credit exposure be next in line? Should this deposit flight continue? And I think ultimately the risk here is that a liquidity crisis turns into a credit crisis unless the Fed turns around and pivots relatively soon. And that is why this banking crisis and this deposit flight crisis ultimately increases the possibility of QE by the end of the day, not just indirect QE as now, but actual QE could be on the cards within a foreseeable future, in my view.

22:03And I think rate cuts will arrive sooner than anticipated by many investment banks, simply as the Fed will be forced into taking that decision if they want to prevent this from turning into a credit crisis on the back of a liquidity slash deposit crisis. So let's take a look at some of the questions that are coming in. We have a question from Raphael asking whether this banking crisis is really over. He sees a KRA underperforming even today when the markets are up. And I think that's a great observation by Raphael. Even after the press release yesterday from the Federal Reserve, which initially sparked a pretty positive reaction in risk assets, we saw how financials and real estate were the two sectors underperforming and even falling after the press release.

22:56And in my opinion, those are the two sectors to watch out for right now. Financials, in particular regionals, and then the overall real estate sector with a particular focus on commercial real estate.

23:13We have a question from Gary asking me whether has there been a correlation between an impending recession and negative S &P prices? And has it been trumped by this recent Federal Reserve balance sheet increase? I think the question relates to whether you can buy risk assets even despite a recession upcoming, given that the Federal Reserve is already now in the process of increasing the balance sheet again. And I at least find pockets of strength in the equity markets despite this potential recession upcoming or this rather certain recession upcoming now, I find things with a high interest rate sensitivity to be interesting to look into.

23:59The best sector to be positioned in is the consumer discretionary sector when interest rates and inflation are coming down. And I would also, at least from a relative perspective, suggest that you look towards such sectors relative to financials, energy, and real estate when you position yourself in equity space in coming months. If you want to be long risk assets, you need to be long those assets with a high duration sensitivity since I think interest rates will drop due to this. We have a question from William asking, how does every 25 basis point rate hike affect these small banks? And I think you need to look at this on a trend basis, because every time we get a hike to the short term interest rate, you essentially widen the spread between Fed funds and deposit rates.

24:56And small banks are typically even more sort of reliant on deposits from consumers. So they will have to at least to a certain extent follow Fed funds higher. and it's very, very expensive for them to do so when the curve is inverted, meaning that profitability takes a massive hit in these regional banks when the curve is inverted. And therefore, they will hope and pray for the Fed to turn around and cut interest rates within a reasonably foreseeable future because otherwise they will take a big hit from a margin perspective. We have a question from Gary asking which banks globally the I find to be the most risky in the current environment.

25:41And I mean, from a US perspective, I've basically listed the names with the biggest exposures to commercial real estate, Valley, National Bank, Corp, Glacier Group, some of the few I could mention. And you should probably need to look into the balance sheet of each bank to really find those vulnerabilities. I think a a large exposure to commercial estate is one of them. At least if you pair it with a weak liquidity apparatus and a weak bond book to post as eligible collateral to the new Fed lending program. In Europe, I actually find cracks to be slowly but surely appearing in some of the bigger banks.

26:26Deutsche Bank is a good example of a bank which has suffered for a few quarters in a row. It seems to a certain extent similar to Credit Suisse, even though the business model is quite different. Other vulnerable targets include big French banks such as Societal General. So I think there are vulnerabilities in certain banks, but I don't have any firm evidence of concrete banks being under a massive pressure from a deposit flight. So I would rather watch price action in some of these banks where you can pinpoint the vulnerabilities in the balance sheet to assess where the next vulnerable targets could be.

27:10We have a final question coming in from Batsirai asking which assets will do well when a recession is confirmed and whether risk assets will do well as soon as the recession is basically confirmed from sort of a buy the rumor sell the fact perspective. And I think Batsy Rai is also something here because typically what we see when the market acknowledges that the recession risk is increasing is that we see a sell-off on an index level in equities. But as soon as the recession is a done deal, as soon as we get those GDP numbers printing at negative territory, then it is typically a sign that central banks will have to push liquidity into the system again to a large extent.

28:05it is typically a sign that the yield curve will start to re-steepen in an aggressive way, etc., which will allow some of the very weak links in the equity market to rebound. But as of now, I would focus my attention on consumer discretionary and similar types of sectors with a high duration beta, so basically a sensitivity to falling interest rates, which is positive for some of these sectors, while financials, energy and real estate are the ones that I will certainly avoid in my own portfolio after this crisis emerged. Final question from Gary. Did the Fed explanation yesterday surprise you in any way, Andreas?

28:56And it didn't really surprise me that they were not willing to accept being the root cause of this crisis. So my working assumption has been throughout this two-week crisis now that it has to get worse before it gets better since the Fed will not acknowledge that interest rate costs are needed unless they are forced to acknowledge it. And markets are simply holding up too well right now for them to acknowledge it. So that is probably the thing that you should watch for if you really want to bet on that Fed pivot, you need to see a slide in risk asset prices before you can go all in on that Fed pivot story and all in on the QE is back narrative.

29:47For now, I think the first leg is lower, which will force the Fed to take the decision, at least in some of those very vulnerable sectors that we've discussed, financials, real estate and energy. And that is probably the final thing I want to mention to you in this live edition of StenoSignals. If the Fed decides to address this question of deposit flights, they will do it in a very technical way initially. And one way of doing it is to cap the access to this overnight reverse repo facility at the Federal Reserve. We discussed it as one of the daily gauges of deposit flight. If the increase or if the usage of the reverse repo facility is on the up, it is a signal that money market funds receive inflows from bank deposits.

30:46And if the Fed decides to just say no thank you to money market funds trying to post the excess liquidity at the reverse repo facility, it is the first sign that the Fed is trying to sort of push clients indirectly back into the banking system. And it would de facto be a pretty material rate cut if they decided to just cap the access to the reverse repo facility. It is designed to keep a floor below Fed funds effectively and also a floor effectively under T-bill rates. So if they decided to cap this reverse repo facility and the supply side of it, it would eventually lead to a landslide in T-bill yields and something that you should be under watch for because I would consider that very risk positive given that if you cannot park your money in a money market fund to the same extent as you've been used to, it also means that yields drop in the front end.

31:45it eventually means that more people will automatically be pushed further out the risk curve and into equities and the likes. I will leave it there for this live version of Stenos Signals. Thank you very much for watching out there and thanks for all of the great questions. We will be back again next week with another update on the global macro landscape. And one thing I can guarantee you is that it will not be boring over the next two, three, four weeks from here because the deposit flight currently continues. Thank you for watching.

32:26Thanks for joining us, everyone. Today's Real Vision daily briefing is sponsored by CraneShares. Learn about their KRBN ETF at craneshares.com forward slash KRBN.