Thursday, March 16, 2023

Fed Tightening (April 13, 2022 - March 8, 2023)

We wrote in our Energy - Q4 2022 Earnings Season post that we have been fighting two headwinds for the past year in our investments: tightening by the central bank, and releases of crude oil from the Strategic Petroleum Reserve.

The Federal Reserve began shrinking its balance sheet the week of April 13, 2022, after it had just hit an all time high of $8.96 trillion of assets. (The Federal Reserve prints money to buy the assets that it owns, which are mostly U.S. Treasury and mortgage-backed securities, so the size of the balance sheet essentially reflects the cumulative amount of money printed since the inception of this central bank.)

Prior to the bank failures last week, the size of the balance sheet had been reduced to $8.34 trillion, a reduction of about seven percent. The latest release shows that the assets have started to grow again:

The balance sheet now has $8.64 trillion of total assets. That is a weekly increase of $300 billion, or 3.6%, which means that it retraced half of the total reduction of $600 billion that took almost a year (from April 13, 2022 - March 8, 2023) to accomplish.

We have seen since 2008 that the Fed's attempts to shrink its balance sheet (i.e. "taper") are bearish for risk assets, and that they have been short lived, and also associated with rebounds that are much larger than the amount of reduction. That is why the balance sheet has grown over time and is an order of magnitude larger than it was twenty years ago.

As we wrote over the weekend, it seemed likely that the bank failures of Silicon Valley Bank and Signature Bank (and threatened failures of several other big, important banks) would bring this episode of tightening to an end:

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

We have only one data point to go on, but we seem to have reached the point where the path of least resistance is to go back to printing money. Our cynical view was that it was only a matter of time until they reached this point:

We like ConvexityMaven's theory that the Fed is going to do yield curve control. Instead of letting the bond market crash and taking everything else with it, print money and buy bonds - keep the yields capped. But as the Maven says, in this scenario, "the other side of the balloon gets squishy" - meaning inflation.

If you look around the world, you will notice tons of countries with fiat currencies are running high inflation rates. Meanwhile, deflationary collapses are rare. Can you imagine the central banks of Brazil, Argentina, or Ghana tightening enough to cause a deflationary collapse? It has never happened, because the path of least resistance is inflation.

Betting on inflation is the cynical bet. But we have to be cynical enough to realize that the central bank doesn't want us hoarding real assets and is going to try to trick us with jawboning talk. People will believe the talk and there will be violent selloffs. This is why we like "first class" inflation protected assets and not leveraged junk.

We actually mentioned back in October 2022 that banks would be a casualty from tightening that might force the Fed to stop:

Banks own tons of treasuries, and their balance sheets have been devastated by the increase in the ten year bond yield, something that is being chronicled over at Oddball Stocks. Higher interest rates also mean that the interest on the $31 trillion federal debt grows, which is a positive feedback loop since the debt is not being serviced. And high interest rates choke the economy, which is unpleasant and also lowers tax revenue - worsening the debt spiral - and causes banks' loans to default. So it has seemed clear to us that printing money to buy bonds (yield curve control, capping bond yields) is the path of least resistance, "kick the can" approach that the regime will choose.

This cynicism about the Fed taking the path of least resistance dates back to our "Rethinking Inflation" post from September 2021:

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.) If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing. Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.

Retracing half of the balance sheet reduction that took a year in only one week is consistent with the results of the previous attempts at tightening.

Note also that Berkshire was buying Occidental Petroleum every day this week while the market (and particularly energy stocks) were crashing.


CP said...

The $297 billion of money printed last week is the second largest weekly total ever:

Largest was Mar 25, 2020 - $586 billion.
Third largest was Oct 1, 2008 - $292 billion.

Anonymous said...

Deflation dead ahead.

CP said...

For the past year, this column has repeatedly warned that Quantitative Tightening (QT) would result in failure and force the Federal Reserve into another round of emergency liquidity injections, just like the repo crisis of September 2019. And just nine months after the official start of QT, here we are.

CP said...

“Quantitative easing” is a classic example. It was marketed as a temporary policy to fight a recession in 2008-2009 when interest rates were close to zero. It is now permanent, whether we are in a recession or in a boom. The way I look at it, the larger Fed balance sheet has survival value because it channels more of the public’s savings into government debt.