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When I published my piece on Tuesday on the failure of Silicon Valley Bank, I questioned whether Silicon Valley Bank’s failure really was a “systemic risk”. I still don’t think those questions were unfounded. But there was too much to digest in the episode itself for me to spend time thinking about the knock-on effects. One of those knock on effects is on the treasury security market. Why is the issue of uninsured depositors at mid-sized banks having an impact on the treasury market? Answering that takes quite a lot of unpacking. We will also be learning more about it in the coming days, and weeks.
The essential issue seems to be not so much “financial contagion” from the failure of Silicon Valley Bank (that’s how systemic risk is ordinarily understood.) Rather, it’s the implications of the Federal Reserve’s actions over the weekend. It is strange to see the Federal Reserve launch a facility commonly interpreted as a “crisis” facility using its 13(3) powers in the current economic situation(check out my Silicon Valley Bank piece as a refresher here). That’s because unemployment is low, inflation has been high and the Federal Reserve is raising interest rates. One interpretation of this event, consequently, is that the Federal Reserve is going to be lowering interest rates.
Yet, inflation remains above the Federal Reserve’s target. It would be quite an extraordinary situation in these circumstances to see the Federal Reserve lower interest rates at a time of elevated inflation. You can see the dilemma. Government securities dealers — those people who buy and sell treasuries every day — are as confused and unsure as you are about which way interest rates will go, in these circumstances. When bond traders are confused and unsure about which way interest rates will be going to this degree, treasury market issues result.
Here is where things get really funny (if you find financial system ironies funny like I do). Remember Silicon Valley Bank? Remember why it failed? Interest rate risk! What was that risk? Interest rates rising and making their bonds worth less! What are those bonds now? More valuable! But it gets better! Many, many participants — including treasury security dealers — have uniformly expected interest rates to keep on rising. What do you not want to be doing when interest rates are rising? Losing money when interest rates rise.
How do you do that? Well, you make bets that work out… if interest rates keep on rising! You might begin to see the problem here.
This weekend a lot of people spent a lot of time haranguing Silicon Valley Bank for not managing its “interest rate risk” properly. In other words, being so exposed to rising interest rates. These bond traders are making sure they aren’t exposed to rising interest rates. But that means they are leveraged, and very exposed to falling interest rates. That’s a replay of many of the same treasury security issues in 2020. I think this kind of leverage should be limited — but that same limitation would keep them more exposed to rising interest rates.
Of course, at a deeper level what we are talking about is that risks can be managed, but it's an illusion they can be gotten rid of completely. You can manage interest rate uncertainty, but at the level of the economy as a whole, interest rate uncertainty can’t disappear. One funny thing is that if it did, interest rate changes would have no impact on the economy at all! Everyone would be “compensated” for interest rate changes, because of their “hedges”. So no one’s balance sheet would be affected.
In the actual world, if everyone bought interest rate risk insurance (a derivative product called interest rate swaps lets say) then the insurers who sold us all this product would risk losing more than what they have put aside to pay claims. They would then go out of business. If they did, we would take losses. Not only that, because of the insurer’s default, we would still be exposed to interest rate changes! Famously, this was essentially what happened with insurance giant AIG in 2008. AIG was selling insurance against the default of a certain type of mortgaged backed bonds called “CDOs”, rather than interest rate risk — but the principle is the same. They sold insurance for one side of a bet in very large amounts, and were threatening bankruptcy that would have taken down the rest of the financial system. So they were duly rescued by Federal Reserve (and federal government) action. You can read more about those 2008 details in this piece I wrote back in 2020. You can’t get rid of the uncertainties, you can only transform one kind of uncertainty (interest rate changes) into another kind (default uncertainty).
From my point of view all of this is so funny because what’s obvious in one week —“make sure you’re not exposed to interest rate increases!” — becomes “make sure you’re not exposed to interest rate decreases!” next week. The Federal Reserve keeps these contradictions at bay by providing clear guidance about where interest rates are going. What happens changes based on data changes, but generally new data is seen as having a clear implication for what the Federal Reserve is going to do. Today however, that is not the case. Using 13(3) this weekend points to interest rate declines, but continued inflation points to interest rate hikes. Whatever the Federal Reserve decides next week will be a surprise.
The other layer to this are those “treasury liquidity strains” this all started with. When non-experts hear about “liquidity strains” in the treasury market, they tend to assume that means the U.S. treasury has to offer higher interest rates to sell securities. However, that often isn’t the case. In fact, these periods tend to coincide with falling treasury interest rates. In March 2020, liquidity in treasury markets worsened. Some short maturity treasury securities even experienced negative money interest rates. That means the situation was so uncertain, many actors were willing to pay such a premium that they would get less money back when the security matured then they paid for it. After all, losing a bit of your money is better than losing it all. To be clear, I’m not talking about “inflation adjusted” amounts. I mean literally, they paid 100 dollars, and got back 98 dollars.
So if “liquidity strains” don’t necessarily mean rising interest rates, what do they mean? They mean the price at which you can buy a treasury is further away from the price at which you can sell a treasury. In this sense, while we don’t often think about it, there is usually never one “market price” to any item. There is instead the asking price. That’s the price that some entity is willing to sell the item, and the bid price i.e. the price that some entity is willing to buy an item. If you think about it, we experience huge differences between the “buying price” and the “asking price” of items every day. When you go buy something from a corner store, the moment you buy it, you can’t just sell it back to the store, or someone else at the price you bought it. If they are willing to buy it back at all, it will usually be at a huge discount over the selling price.
In the terms of financial professionals, that’s called a large bid-ask spread! This is just a fancy way of saying the difference between the buying price and the selling price. Most of the everyday goods and services we purchase have very large bid ask spreads, and some simply can’t be resold by an individual at any price. This is especially obvious with services. If you purchase a foot rub, you can’t sell that foot rub to someone else for the price you bought it for! You just have to get that foot rub.
Which brings me back to treasury securities. A lot of what happens in financial markets is the creation of new products that have big bid ask spreads because big spreads means big profits. Then other people start participating in these new financial markets and as the market grows, spreads tighten. The market becomes more and more liquid i.e. those bid ask spreads shrink. At that point financial professionals seek out a new illiquid market to create. In other words, financial professionals seek to both buy and sell the same financial assets. The difference between the prices they offer to buy and the prices they offer to sell is their profit margin (very roughly speaking).
The treasury market is supposed to be the most liquid market in the world, i.e. the financial market with the smallest difference between buying and selling prices. Interest rates change all the time, but what that means is just that the buying price and the selling price move together. Unless something like what’s happening now is going on. Let’s think about this by thinking about the interest rate uncertainties we’re currently experiencing.
Normally, bond traders have a pretty good sense of where interest rates are going to go. They are not always right (by any stretch). But this usually does not impact the differences between buying and selling prices that much. One way to think about this is, when bond traders are wrong they tend to be wrong slow enough and gradual enough that there is time for them to “catch up”. And generally, for the past 30 years if not more, when they are really wrong it's obvious. So both buying and selling prices really jump. When Lehman Brothers collapsed, everyone understood short term interest rates were going to go to zero and stay there for a while. If inflation had been 6% when Lehman collapsed, the treasury market may have faced the same problems it's facing now.
Faced with this uncertainty, the treasury market is getting less liquid. That means selling prices and buying prices are diverging even though interest rates are overall declining. But remember those bets that so many government bond market participants made? This is where they get hammered twice. Not only are interest rates going down when they expected interest rates are going up. In addition, “bidding interest rates” and “selling interest rates” are diverging, when these same bets often assume that the treasury market is liquid. In other words, embedded in these bets about the direction of interest rates are bets about the differences between bidding interest rates, and selling interest rates. In short, they also bet the spread would be small when the spread has been getting larger.
The final component of this on my radar is something that financial economist Daniela Gabor said over on Twitter:
“Why would you sell securities you can monetise at the Fed for par value?” This returns us to a more direct impact of the Silicon Valley Bank failure and the Federal Reserve response than the possible implications of that response for interest rate policy. The Bank Term Funding Program (again read Tuesday’s piece for the details) provides terms that are so overwhelmingly generous. That calls into question why any chartered bank (“depository institution”) who is allowed to access the BTFP would be selling treasury securities right now. What’s the point? You get a better deal handing it over to the Fed as security for a loan.
This makes sense for them individually, but it means suddenly trillions of dollars of treasury securities are not available for sale. Many fewer treasury securities “in circulation” must be having an impact on this liquidity situation. These banks would need a selling price that is much higher than the buying price, in order to be willing to sell their securities. This is a fluid and volatile situation, where the news coming out is confusing and fast paced. As a result, it will be months, maybe even years, before we have a good idea of how big the direct impact of this quasi-emergency facility was. Some other elements of this piece may be subject to revision once we learn more. But this is how I think the “state of play” looks today.
So what does all this mean? What’s the policy implication? There are a number, but for right now the big picture I want to end on is that it’s hard for me to see this as a result of the failure of Silicon Valley Bank. Events may further call into question the view I provided on Tuesday. But I don’t actually think the treasury market strains illustrate that they were right to treat this as a crisis (Credit Suisse might, I am still formulating my view on that particular crisis!) Instead, what they illustrate is that the Federal Reserve didn’t think through what they were doing.
It is no secret I have not been a fan of the Federal Reserve’s interest rate increases. However, if you are going to continue them then, when you announce the use of what is normally seen as a crisis facility, that should come with clear explanations of the implications for interest rates. Indeed, it's maddening to even have to say this! Forward guidance is supposed to be what the modern Federal Reserve is all about! If they had said “interest rates will keep on increasing as usual, though we probably will be doing smaller interest rate hikes for the next three months”, then the implications of this situation would be clear. Treasury security interest rates would have rapidly adjusted without impairing treasury liquidity.
Of course, the Federal Reserve might not want to do that — because they might want to avoid acting like the European Central Bank and raising interest rates into the teeth of a potential financial crisis, like the ECB did in June 2008 (or, um, what it just did today). But then, if you’re worried about that eventuality, you simply say you are pausing interest rate increases for the next three months! You can even declare that you will be doing small interest rate cuts. But you don’t have to go that far. Regardless, provide forward (i.e. "future”) guidance on whatever you will be doing soon! Getting things “a little wrong” is better than causing more financial system problems with indecision.
Now, there may still be a question of those big bets taken on rising interest rates in this circumstance. With smaller spreads, i.e. better liquidity because they provided clear expectations those issues would be less severe. But nonetheless, there may be some “liquidity strains” which appear as a result of those. All that means is you need to pair your crisis response with more treasury security purchases. I know the Federal Reserve is obsessed with “shrinking its balance sheet”, but net selling treasury securities doesn’t actually change economic conditions very much. It simply periodically causes financial market problems, which force them to start net buying treasuries again. Preemptively announce the purchases when you know there will be issues, and let's skip the whole song and dance. As I said in 2020: “The Way People Talk About the Federal Reserve's “Big” Balance Sheet is All Wrong”. Indeed, the Fed is already “expanding its balance sheet”, lending against treasury securities with its fancy new program right now!
This is why I haven’t been convinced that there was really systemic risk involved in the resolution of Silicon Valley Bank. Most of the issues which we are seeing right now are caused by the incomplete and incoherent Federal Reserve response, rather than the direct financial institution implications that were originally brought up.(A big exception is Credit Suisse, that I'll be investigating shortly.) As I said earlier, I may yet revise my views on the Fed's response. But even if I do, their response still makes no sense, and has proven to be incredibly shortsighted. Make a decision, stick to it, then make financial conditions consistent with your decision. Wishy washiness is a killer in times of financial stress. Let’s see how Tuesday’s FOMC meeting goes. I hope their choice to wait that long does not prove fatal.