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Stylised representation of a black bull with horns, against a green and white background, reminiscent of the cover of Ernest Hemingway’s novel, The Sun Also Rises

Articles by Jamie

Jamie Dannhauser

Economist

5 May 2023

The internal memo from which this article is adapted was written in March 2023. If you would like a copy of the original piece, please email ruffer@ruffer.co.uk.

Has the Federal Reserve finally broken the financial system?

We don’t know for sure yet. But something has broken.

Over just a few days in March, three US banks collapsed. One, Silicon Valley Bank, was the country’s eighteenth largest lender, with assets of over $200 billion. First Republic Bank, another major regional player, also appears to be on the verge of collapse.

This episode taught investors, bank supervisors and regulators a painful lesson. They were caught off guard by how fast deposits flew out of the door. Social media and mobile banking have transformed modern bank runs. In less than a week, the assumptions that underpinned a decade of (supposedly) enhanced liquidity regulation for the core banking system were blown to smithereens. For now, the fallout appears to have been contained. But this mini banking crisis has revealed concerning truths about today’s financial system – it’s fragile, just not in the way policymakers believe.

“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said.
“Gradually and then suddenly.”
Ernest Hemingway, The Sun Also Rises (1926)

WARRANTY EXPIRED

Didn’t policymakers fix the financial system after the 2008 catastrophe? Well, yes. And no.

The global systemically important banks (G-SIBs) have much stronger balance sheets than 15 years ago, when they were at the epicentre of the global financial crisis (GFC). Regulation has made sure of that. Strong enough? Probably.

The risks generated by a decade of essentially free central bank money largely reside on other, less heavily regulated balance sheets. The deeper problem is a rewired volatility-driven financial ecosystem of illusory asset liquidity. A system that nonetheless remains dependent on the G-SIBs for leverage and collateral transfer. In making their balance sheets more robust, regulators have made them far less flexible – and that is a big issue for the outer layers of the banking sector and the non-bank credit system. Central bankers’ ‘fix’ for the system after the GFC came with a warranty. That warranty looks to be nearing expiration.

We can’t predict exactly how or how fast this plays out. Phases of financial distress are unpredictable and non-linear. But it seems the dam has finally been breached. The liquidity tide has been ebbing for a while now. The froth of the most exuberant parts of the market – cryptocurrency, profitless tech, housing – began lapping against the shores of reality months ago.

So is the Hemingway recession – a well-telegraphed economic contraction moved towards gradually and then plummeted into suddenly – finally upon us? Not quite. But emergent stress in the US regional banking sector may be hard to contain for much longer.

Moment of impact

Ruffer’s liquidation thesis (outlined by Co-Chief Investment Officer Henry Maxey last summer) argued that an accelerated flow of deposits into money market funds (MMFs) would be problematic at best, and at worst a harbinger of havoc-wreaking liquidity dynamics. The recent bank collapses have accelerated this flow of deposits. The incentive to earn a higher rate of return on cash assets has quickly morphed into a strong impulse to protect rainy-day funds from wipe-out. Loss aversion is a powerful human instinct, and mobile banking has eliminated many of the behavioural frictions that previously prevented depositors acting on it.

The important thing, as Henry noted, is not the anticipation of rising interest rates, reflected in falling bond prices. It is the landing of the Federal Reserve’s (Fed’s) interest rate rises on the liquidity of a hyper-financialised system. We are approaching the moment of impact.

Generals fighting the last war

This is not 2008, when a solvency crisis (a system-wide lack of equity) spawned interlinked and self-reinforcing liquidity shocks (a funding drain combined with a lack of sellable liquid assets at stressed institutions).

Solvency crises cannot be resolved by monetary policy and lender-of-last-resort support; and they entail deep economic contractions, as the impaired credit system reinforces the negative feedback loops of all recessions.

The dynamics are critically different today. In the GFC, idiosyncratic stresses worsened the collapse of confidence in the big banks at the heart of the system. A generalised run from all leveraged financial institutions was contained only when the state deployed its balance sheet as a back-stop.

By contrast, in March, the G-SIBs have been net beneficiaries of liquidity stress elsewhere in the financial system. No doubt the system’s overall preference for liquidity (over risky assets) has increased – the central dynamic in risk-off phases. But, to date, this has been primarily about where investors want to hold their liquid assets – the very definition of a liquidity shock.

In this cycle, the causation is set to work in reverse: idiosyncratic liquidity stress, via its impact on broad financial conditions and economic activity, will threaten a solvency crisis.

The core banking system has more than enough capital and liquidity to function through a normal cyclical downturn. Crucially, if central bankers are willing (backed by the political and intellectual elite) and able (their price stability mandate is not threatened) to flood the system with liquidity, it will only ever remain a threat. The key judgement is how quickly, and how far, the major central banks will go to forestall a series of liquidity shocks morphing into a deep recession that undermines the core banking system.

The Fed will not countenance widespread financial distress that turns a run-of-the-mill recession into something far ghastlier.

The Fed is perfectly willing to be blamed for a shallow recession that prevents a repeat of the 1970s. In the long run, it would surely enhance the institution’s credibility, much as Paul Volcker is now lionised for his actions in the early 1980s. But the Fed will not countenance widespread financial distress that turns a run-of-the-mill recession into something far ghastlier. That is the route to irreconcilable political breakdown in Washington, a permanent fracture of the Republication Party and an existential threat to the Fed.

For three decades, there has been no trade-off in periods of financial distress: demand stimulus and liquidity provision could be justified to minimise the threat of deflation (falling consumer prices) and limit contagion across the financial system (falling asset prices). Today, a trade-off does exist: a potentially significant downturn is needed to curtail inflationary momentum, but the only route to a downturn is a Fed-induced squeeze on the financial system that could rapidly get out of hand.

This will not be a multi-year crisis born of excessive balance sheet leverage, as in 1929-1933 and 2008-2013. Instead, the system’s fundamental weakness is asset illiquidity. Policymakers have the artillery that worked in previous crises at their disposal, they can and probably will use it. But to do so would be in an act of short-term expediency which comes with a long-term cost.

More casualty than cause

A decade of historically repressed nominal (and negative real) risk-free interest rates has sustained an aggressive and self-reinforcing search for yield. Investors have allocated to ever riskier, more opaque asset classes. This has created the illusion of lower volatility and greater market liquidity. Lower volatility begets riskier portfolio allocations which begets lower volatility and so on, and so forth. This dynamic is perfectly fine, so long as inflation remains absent.

But the return of inflation changes the calculus. Higher inflation alters the parameters of the Fed’s reaction function. Higher inflation also tends to actuate more volatile inflation which makes for more volatility in the macroeconomy. Crucially, inflation risk demands a historically normal level of nominal risk-free interest rates – bringing the prevailing dynamic of the past decade to an abrupt end.

As the liquidity tide recedes, the too-big-to-fail major banks’ balance sheets are the obvious place to warehouse the associated risks. Constrain those balance sheets, as we have done since the GFC, and you leave the system more dependent on one institution, the central bank. In two critical ways.

Ex post, the central bank has to back-stop market liquidity more frequently and generously.
Ex ante, market liquidity and risk appetite are more closely linked to perceptions of the central bank’s reaction function.

Belief in an asymmetric reaction function – the so-called Fed put – has become entrenched. Paradoxically, this has made the financial system less volatile but more fragile.

Good news is good news; bad news is never really bad news, because the expectation of looser monetary policy both limits the downside threat to earnings and reduces the discount rate applied to those earnings. The absence of inflation risk has made such dynamics possible – and in policymakers’ eyes desirable.

As we are discovering, this has come at the cost of greater fragility: even a historically moderate level of nominal risk-free interest rates has exposed it. The Fed put may limp on a while longer, but it is not yet in the money. For now, central bankers are adamant that they have two sets of tools to manage two separate problems: interest rates and quantitative tightening to manage price instability; and lender-of-last-resort liquidity facilities to manage financial instability. The danger is that inflationary momentum keeps the Fed hawkish for longer than the market can stomach.

Reaching for the 2008 playbook is unwise. If anything, the core banking system will be more casualty than cause.

Reaching for the 2008 playbook is unwise. If anything, the core banking system will be more casualty than cause. What will be revealed is not hidden credit losses on G-SIBs’ balance sheets that threaten their viability. But, instead, flawed and unsustainable investment strategies in the outer reaches of the credit system and asset management industry.

This will be painful for investors. But it will not tip the world economy into a deep recession. Central bankers ultimately have the weaponry to prevent a liquidity crisis mutating into a solvency one. And they will use it. Much as inflation may appear a constraint today, political reality dictates that they cannot risk financial instability. Data dependency and central bank risk management (of upside inflation risks) have until now focused investor attention on spot inflation; but that cuts both ways. In an emergency, risk management will shift attention to prospective inflation. In short, elevated spot inflation will no longer constrain Fed behaviour.

A Hemingway recession

Until the recent banking stress, most analysts missed how abrupt the coming downturn would be. This explained our high conviction that central banks would pivot aggressively once the Hemingway recession revealed itself.

Early this year, things were looking a bit better, if not clearer, to the market. President Xi reopened the Chinese economy after prolonged covid-19 restrictions, providing a powerful impulse to global growth. And Europe had a warm, dry winter, alleviating fears of restricted industrial access to gas and electricity (and accompanying stratospheric prices).

Things aren’t looking as rosy now. Markets are fumbling in the dark, trying to work out what banking stress means for near-term central bank policy. Moves in front-end rates across the major currencies have been violent; rate volatility has jumped to levels last seen during the GFC. That central banks were on the verge of another hawkish tilt has only thickened the fog.

The chronic pain – a function of central banks’ efforts to tighten financial conditions – continues to build. A Hemingway recession is the logical endgame for this cycle.

We can make this statement with conviction. Not because there is any certainty that liquidity stress will remain an acute threat to the US banking sector (and the global financial system). But because prospective Fed policy is now intimately tied to the trajectory this liquidity shock takes.

If the shock remains acute, the US economy will be dragged rapidly into recession by a severe credit squeeze that ripples outwards from the regional banking sector. So bad news – acute banking stress – is surely bad news for the real economy and even worse news for inflated corporate earnings.

But so too is good news. Perversely, because a policy that restores depositor confidence, even temporarily, will re-focus the Fed’s attention on its price stability mandate and the market’s attention on a much higher terminal policy rate.

The market has been backed into a corner.

Whether because acute liquidity stress has unleashed a credit crunch, or because its resolution will force front-end rates back up, the Hemingway recession is now close at hand. It has three interrelated dimensions: first, an unexpectedly abrupt slump into recession; second, an unexpectedly dramatic deterioration in corporate margins and earnings (especially for the US); and third, an unexpected evaporation of market liquidity and risk appetite that will coincide with, or even precede, the first two.

If it isn’t hurting, it isn’t working

Why might the real economy slump abruptly?

A year into a Fed tightening cycle, it seems strange to be anticipating such a moment. It normally takes far longer for the Fed to break something. But this has been the most abrupt and material tightening cycle in four decades. Figure 1 shows the Fed’s overall policy stance: an effective tightening of over 600 basis points since mid-2021, easily powerful enough to drive the economy into recession by now.

Figure 1: line chart showing the stance of US monetary policy, 1986-2023, %

Click to view larger image

Monetary policy transmission to the real economy is proverbially long and variable. Too much emphasis has been placed on the long. Far too little on the variable.

Monetary policy effects on the real economy are contingent on a host of factors. Context is everything. This unusually fast and substantial hiking cycle suggests an abnormally large impact on growth. Yet it has taken place against an unusually benign backdrop. When central banks started hiking, the economic system had several buffers that should delay, possibly even diminish, the impact of monetary tightening.

The mistake would be to confuse a diminished economic impact with a delayed transmission to activity. Buffers get used up.

The mistake would be to confuse a diminished economic impact with a delayed transmission to activity. Buffers get used up. Ultimately, it is through the level of interest rates, and credit conditions more broadly, that monetary policy increases or reduces aggregate demand. Those safety buffers explain why spending has been so insensitive to the hiking cycle thus far. But, even if growth headwinds have taken longer to build, they are now blowing strongly, which will become apparent as the buffers normalise through 2023.

Everybody behaves badly – given the chance

The second dimension of the Hemingway recession is an unexpectedly dramatic slump in corporate earnings. Despite the most severe Fed hiking cycle in decades, equity market investors have maintained a benign view of earnings prospects through 2023-2024. That’s not unusual: at the peak of the cycle, analysts’ forward earnings estimates rarely reflect prospective macroeconomic dangers.

This smacks of classic end-of-cycle complacency. Risk metrics are always most depressed when macro dangers are most pressing. But, in this cycle, the threat to corporate earnings is even more serious than that to the real economy. Indeed, what could well be a shallow downturn for economic activity may be very unpleasant for the listed corporate sector.

The unique post-pandemic circumstances allowed firms to increase mark-ups and profit margins significantly. And firm-level data shows that the most profitable ‘superstar’ firms, which overlap significantly with the growth darlings of the S&P 500, increased mark-ups the furthest. In caricature, the pandemic shifted demand more towards the ‘nationwide goods economy’ and away from the ‘localised service economy’.

In downturns, labour costs tend to run ahead of prices, sustaining real wages for a time once the cycle has turned, thereby squeezing corporate margins. Just such a dynamic is already apparent in the macro data. Labour has the upper hand now. In short, corporate earnings could be squeezed far harder than headline macroeconomic variables would suggest.

Air pocket ahead

There is a widespread view that a shallow recession will translate into a run-of-the-mill bear market which, with the S&P 500 down 14% from its end of 2021 peak, we are already some way through.¹

This is dangerously complacent. The logical causation does not run from a shallow recession to a contained bear market. Instead, something has to break in financial markets to ensure that nothing breaks in the real economy. Unacceptably high inflation is the reason why. We can put to bed the notion of an immaculate disinflation: a return to 2% inflation without a recession.

Only financial market dislocation will create the political space for central banks to take their foot off the brake. But they cannot hit the accelerator pedal until this dislocation has become systemically threatening. If this cycle has an overarching theme, it is this: central banks will break something of high political salience long before they’ve fundamentally cured the system of its underlying inflation problem.

Everybody likes to get rid of inflation but when one comes up to actions that might actually do something about inflation, implicitly or explicitly, one says: ‘Well, inflation isn’t that bad compared to the alternatives.’”
Paul Volcker

We have high conviction on this view, and for good reason – central bankers have told us this before. Admittedly, it was Paul Volcker – the now lionised former Chair of the Federal Reserve – speaking at the February 1981 meeting of the Federal Open Market Committee. His observation reveals the reality we are soon to encounter: “Everybody likes to get rid of inflation but when one comes up to actions that might actually do something about inflation, implicitly or explicitly, one says: ‘Well, inflation isn’t that bad compared to the alternatives.’”

Bloomberg, as at 3 May 2023

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