Q1 2023: “From Big Squeeze to Banking Crisis”
We’ve all surely become numb to how extraordinary things are. We’re living through a critical period of history in real time.
The quarter started with a powerful cross asset short squeeze – stocks, bonds, corporate credit, the cryptocurrencies.
In the face of economic resilience and persistent inflation, market yields nonetheless sank to start the year. After beginning January at 3.88%, 10-year Treasury yields were down to 3.37% by mid-month. Shorting Treasuries had become one gigantic “crowded trade” – with huge hedging-related shorts along with bearish speculative bets. An intensifying short squeeze and unwind of hedges – that began in Q4 - significantly bolstered marketplace liquidity, with loosened conditions stoking a powerful equities squeeze.
At its February 2nd peak, the Goldman Sachs Short Index had gained 35% y-t-d. The Nasdaq100 was up 18%, the Midcaps 12%, and the small caps 14% - all significantly outperforming the 9% S&P 500 gain. Last year’s big winning macro trades – including shorting tech stocks, Treasuries, corporate credit, and crypto – all reversed sharply higher.
But so much abruptly changed in March, with the eruption of banking system instability and two of the three largest bank failures in U.S. history. I’ll return to the spectacular Silicon Valley collapse and banking crisis.
As a segue to our performance discussion, I’ll highlight pre-crisis stock trading in Silicon Valley Bank – or SVB - as an illustration of how challenging the quarter was on the short side.
Imagine you were an ace short-side bank analyst – having astutely researched SVB’s balance sheet, securities holdings, and asset/liability mismatch. You were convinced SVB was in trouble – with 100% conviction. It was your favorite short, and you came into the quarter with an outsized short position. Well, at its February 2nd peak – the stock had surged 48% y-t-d. The number of shares - sold - short had increased 60% during Q4 – just in time to get slammed by a major squeeze. And while some shorts could have had the staying power, we can assume that many reversed their losing short bets weeks or even days prior to the stock’s stunning collapse. SVB provides a cogent example of the ongoing difficult environment for shorting individual company stocks.
In this environment, the odds of major squeezes are unusually high. Arguably, these are the most speculative markets since the late-1920’s. There are tens of millions of online accounts trading stocks from home. American households, enamored by the perceived liquidity and safety of ETFs and enthralled with option trading, has never been as active in the markets. And there are individual hedge funds that with tens of billions of assets – and investment companies with trillions – all aggressively playing the game.
A record 68 million option contracts traded on the CBOE on February 2nd, the peak short squeeze day I mentioned earlier. 3.2 billion options were traded last year at the CBOE, the third consecutive annual record. Volume on individual company options has doubled since 2019 (FT). Yet no option category has enjoyed such breakneck growth as ultra short-term options – so-called zeroDTE - or “zero days to expiration” options.
Meanwhile, there’s a multi-Trillion dollar global leveraged speculating community – the hedge funds, family offices and such. We’ve witnessed a proliferation of quant funds and algorithmic trading – that tend to be trend-following momentum traders.
In general, the institutional investment-management complex has become heavy users of trend-following models and derivative hedging strategies.
And especially after the Fed-induced Covid crisis rally, there’s a cottage industry of institutions and online traders dedicated to targeting short positions - given any opportunity.
Putting it all together, there’s no surprise here that markets have turned so acutely speculative, unstable, and unpredictable.
Let’s return to Silicon Valley Bank. And to begin, I’ll share some relevant data that I hope brings some perspective to the unfolding banking crisis.
At $25.6 TN, total U.S. Banking System Assets ended 2022 almost double 2007. Bank Assets ballooned an unprecedented $5.5 TN, or 28%, over just the past three years.
The Federal Reserve’s balance sheet inflated $5 TN on the back of covid stimulus. Keep in mind that QE comes with disparate dynamics and impacts. 2008 crisis QE was mainly the Fed creating new money to accommodate deleveraging – providing liquidity to financial institutions and speculators, so they could de-risk and pay down debt. The pandemic $5 TN QE was altogether different. Not only was it not part of deleveraging, but massive monetary inflation incentivized risk-taking and speculative leverage.
The Fed flooded the system with unprecedented liquidity that, to a large extent, led to the creation of Trillions of new bank deposits. And what did the banking system do with this deluge of deposit money? They loaned aggressively and loaded up on more securities. Worse yet, this massive monetary inflation came after years of credit bubble excess.
Too much of the recent lending boom was of the late-cycle, high-risk variety. It was too often directed at the bevy of uneconomic enterprises that proliferated throughout this boom – as well as financing loans to over-priced office buildings, multifamily housing, and all types of commercial properties. Moreover, much of the portfolio buying was Treasury and agency securities whose market prices had been inflated by the Fed’s zero-rate and QE policies.
At SVB, commercial loans were up 140% in three years, while its securities portfolio surged four-fold – from $29 billion to $120 billion. Deposits doubled to $81 billion. SVB is somewhat of an outlier, yet total banking system Treasury holdings jumped 80% in three years, corporate bonds 49%, and Agency&MBS holdings 20%.
Bank Loans last year increased an unprecedented $1.4 TN, or 11.3%, more than doubling the previous annual record from 2015 – with loan growth also double peak annual lending during the mortgage finance bubble period.
Such late-cycle excess ends badly. Ominously, we’ve already witnessed the eruption of a banking crisis – with major runs and failures – despite only 3.5% unemployment, positive GDP growth, and so far uninterrupted credit expansion. The crisis was kicked off with securities portfolio losses and deposit flight. Severe credit issues will be forthcoming. We’ll see more judicious bank regulators, along with nervous lending officers and bank managements. Standards will tighten, and loan growth will slow, marking a major inflection point in what have been historic credit and economic cycles.
For the here and now, I’ll highlight recent incredible market instability – a key late-cycle manifestation of what I refer to as “monetary disorder.”
Two-year Treasury yields, as high as 5.07% in early March, dropped to as low as 3.71% on March 15th. In three sessions, market expectations for the Fed’s policy rate in December collapsed almost two full percentage points - from 5.67% to 3.73%. This rate is now back up to 4.64%, with two-year Treasury yields having recovered to 4.2%. Markets were quick to price in a crisis – or at least a recession and dovish Fed pivot.
The Fed moved immediately to establish a new lending facility, while the failures of SVB and Signature were deemed as a sufficient systemic risk for the unusual action of protecting even uninsured deposits at these banks. Yellen has waffled on the issue, but at this point there appears an implicit blanket guarantee of U.S. bank deposits. The Fed also bolstered swap lines with foreign central banks. Clearly, Washington officials had real fear that the bank run could spiral out of control. The upshot: more desperate measures to thwart bubble collapse.
Federal Reserve assets surged $364 billion in three weeks, reversing two-thirds of eight months’ worth of quantitative tightening. And, importantly, it appears the Federal Home Loan Banks – or FHLB – expanded member lending an additional $400 billion. This was an extraordinary amount of liquidity quickly injected into the system, rivaling the panicked 2008 response.
Over the past five weeks, money market fund assets surged $384 billion to a record $5.3 TN, with year-to-date growth of $463 billion, or 42% annualized.
The SVB-related bank run dynamic is different than the 2008 run on Lehman Brothers’ “repo” and money market obligations. However, there are today unsettling parallels to the backdrop heading into the great financial crisis.
Not coincidently, when the subprime mortgage crisis erupted during Q3 2007, FHLB “Loans and Advances” surged a record $180 billion. And over the five quarters Q3 ‘07 through Q3 ‘08, total government-sponsored enterprise – or GSE - assets inflated a record $1.6 TN. Powered by the GSEs, Financial Sector borrowings expanded an unprecedented $2 TN, or almost 14%, in 2007. I know these numbers can be numbing, but the key point is that in response to the initial piercing of the mortgage finance bubble, the GSEs stepped up to provide a massive liquidity backstop. Financial sector debt expanded rapidly, taking up the slack from incipient marketplace deleveraging.
I have argued that these operations only worked to extend the terminal phase of Bubble excess, in the process exacerbating market, financial and economic fragilities. Clearly, GSE liquidity operations didn’t prevent crisis in 2008. Instead, risk became only more precariously concentrated in a rapidly ballooning financial sector.
Last year, GSE Assets expanded an annual record $921 billion, to $9.2 TN, as total Financial Sector borrowings increased $1.8 TN. These were by far the largest expansions since fateful 2007. And I expect record Q1 growth in GSE assets, perhaps surpassing $500 billion.
Extraordinary lending by the Fed and GSEs is extending the cycle, but I fear the consequences will be similar to ‘08: acute monetary disorder and more fragility for speculative markets, the financial system, and the bubble economy.
For more than a decade, I’ve referred to the “global government finance Bubble.” And we see today a system dominated by government finance – the Federal Reserve, the Treasury market and the GSEs. From my perspective, it’s runaway debt growth that will prove difficult to contain.
The federal deficit surged to $378 billion last month, almost double March ‘22. Halfway through the fiscal year, the deficit has already reached $1.1 trillion, 65% higher than comparable 2022.
My hopes that higher bond yields might impose some discipline on Washington have been dashed, as the bond market now prepares for some type of accident. Markets are pricing a 50 bps reduction in the Fed’s policy rate before year-end, while Fed officials are rather adamant with “higher for longer.” The way I see it, it’s not so much that the market is expecting a couple rate cuts - as it is the market pricing probabilities of a major development forcing the Fed into a dovish pivot. Think in terms of the market seeing, say, a 50% probability of an accident that would induce a 100 bps cut – or perhaps 25% probability of crisis forcing the Fed to slash rates 200 bps.
With the current backdrop quite conducive to a market accident, rate cuts this year are a distinct possibility. But I don’t expect the Fed to be in as much of a hurry to pivot as markets anticipate. For starters, the Fed has again injected significant liquidity – when they were supposed to be removing it to fight inflation. Moreover, this latest shot has spurred another short squeeze and unwind of hedges, creating liquidity for loosened market conditions. “Risk on” has the potential to again complicate the Fed’s inflation-fighting efforts.
And brief comments on inflation. Fortunately, price gains have come off the boil. However, inflationary pressures persist. Labor markets remain tight and wage gains elevated. Crude oil and gas prices reversed higher after unexpected OPEC production cuts. We believe that there are significant structural issues that ensure ongoing risk of heightened price pressures. These include de-globalization and trade frictions, persistent supply chain challenges, myriad factors associated with climate change, and constrained supplies of many global commodities. We continue to see corroboration of our new cycle thesis.
And while markets assume the Federal Reserve will swiftly slash rates back toward zero in a crisis environment, there are reasons Fed officials might move cautiously this cycle. Even in an economic slowdown, we expect inflationary pressures to prove sticky. The ongoing inflation scare will not be soon forgotten. Moreover, banking and market upheaval will ensure the Fed has no alternative but to once again significantly expand its balance sheet. This could leave Fed officials wielding their rate cutting tool less zealously. Besides, at this point, even the Federal Reserve recognizes that low interest rates come with major unintended consequences.
Importantly, the SVB crisis exposed a key risk that has grown stealthily throughout this boom: with a simple keystroke, depositors, investors, and speculators can instantaneously exit a position. No need to drive to your local branch and get in a long line to participate in a bank run. Some years back, I introduced the “moneyness of risk assets” concept – an evolution from the “moneyness of credit” that was at the heart of the mortgage financial bubble. Government policies – Fed and GSE liquidity backstops in particular – have instilled the perception of safety and liquidity upon a large cross-section of financial-market risk assets – including stocks and corporate credit.
I view the incredible ongoing surge in money market fund assets and ETF shares as creating particular vulnerability. Money fund assets have expanded $1.44 TN, or 38%, since 2008, with the ETF complex inflating more than 10-fold from $600 billion to $6.5 TN. A sudden shift in perceptions of safety and liquidity – along with millions of nearly simultaneous keystrokes – and immediately there are highly destabilizing runs on trillions of market holdings.
In previous calls, I have discussed the risk posed by dynamic hedging of derivative positions. Those that have sold derivative hedges must, in a declining market, sell instruments to have the required cashflow for payouts, creating the risk for cascading sell orders to overwhelm marketplace liquidity. In the event of a run - on money funds and/or ETFs, the concurrent triggering of massive derivative-related selling would quickly lead to market dislocation. At this point, these risks are disregarded because of faith in the Fed liquidity backstop. I fear it is because of Fed and GSE backstops that this crash risk has been building for years.
I believe the great bubble has been pierced, with policy measures only delaying the day of reckoning. After a historic lending boom, banks will now pull back. SVB was at the heart of finance for startups, providing a lifeline for scores of negative cash flow companies. Overall, the first quarter saw dramatic drops in both venture capital finance and private equity. There are also cracks in so-called “private credit,” illustrated by redemption issues with Blackstone’s $70 bn BREIT fund and similar vehicles. There are also holes in “decentralized finance” and ongoing issues with crypto.
Stress is mounting rapidly throughout commercial real estate. Banks and insurance companies are backing away from office building finance, while property buyers have turned risk averse. And with the money spigot being turned down after years of excess, expect a steady drumbeat of bad news. Multifamily transactions have also slowed sharply, with even indications of waning investment demand for single-family homes.
Everyone has grown accustomed to economic resilience. But it really has been the unheralded force of powerful credit expansion driving growth dynamics. Even last year, with securities markets under pressure, the irrepressible U.S. economy hardly missed a beat. It didn’t miss a beat because of record bank lending.
I believe Q1 marks a major credit bubble inflection point. Bank lending will now slow. Currently - buoyant securities markets are providing an uptick in bond issuance, for now somewhat offsetting the bank lending downturn. But tightened bank finance can be expected to transmit to tighter market conditions, risking significant credit weakening.
A credit downturn after such a historic boom cycle is sure to come with a parade of negative surprises. First it was crypto and FTX. During the quarter, instability erupted in the riskier banks. Now tighter credit will squeeze scores of negative cash-flow startups and uneconomic business models. And, more generally, a restrained credit environment will finally begin to expose the severe economic structural maladjustment that comes from years – even decades – of excessively loose finance.
As I’ve explained in the past, the “government finance Bubble” is the end of the line. There are no other credit sources to be expanded sufficiently for reflating the next bubble. The Q1 reflation of the Fed’s balance sheet confirms system fragility, while supporting my view that the Federal Reserve will be forced to aggressively expand its balance sheet to keep a deeply maladjusted financial sector liquid. Furthermore, the six-month trillion-dollar federal deficit is a harbinger of things to come.
Gold surged $145, or 8%, during the quarter, as the dollar declined 1.0%. Gains in the shiny store of value are consistent with our view of heightened financial stability concerns. Both the Fed and Treasury are trapped in inflationary policymaking. I fear the Fed’s balance sheet will inflate by trillions come the next serious de-risking/deleveraging episode. And I would not be surprised by $2 trillion annual fiscal deficits as far as the eye can see.
For years, the dollar has withstood misguided policymaking and perpetual current account deficits. Our currency has been underpinned by the global perception that U.S. finance is sound and Federal Reserve operations ensure robust securities markets. I fear the dollar is now vulnerable to shifting perceptions.
And as far as deficits go, the federal government has company. The latest projection has California facing a $22 billion fiscal hole, alarming deterioration from a recent $100 billion surplus. Deflating bubbles are in the process of radically altering the fortunes of governments, financial institutions, businesses, and households.
The new cycle presents challenges but also opportunities. We believe an unfolding crisis of confidence in policymaking and finance bodes particularly well for the precious metals. We also expect new cycle dynamics will support significant hard asset outperformance relative to financial assets.
I need to spend a few minutes on China. I continue to be astonished by Chinese developments. It’s still difficult to believe that Xi Jinping has chosen to closely align China with the likes of Russia, Iran, Pakistan, and North Korea. That he is willing to embrace his “partner without limits” after Putin’s brutal Ukraine invasion speaks to how determined he is to pursue new world order transformation - to counter the U.S.
The geopolitical environment is today fraught with risk – perhaps extreme risk. Putin is not backing down in Ukraine. And while we’ve all grown numb to it, Putin’s nuclear sable rattling is turning only more alarming. He is positioning nukes in Belarus, while testing nuclear capabilities in the Pacific. I’m assuming the odds Putin would actually resort to nuclear are low, though probabilities of some type of nuclear blackmail increase as the war grinds on.
Relations with China are also at new lows. It’s only a matter of time before Xi moves on Taiwan, though most analysts believe military confrontation is still a few years off. Recent Chinese military drills rehearsed the enforcement of a full island blockade, a scenario top Taiwanese officials have warned is more likely than outright military invasion. Last week, Chinese military officials stated they were ready to fight, a declaration seemingly directed more at Washington than Taiwan. China’s defense minister just met with Putin, where Russia and China announced closer military cooperation and a deepening partnership.
This is a critical juncture for China. Their historic bubble has been pierced, with severe stress enveloping the massive developer industry and the Chinese economy more generally. And in a world that now views banks more guardedly, China’s bloated $60 TN dollar banking system is vulnerable. Their economy had started a free-fall late last year, provoking extraordinary measures from Beijing. They instituted a comprehensive stimulus plan, loosened monetary policy, and dropped “zero covid.”
And with last week’s data, it became beyond a doubt to me: Beijing is absolutely determined to do everything possible to resuscitate China’s economic boom.
China’s Aggregate Financing, their metric of system credit growth, expanded a much stronger-than-expected $780 billion last month. And a huge March put Q1 Aggregate Financing growth at an incredible $2.1 TN. This was the largest ever three-month growth in Chinese credit, surpassing even the Covid crisis response. Not many years ago $2 TN of credit growth would have been a banner year. Now it’s done in a span of 90 days. Chinese officials are trapped more deeply in bubble dynamics than even we are here in the U.S.
Beijing has done an about face. They’ve clearly thrown in the towel on reining in credit excess. Caution thrown to the wind. And to dump this amount of new credit on such a deeply maladjusted system is playing with fire; a gamble that makes me uncomfortable. It is, however, consistent with the view that Xi’s global ambitions have become China’s top priority. He needs a stronger economy as he forges trade and military alliances to counter the U.S. and West. Uninterrupted growth is necessary to further expand his military and global superpower ambitions.
In what was a notable escalation of rhetoric, Xi last month took a direct swipe at the U.S., saying, “Western countries, led by the United States, have implemented all-round containment, encirclement and suppression against us, bringing unprecedentedly severe challenges to our country’s development.”
And the following week Bloomberg reported similar from The People’s Bank of China, where the PBOC will “appropriately respond to the containment and suppression of the US and other Western countries.” And this statement was released following “a meeting to study Xi’s speeches during the National People’s Congress session…”
I can only shake my head. These comments speak to an irreparably damaged China/U.S. relationship. It was the most direct effort by Xi to cast blame upon the U.S. for China’s expanding problems. I’ve long feared that China’s bursting bubble would somehow see Beijing holding its U.S. and Japanese adversaries responsible. Well, it’s happening. At the minimum, it’s doubtful that the Fed and PBOC will be on the same page with crisis management cooperation as they were in 2008.
I hope I’m wrong on this. But I’m compelled to share a fear. Beijing is now in full crisis management mode. They are expending tremendous resources to restart their boom - fighting a deflating bubble with all the might the communist party can muster. Beijing is working 24/7 to build alliances to counter U.S. global power and influence.
They are executing a comprehensive plan for economic revival at home and profound change globally. Meanwhile, Beijing is also preparing for “plan B.” Sure, massive stimulus and state-directed lending can ensure China meets near-term GDP targets. I just don’t see China escaping bubble dynamics. Indeed, the more egregious this late-cycle monetary stimulus, the more perilous their predicament.
So, I worry about China’s “plan B”. Beijing is clearly preparing its military and people for confrontation with the U.S., a conflict I fear will be increasingly likely when China’s economic gambit falters. Xi and the communist party will never accept responsibility for so mismanaging China’s financial system, economy, and international reputation. Crisis will have Beijing pressing the Taiwan issue, deflecting attention and responsibility, while increasing the odds of a direct showdown with the U.S.
I’ve discussed previously how boom periods engender perceptions of an expanding global pie. Cooperation, integration, and alliances are seen as mutually beneficial. But when the cycle turns, the pie is increasingly viewed as stagnant or shrinking; zero sum game thinking dominates. Insecurity, animosity, disintegration, fraught alliances, and conflict take hold.
We are in a period of momentous change. A historic global bubble has begun to deflate. The war in Ukraine has unleashed pernicious forces that will be difficult to control. China’s autocratic communist government has towering ambitions - inflated by a historic bubble that is now leaking a lot of air. Japan has a new central bank governor that will need to end a historic monetary experiment that was for a decade left to run wild. Across the globe, economies big and small, wealthy and poor alike, confront unprecedented debt overhangs. Policymakers almost everywhere face the predicament of elevated inflation and weakening growth prospects.
We’re at a critical juncture in the global bubble, where acute fragility is forcing another round of desperate measures meant to hold crisis dynamics at bay. We’ve over recent quarters witnessed major instability and volatility. I suspect this has become the new normal. We should be prepared for the environment to turn only more uncertain and tumultuous, with odds rising for a major accident.
In conclusion, I see developments at home and abroad corroborating the new cycle thesis. I just wish I could be more optimistic about future prospects. A lot has to go right - and we need lucky breaks - to avoid a destabilizing downturn. So much is uncertain. However, there’s one thing I am certain about: additional monetary inflation and massive government deficit spending are not the answer. They only make things worse.