Edge of the Edge

Guest Post by John Hussman

Don’t hassle me about the crumbs, man. I’m on the edge of the edge.

– Christopher Walken, Envy

The simplest thing that can be said about current financial market and banking conditions is this: the unwinding of this Fed-induced, yield-seeking speculative bubble is proceeding as one would expect, and it’s not over by a longshot.

I expect that FDIC-insured, and even most uninsured bank deposits will be fine. I also expect that hedged investments will be fine. In contrast, a great deal of market capitalization that passive investors count as “wealth” will likely evaporate, possibly including steep losses to bank shareholders and unsecured bondholders. Investors and policy-makers have confused speculation and extreme valuations with “wealth creation,” but it never was. A parade of seemingly independent “crises” will emerge as this bubble unwinds, including bank failures, pension strains, and market collapses, but they all have the same origin.

The chart below shows our estimate of likely 12-year total returns for a conventional passive investment mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills, along with actual subsequent total returns. At present, this estimate stands at just 1.03%, matching the level of August 1929. By contrast, the average return for this conventional portfolio mix across history is just over 7% annually, which is where current pension return assumptions stand. That’s another way of saying that investors are setting their return assumptions based on average historical returns, ignoring the valuations that actually drive those returns. As explained in more detail at the end of this comment, I continue to expect a loss on the order of -58% in the S&P 500, from current levels, over the completion of this cycle. Nothing in our investment discipline relies on that outcome, but having correctly anticipated the extent of the 2000-2002 and 2007-2009 collapses, it’s best not to rule it out.

Notice that by late-2021, a decade of speculation by yield-starved investors had driven prospective investment returns to negative levels. That’s something that didn’t even occur at the 1929 and 2000 extremes. The sudden crises and financial strains emerging today are just the consequences of the extreme valuations and inadequate risk-premiums engineered by reckless zero-interest rate policies.

Origins of a bank crisis

In recent weeks, Silicon Valley Bank became the second-largest bank failure in U.S. history, second to the 2008 failure of Washington Mutual. Yet the bank appeared to be quite stable even at the beginning of this year. Indeed, in its most recent financial report as of December 31, 2022, deposits represented 82% of Silicon Valley Bank’s liabilities, and over 60% of those deposits were invested in cash or government securities. Silicon Valley Bank’s report noted “continued strong capital, with all capital ratios considered ‘well capitalized’ under banking regulations.”

What went wrong?

The short answer is 1) the bank’s assets suffered large, unrealized losses in recent quarters; 2) in response to the bank’s announcement that it was taking steps to raise more capital, depositors rushed to withdraw their money in a classic bank run; 3) the bank was unable to accommodate the withdrawals, causing the bank to fail due to inadequate liquidity and insolvency.

Still, saying that a house collapsed because a wrecking ball hit it doesn’t explain how the wrecking ball got there in the first place. The answer is that the wrecking ball got there because the Federal Reserve put it there.

As I wrote in a January 2022 Financial Times OpEd, The Fed Policy Error that Should Worry Investors, the central policy error of the Fed occurred well before inflation became problematic. That error was “abandoning a systematic policy framework for more than a decade, in favor of a purely discretionary one. The critical policy error may be the consequences of discretionary policy on the financial markets. By relentlessly depriving investors of risk-free return, the Fed has spawned an all-asset speculative bubble that may now leave investors with little but return-free risk.”

The essential ingredients of recent bank strains involve excess bank deposits, well beyond FDIC insurance limits, coupled with losses in the asset holdings of banks, particularly in securities like long-term Treasury bonds that are ordinarily considered “safe.” Silicon Valley Bank did not have enough liquidity to tolerate a bank run, and it did not have adequate solvency to qualify for emergency loans. But emphatically, the failure did not occur because there is too little liquidity in the banking system as a whole. It occurred because there is too much.

The “excess deposits” are there because the Fed put them there. The U.S. banking system has more than $1 trillion of deposits that exceed the FDIC insurance limit, and nearly $8 trillion of bank deposits in excess of bank loans, because more than a decade of “quantitative easing” took bonds out of the hands of the public and replaced those bonds with zero-interest bank deposits. Overvalued long-term securities dominate portfolios because yield-starved investors and banks couldn’t tolerate the perpetual zero-interest rate world created by the Fed, and felt forced to reach for yield.

All of those holders – investors, banks, pension funds, everybody – reached for yield, driving the equity market to valuations beyond their 1929 and 2000 extremes; driving interest rates to historic lows; driving the risk-premiums on low-grade debt to levels that still provide little margin of safety; encouraging speculative new issues of stock and covenant-lite debt; encouraging Silicon Valley Bank and others to invest their excess deposits in securities that might offer them something more than zero.

Even as banks like SIVB created a “duration mismatch” by using short-term deposits to finance investments in long-term Treasury securities, they escaped the scrutiny of regulators because “risk-based capital ratios” consider Treasury securities as risk-free, with a risk-weighting of zero. As former FDIC Vice-Chair Tom Hoenig observed, “The weakness is the use of risk-weighted capital measures, rather than equity capital measures that take in all assets. Silicon Valley Bank’s 16% risk-weighted capital looked great, but if you include securities with interest rate risk, and losses on them, they only had 5%.”

Investment losses have emerged since early 2022, both because inflation pressures forced the Fed to normalize rates after 13 years of zero-rate financial repression, and because extreme valuations are never sustained indefinitely. Sudden banking strains in the U.S. and Europe, the British pension crisis last year, all of these are just symptoms of an unwinding bubble. The same process is underway in the equity market, and the downside risk remains absurdly high.

That the rate of interest will be lower when commerce languishes and when there is little demand for money, than when the energies of commerce are in full play and there is an active demand for money, is indisputable; but it is equally beyond doubt, that every speculative mania which has run its course of folly and disaster in this country has derived its original impulse from cheap money.”

– The Economist, 1858

The excess deposits are there because the Fed put them there

When people say the Fed is “pumping money into the economy,” what actually happens is that the Fed buys interest-bearing securities like Treasury bonds from the public, and the Fed pays for the bonds by creating electronic entries called “bank reserves” that back a new bank deposit owned by whoever sold the bonds. The Fed takes interest-bearing securities out of public hands, and replaces them with zero-interest bank deposits backed by newly created “base money.” (We’ll get to the recent practice of paying interest on reserves shortly).

On the asset side of the Fed’s balance sheet are securities the Fed has purchased. On the liability side is base money the Fed has created. The Fed “expands its balance sheet” by buying interest-bearing securities from the public and paying for them with newly created base money. The Fed “shrinks its balance sheet” by selling interest-bearing bonds and receiving base money as payment.

Once the Fed creates base money, it has to be held by someone in the economy, in the form of base money, until that base money is retired by the Fed. If you try to put your money “into” a security, the seller of that security takes the money right back out. For more than a decade, all those reserves – and associated bank deposits – earned nothing. Zero. Someone had to hold them, and nobody wanted to.

Conceptually, you can think of your bank deposit as being “backed” either by reserves that your bank holds on deposit with the Fed, or by an IOU that your bank received in return for a loan it made with your money. By pushing trillions of dollars of reserves into the banking system, quantitative easing also pushed trillions of dollars of deposits into the banking system.

The relationship presented in the chart below isn’t perfect because some Fed liabilities are outside of the banking system (currency in circulation, reverse repurchases with money market funds), and banks finance some of their assets with non-deposit liabilities (senior debt, unsecured notes, equity capital), but the point should be obvious: the excess deposits in the banking system are there precisely because the Fed put them there.

You’ll notice a sharp spike in the Fed balance sheet in 2008 that wasn’t matched by a spike in excess deposits. That spike was driven by lending through the “discount window”: the Fed provided short-term liquidity to banks in return for collateral from the banks. Discount lending is not “quantitative easing” because the Fed doesn’t actually buy the securities. It just provides short-term liquidity, backed by collateral. That’s notable because many observers have misinterpreted a recent spike in the Federal Reserve’s balance sheet as “QE,” when it is actually discount lending under a new – though legally questionable – program called the Bank Term Funding Program (BTFP). More on that below.

Fueling a bubble, setting up a collapse

Historically, the reserves created by the Fed have earned zero interest. As the Fed creates more zero-interest liquidity, investors respond by seeking yield in other securities, starting with T-bills. The more plentiful zero-interest liquidity, the lower short-term interest rates.  Prior to 2008, the amount of base money never exceeded 16% of GDP. Once the Fed drowned the public with that much zero-interest money, even a few basis points of interest on T-bills became enough to chase yields back to zero.

Quantitative easing “worked” by flooding the economy with so much zero-interest base money that investors lost their minds, driving even long-term interest rates to record low levels, and driving our most reliable stock market valuation measures beyond even their 1929 and 2000 extremes.

But wait. Now that the Fed has been forced to raise rates to fight inflation, how has the Fed been able to keep its balance sheet at a ridiculous 33% of GDP and yet hold short-term interest rates above zero? Well, the only way the Fed has been able to lift short-term interest rates away from zero in recent years is by explicitly paying interest to banks (currently 4.65% IORB) on their reserve balance

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