Stop Trying To Make BRICS Happen

BRICS was a brilliant bit of sell side marketing, but it has taken a life of its own. One needs to stop projecting fantasies onto the global financial system, and accept that its form follows function.

The extreme dominance of the share of global GDP after World War II by the United States was a historical accident, and so the relative rise of other economic powers was inevitable. Meanwhile, the eagerness of the United States to use sanctions as a foreign policy tool is going to create incentives to develop mechanisms to do an end run around those sanctions. Nevertheless, the geopolitical system is far more stable than is commonly described. (I will enter a geopolitical tangent later in this article to justify that claim.)

Pleading The Fifth On The Fourteenth

I am currently working on another article, but given the clamour about the debt ceiling, I just want to repeat my stance that I guess a “last minute” deal will be done. I do not expect any unilateral moves to invalidate the debt ceiling ahead of that proverbial last minute. My feeling is that announcing the intention to use any such mechanism is effectively an announcement of an unwillingness to negotiate, which looks bad. Beyond that, I do not see any reason to waste any more of my readers’ time with my takes on that matter.

(I hope to deliver that other article tomorrow.)

Another Bank Bites The Dust

First Republic Bank was forced into a take over by J.P. Morgan Chase, and was yet another Californian victim of bad banking risk management. My bias was that First Republic was not large enough to worry about, so I cannot offer any insights into the event. My main complaint is that this appears to be another bank that blew itself up with interest rate risk, which makes my life of writing a banking primer more difficult. I had always made allowances for bad bank risk management in the United States, but I had underestimated how large an incompetent bank can get.

Other than for the unfortunate owners of securities issued by First Republic (and apparently wealthy people in San Francisco who wanted overly generous mortgages), the demise of this bank is not a big deal by itself for the macroeconomy. Instead, the issue is whether there are still other weak links in the banking system? I am not in a position to have a strong opinion on that question, but it would be a question worth looking in to. My bias is to not pay too much attention to interest rate risk — credit risk is the killer for financial systems. Although I am seeing people pointing to commercial real estate risk, I do not think I could point to a time in recent decades where somebody was not worried about credit risks in commercial real estate.

The usual worry is that the Fed hikes until something breaks — which is exactly how I describe previous cycles.1 Since the current bank failures were due to interest rate risk, we can blame them on Fed action. The question is whether these are enough to derail the economy? Although the Monetarist-inclined are worried about M2, my concern is credit growth (since Fed balance sheet shenanigans are forcing reallocations of financial assets which do not have much economic impact). One measure of credit that I like — commercial & industrial (bank) loans outstanding (above) — has rolled over.

As can be seen in the chart, C&I loans rolling over only tended to happen in recessions. However, we did see a lack of growth in the mid-2010s without a recession (circled episode), so I would be cautious about panicking.

I am not in the forecasting business, and do not want to be calling for recessions every six months. Although there are certainly negative vibes, one can still argue that they are consistent with a “soft patch,” which is a part of lengthy modern business cycles. You pays your money, and you takes your chances.

1

There is a survivorship bias in that observation. It could be explained by (1) business cycles being typically ended by financial fiascos, and (2) the Fed tending to hike rates until the expansion ends, with (1) and (2) being independent.

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(c) Brian Romanchuk 2023

Learning From The Crisis (MMT Perspective)?

The panel I am on is shifting its topic a bit to include some discussion of the latest crisis. Although this is more topical, it is not exactly moving in a direction that fits my knowledge of Modern Monetary Theory (MMT). I see two broad issues. The first is the discussion of bank failures (so far!) which I have a limited ability to comment on. The second is more useful for a MMT debate: interest rate policy is not exactly as costless as neoclassical arguments suggest.

Late Fed Hike Comments

The Fed hiked the policy rate by 25 basis points this week, while forecasters were split on the outcome. My feeling is that this is a “dovish hike” — whatever that means. Realistically, the Fed wants to drift into at least a temporary pause while they survey the wreckage left behind by their hiking campaign.

Currency Swap Facility Comment

I have something written on currency swaps, but it is probably too complex. I want to make a brief and hopefully simple comment on the topic. (The fact that I am writing an article a day tells us something about markets.)

The term “currency swap” is the term that we usually see, although there are a few variants. The variants are differentiated by the way in which interest rates are calculated. The cross-currency basis swap1 is the floating rate/floating rate version of a “currency swap,” and is the 800 pound gorilla of cross-currency funding trades. This is the wholesale hedging tool, and other foreign exchange hedging instruments are priced off these swaps. Although “cross-currency basis swap” sounds cool, I will just “currency swap” in this article, since I am not concerned about the interest rate terms.

Bank Capital Contagion Comment

The details of a shotgun marriage between UBS and Credit Suisse arranged by Swiss regulators have been leaking out. Credit Suisse has been plagued by problems, and one might hope that this act would finally clear them up. The concern I am seeing at the time of writing is the risk of contagion.

As an aside, we can tell this is a bit of a crisis by my posting frequency.

Credit Suisse had AT1 notes, which are a subordinated perpetual security that acts as bank capital. Under normal circumstances, perpetuals are senior to equity. However, AT1’s have clauses that allow regulators to write them down to zero — an option that the regulators seemingly exercised. I have seen a lot of people online surprised by this, since they were unaware of the contractual terms. We will find out Monday (possibly the hard way) how many portfolio managers were unaware of them.

What We Learned: Something Is Seriously Wrong With Silicon Valley

I am seeing a lot of attempts to argue in favour of major changes to banking because of what happened with Silicon Valley Bank. Although I see a chance that Congress might reconsider the lax regulations of regional banks in the same category as Silicon Valley Bank, it is going to be hard to get too much momentum for broad reforms. The actions of everyone involved was breathtakingly stupid, and it is going to be hard to replicate that level of stupid at any other bank of a similar size.

Bailout!

The U.S. Treasury, Federal Reserve, and Federal Deposit Insurance Corp banded together to create the Bank Term Funding Program (BTFP — the bureaucrats are going for the laughs with the acronyms at this point), which gives 1-year financing to eligible banks against Treasury/mortgage-backed security collateral at par. They also announced that uninsured depositors at two failed banks (the known failure Silicon Valley Bank, as well as the newly-shuttered Signature bank) will be made whole.

With the FDIC auction underway, the Silicon Valley Bank Crisis may either be over or raging uncontrollably when you read this. I lean towards the scenario of excitement winding down, but at the same time, I know literally nothing about the quality of SVB’s asset book. Rather than speculate, I just want to point out what I see as key: credit market conditions (including wholesale funding) are the only thing the Fed really cares about. Even if one worries about other large regional banks, credit investors — and existing lending facilities for banks, like the discount window and FHLB advances — can pump money into the back door of a solvent bank faster than a bunch of people who read stuff on Twitter can withdraw it out the front.

Oh No, Panic In Silicon VAlley

The American Federal Deposit Insurance Corporation (FDIC) made the unusual step of shutting down the flailing Silicon Valley Bank (hereafter, SVB) during business hours yesterday (Friday). (FDIC Friday usually involves teams swooping in after the close on Friday.) Since I have to write this article quickly in the morning, I am not sure of what the latest developments are for SVB, rather I want to discuss the possibility of contagion.

The Return Of The Debt Ceiling (Again)

The debt ceiling is being used a negotiating tool in American politics yet again. My concern with American politics is that most things seem to be over-dramatised, while some disturbing things are shoved under the carpet. The debt ceiling is a great source of hysterics from south of the border. My highly non-informed take is that this debt ceiling drama will end in the usual way, going to the 11th hour before some kind of deal is struck.

Default Of Currency Sovereigns

I discussed default risk of sovereigns with floating currencies (“currency sovereigns”) in Understanding Government Finance. The formula that I have settled on: floating currency sovereigns are immune to involuntary default for financial reasons. This is not “floating currency governments cannot default,” rather “the so-called ‘bond vigilantes’ cannot force such a government to default.”

Currency Swap Comments From The BIS

Claudio Borio, Robert McCauley, and Patrick McGuire solved the problem about what I will write about this week by publishing “Dollar debt in FX swaps and forwards: huge, missing and growing” as part of the Bank of International Settlements’ quarterly review (https://www.bis.org/publ/qtrpdf/r_qt2212h.htm). One can interpret the text as a plea for more data, which is reasonable enough. However, the lurid headlines and commentary that the article has attracted elsewhere is somewhat missing the point. I am not attempting to discuss that article in depth, rather offering my interpretation of the underlying issues.

Runs, Cascades, Squeezes, and Crises

Recent discussions about bank runs in economics has led me to the conclusion that economists want to lump practically all behaviour around default as a “run,” which is not helpful. In order to have a better grasp of the situation, we need to distinguish various possibilities — runs, cascades, squeezes, and good old fashioned financial crises.

Crisis, Pre-Crisis, Or No Crisis?

I divide the regimes for the global capital markets into three states: crisis, pre-crisis, and no crisis. The one term that is non-standard is pre-crisis; it is a state where something has gone horribly wrong in funding markets, but it is not yet well known and there is a hypothetical possibility of a full financial crisis being averted.

My “no crisis'“ state does not imply that we cannot find panicking people in the financial press. Unimportant markets like Magic the Gathering™️ cards, crypto, or equities might be blowing up, but as long as the funding markets are not touched, the effects on the real economy will be limited. Those markets are largely zero sum transfers of wealth between participants, and not used to raise funding for investment (fixed and inventory). Since we can always find an unimportant market blowing up somewhere, if we labelled them “financial crises,” we would be living in a permanent “crisis,” making the term meaningless.

Primer: Basics Of A Swap Meltdown

I am now seeing more attempts to dig into what exactly happened in the United Kingdom interest rate market. In this article, I am not attempting to do that. Instead, I am just giving a primer on how interest rate swaps are used to hedge liabilities, and what can go wrong when interest rates rise. The mechanisms I describe were likely part of the issue, but I am not saying that this is “the” explanation. Since most people are unsure what liability-driven investment and swaps are, so I am hoping to cover big picture issues for those readers.

I have not seen too many longer articles about the “gilt crisis” in the United Kingdom, but have seen a variety of reactions on Twitter. My reaction is that the discussions reminded me why I mainly followed people who used the title “rates forecaster” and not “economist” when I was in finance. (The “rates forecasters” might have had economics degrees, but they knew that if they wanted people like me to take them seriously, they needed to not sound like the people with “economist” in their title.) It is rather impressive how the most interesting part of this crisis has been buried.

We finally have had the financial instability crisis that everyone was a bug about throughout the 2010s. Many people have spent more than a decade calling for a repeat of the Financial Crisis — well, we just had a small version of it. Based on the initial reporting (which may not be perfect), pension funds managed to blow themselves up with leverage (created by fixed income derivatives) by crowding into one side of a trade. This alleged distress forced the Bank of England to intervene to reduce gilt yields (and hence swap rates).

Gilt Market Mayhem!

Bond markets are finally getting interesting, with the Bank of England launching emergency purchases to restore order in the gilt market. Since I am not in constant contact with people trading gilts, I will just offer a tentative description of what seems to be going on, and what it “really means.”

Comments On The Russian Military Collapse

Although I am supposed to be working on some material on banking, I have been distracted by the flood of news out of Ukraine. Although there is always great uncertainty, I think that a lot of geopolitical commentary has been based on the premise of a drawn out war (a “forever war” according to one economist). The problem with that view is that it assumes that the Russian troops are willing to fight in line with their theoretical capabilities. However, a collapse in morale means that theoretically superior forces can be rolled up. The classic example was the British/French army in 1940 that not only outnumbered the Germans, they had arguably better equipment — and lasted six weeks of contact.

Macro Effects Of A Hypothetical Crypto Crash?

This article is a short outline of what I see as the macroeconomic effects of a possible continuation of weakness in crypto financial markets. The direct effects would be small, although weakness in crypto is interleaved with the fortunes of the tech sector. It is certainly possible that all risk assets will be under pressure if the economic situation deteriorates, so crypto might be akin to the canary in the coal mine — a signal of other dangers.

I end with a discussion of so-called “stable coins.”