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Market Lab Report - What black swan is next?

Market Lab Report

by Dr. Chris Kacher

The Metaversal Evolution Will Not Be Centralized™ 

Highlights from the Mar 22 Fed meeting:

= inflation remains enemy #1
= Fed committed to higher rates, more increases likely yet much less conviction about further hikes given what may happen with bank credit since banking stress is the equivalent of a rate hike. 
= Fed baseline is for no rate cuts in 2023
= A significant minority of FOMC officials (7 of 18) now see inflation risks as balanced
= With respect to balance sheet expansion being at odds with combatting inflation, Powell says the discount window balance sheet expansion and securing depositors is different from buying long term bonds to bring yields down so banks can make money to repay loans on bonds bought from the Fed.

What black swan is next?

Massive bond losses sit on the books of banks and unfunded liabilities such as pensions. This is on a global scale. To ensure smooth operations if needed, the Fed and other global central banks announced last Sunday evening an expansion in the frequency of dollar swap line operations. The standing swap lines currently conduct weekly dollar loan operations. Starting Monday Mar 20, they will offer daily operations. It will remain in place at least through the end of April to support the smooth functioning of US dollar funding markets. Historically, once the Fed resorts to reopening dollar swap lines, the rest of the programs follow from rate cuts to QE.

The banking fiasco may push the Fed to print as much as $2 trillion to save the depositors from banks the Fed has designated so far according to JP Morgan. But there's an additional $1-2 trillion the Fed will need to backstop the top 4 largest banks given that the bond losses can be typically between 10-15%. Banks get a loan from the government collateralized by their bonds. The banks then buy bonds yielding much higher rates than the bonds they originally bought. The Fed wants to postpone the crisis by a year which will give them time to lower rates as inflation stabilizes or cools. Rates will be lower by then so the bonds these banks hold will be worth more in a year which will allow banks to repay the loan. But on Mar 15, 2024 banks will have to repay the loans so it's kicking the can down the road. The Fed will likely continue to print more than expected as seems to always be the case. The world is realizing the FDIC insurance fund only has $128 B while total deposits in US commercial banks = $17,600 B. 

At $3-4 trillion in total backstopped by the Fed over the next year or so, this is a black swan of potentially major proportions. The Fed's balance sheet quickly rose by $303 B just last week which is pushing markets higher. But other connected black swans lurk such as 1) unfunded liabilities from pensions and IRAs who are also exposed to bonds and 2) hundreds of billions of dollars in REITs such as O and BX that remain vulnerable as mortgage backed securities also took deep hits. 

That said, the bank failure black swan alone could restart the bull or at least put a floor to the bear market but at the price of even higher inflation. And due to inflation, the Fed is likely to print just the bare minimum needed though this is potentially as much as $3-4 trillion depending on how much they need to print to backstop the banks. 

There is a counterbalance to the massive money printing argument. In fractional banking, most "money" is created out of thin air by lending. It doesn't matter who the lender is. The commercial banks do most of it, the fed less. At this time, the banks aren't lending which cancels out more of the money central banks may have to create than normal. Indeed, the slowing of lending does the same thing that raising rates does since it makes it harder for anyone to get money. This pushes asset prices down, ie, inflation falls. But this is just postponing an accelerating M2. 

The Fed is damned by inflation if they print, damned by bank runs if they dont print. And with recession on the way, history shows we could plumb to new lows if the Fed only prints enough to backstop banks and pensions. Early 2000s and early 1930s were two such cases where the Fed aggressively lowered rates for well over 18 months but markets continued to trend lower anyway. But 2008 ushered in central bank quantitative easing, so with QE at the Fed's disposal, it is more likely the growth of M2 will accelerate which will keep inflation stubbornly high if not higher.

A new factor that wasn't present before is that we have increasing M2 from China and Japan which has been a large driver of the market bounce we've seen in stocks and crypto since the start of the year. 

The 2-yr and 10-yr rates are heading lower in a hurry. CME Fed futures currently predicts one more 25 bps hike to a terminal rate of 500-525 then three consecutive drops of 25 bps. Higher inflation would become the standard as the Fed would be forced to accept a higher inflation target well above 2% which Ray Dalio had predicted in one of his published pieces.

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