Simon White, Bloomberg macro strategist and author,
SVB's collapse and Credit Suisse's turmoil will result in
Turbo-charge QT's effects, sealing the case against a US recession
This remains underpriced by credit and equity markets.
Remember QT? Dirty Harry is wrongly quoted: In all the excitement it's easy for one to lose track of everything else. Quantitative tightening's effects will likely accelerate now that banking stress is causing a steeper drop in bank reserves, triggering a potential deep recession.
Therefore, the Fed is more likely to stop QT and end the rate-hiking cycle. However, it won't be enough to save credit and equity, which are significantly underpriced in an economic slump.
Understanding QT is key because it is both a duration transformation and a velocity transformation. The Fed gives back the market duration through asset redemptions and asset sales, and removes velocity as it absorbs reserve.
Falling velocity means lower inflation. However, to achieve this goal the market's interest rate risk rises because it is taking back the Fed's duration. Credit Suisse is also a victim of this effect. SVB is the worst. The bank was granted access to liquidity at the SNB, which partially restored the mood.
There is a real danger that banks' lingering concerns could cause a significant migration of bank deposits to money-market funds or T-bills.
Many people will be shocked at the higher rates offered by MMFs. Even though the FDIC has decided to make all SVB depositors whole, deposits could be moved from smaller regional banks, which are likely to be more risky and have greater relative exposure to liquid assets like CRE, directly into MMFs, particularly if larger banks slow to increase their deposit rates.
A decrease in bank deposits will result in less "high-powered" money, i.e. Bank reserves will fall, which will lead to less 'high-powered' money, i.e., tighter financial conditions.
This would be the last straw for an economy already in danger of entering a recession by the end of the summer.
Already the trickle is underway, with bank deposits falling almost in line with banks' holdings in Treasuries, agency securities, and bank deposits declining since last summer. This is due to banks selling their securities net to non-banks.
This trend should be expected to continue.
The chart below illustrates that banks tend to reduce their Treasury holdings in proportion to assets when the Fed raises rates. This ratio falls before a recession and peaking during one.
This trend could be amplified as yield-seeking depositholders - or those who don't want bank issues to become systemic if they aren't around - may take their deposits out the banking system, further reducing bank reserve.
Higher-velocity bank reserve are likely to drop more rapidly as the flow of money leaving banks for MMFs increases. MMFs' total assets have increased by more than $400 billion in the summer, nearly the same amount as bank deposits fell over the same time period. However, SVB is likely to increase the number.
We shouldn't expect banks to lend to offset the negative effects of falling deposits. Banks have so far allowed their loan to deposit ratios to increase, which means that bank balance sheets have not shrunk despite losing deposits.
This is likely to change as banks tighten lending standards. Invariably, this leads to fewer loans being made overall. A direct bank balance-sheet contraction is a strong headwind that the economy has not had to deal with yet in this cycle.
QT's second goal, reducing velocity, has so far been missing.
This was evident by the yield curve's constant flattening. As crisis-fever grips, short-term yields fall, steepening is back in full swing. This will cause a drop in velocity and some easing of inflation.
However, the economy is unlikely to experience a drop in velocity that causes a recession.
Now, the odds are that the Fed will rethink its hiking cycle and reduce the pace of reserve depletion. Even a 25-bps increase in the balance could be seen. As the pace of reserve destruction accelerates, QT will also be at risk.
The S&P was only 4% below its March high as of Thursday morning. As recession risks rise, however, a deeper selloff is likely. The S&P Gamma has moved into negative territory recently, which means that market movements, especially to the downside are susceptible to being exacerbated due to option dealers' delta-hedging.
QT and rate rises are proving that it will be difficult to reverse years of zero interest rates and large balance sheets at the central bank.