Will You Play It Fast And Loose?

This article originally appeared in the Economic Prism.

 

“How should I play that one, Bert?  Play it safe?  That’s the way you always told me to play it: safe… play the percentage.  Well, here we go: fast and loose.  One ball, corner pocket.  Yeah, percentage players die broke, too, don’t they, Bert?”

– Fast Eddie Felson, The Hustler

QT2 Master Plan

Stopping the excess is always much harder than starting it.  But sometimes it must be done.  And done all the way.  Half measures avail nothing.

On June 1, 2022, Fed Chair Jay Powell commenced Quantitative Tightening (QT) Part 2.  “Brace yourself,” was the advice of JPMorgan Chase CEO, Jamie Dimon.  Were his banker cohorts listening?

The master plan for QT2 was for the Fed to reduce its holdings of Treasury notes and mortgage-backed securities by a combined $47.5 billion per month for the first three months (July thru August 2022).  Then, by September 2022, the Fed would start reducing its balance sheet by a total amount of $95 billion a month (i.e., $60 billion in Treasuries notes and $35 billion in mortgage-backed securities).

Wells Fargo Investment Institute took the Fed at its word and even projected that its balance sheet could shrink by almost $1.5 trillion by the end of 2023.  Taking it down to around $7.5 trillion.

To anyone with a memory that extends back longer than two years, it was obvious that there wasn’t a snowball’s chance in hell the Fed would contract its balance sheet to $7.5 trillion by the end of 2023.  At the time, we remarked, “We’ll bet dollars to doughnuts this never happens.”

Our certainty was not based on any special insight about the future.  It was merely the recognition that QT1 flamed out early.

Specifically, it took 24 months for the Fed to reduce its balance sheet by $800 billion between October 2017 and September 2019 (in the wake of a $3.5 trillion expansion).  That was before QT1 abruptly ended in repo-madness.

QT2 Fail

Like all plans of central planners, the QT2 plan laid out by the Fed to extinguish nearly double the ‘assets’ in 19 months that were terminated in 24 months during QT1 was nothing but a pipe dream.  Clearly, something was bound to break well in advance of the Fed hitting a balance sheet of $7.5 trillion.

By now we all know what broke.  Silicon Valley Bank broke.  As did Signature Bank, First Republic Bank, and Credit Suisse.  More banks could fail too, even in the face of mega bailouts being engineered by activist central banks.

With respect to the Fed’s balance sheet, after peaking at over $8.9 trillion in April 2022, it fell roughly $626 billion through the end of February 2023.  As of March 15, 2023, the Fed’s balance sheet had jumped $300 billion.  And by the time you’re reading this, or shortly after, we’ll know how many more hundreds of billions in credit the Fed has created out of thin air to liquify the financial system.

In short, QT2 was a complete and utter failure.  Of the $626 billion reduction that occurred, $300 billion was added back – in a matter of days.  This massive increase marks the return of Quantitative Easing (QE).  It also surfaces an important question.

How much Fed credit creation – out of thin air – will be needed to stem the banking crisis?

One trillion dollars, $5 trillion, $10 trillion?

Your guess is as good as ours.  In matters like this, however, it is always best to think in big, round numbers.  So, don’t be surprised when the Fed’s balance sheet eclipses $20 trillion over the next several years.

Inflation Deflation

Inflation of the money supply is inflation in the truest sense.  It’s what comes first.  Asset price inflation and consumer price inflation then follow in wild and unpredictable ways.

Are these massive new additions to the Fed’s balance sheet inflationary?

By definition, yes.  As the inflation of the Fed’s balance sheet supplies additional credit to the financial system.  But how will this inflation impact asset and consumer prices?

This is to be determined.

The immediate concern is credit contraction and debt deflation.  The forces causing banks to go belly up are relentless.  As TradeSmith recently noted, the money supply (M2) is contracting for the first time in the modern era.  Liquidity has disappeared from the marketplace.

For example, for investors holding the $17 billion of Credit Suisse’s additional tier 1 (AT1) bonds, the banking crisis is deflationary.  This includes retail investors in Asia, PIMCO, Invesco, and Legg Mason, among others.  Their investment – principal, interest, the whole nine yards – has been written down to diddly-squat.

But what about for SVB depositors, including those with accounts above and beyond FDIC insurance limits?  Is the BTFP bailout inflationary when depositors are merely being made whole?

Make of it what you will.  The moral hazard of it all, which rewards bankers for going hog-wild speculating with customer deposits, is a disaster.

What is clearly inflationary, and what is explicitly driving consumer prices higher, is the massive amount of deficit spending being racked up by Washington.  The federal government has already spent $723 billion more than it collected in revenue in fiscal year 2023.  Yet the fiscal year hasn’t even reached the mid-point.

According to the Congressional Budget Office, the FY 2023 deficit is projected to hit $1.4 trillion.  This is on top of the $1.38 trillion deficit accumulated in FY 2022.  Thus, as the credit market contracts, and banks fail, consumer prices will remain elevated.

Will You Play It Fast And Loose?

With consumer price inflation just off its highest levels in over 40 years, we suppose the massive deficit spending combined with the broadening scope of the bank bailouts will be a tailwind for rising consumer prices.  This is especially true as shameful opportunists like Senator Elizabeth Warren use the politics of the bank crisis to justify creative ways to inject printing press money into the economy.

But at the moment, we expect the real action will be in asset prices.  And there’s great uncertainty in how it will all play out.

Those expecting Fed liquidity to pump up the stock market should moderate their enthusiasm.  That time will come.  But first, there’s plenty of wreckage in the debt market that needs to reconciled, written off, or bailed out.

This week Fed Chair Powell, following the federal open market committee meeting, hiked the federal funds rate 25 basis points to a range of 4.75 to 5 percent.  This, no doubt, is deflationary for the debt market.  It furthers the negative carry problem that banks foolishly got themselves in.

Still, what could Powell do?  Inflation is out of control.  It must be restrained.  Shortsighted decisions made during the COVID Panic must be corrected.  Moreover, with Washington spending like drunken sailors, Powell must hold the line as long as politically feasible.

Ultimately, it’s a losing cause.  Interest payments on the national debt during the current fiscal year are up 29 percent year over year.  Soon enough, the Fed will have to cut rates to bail out Washington – inflation be damned.

In the interim, a hardcore stock market panic is in store.  We expect this will be one for the history books.  We also expect it will provide buying opportunities of a lifetime, which most people will miss out on.  Are you psychologically prepared to buy when the time is right?

At the point of maximum fear, when the sky is falling, the world is ending, and shares of Bank of America trade below $8, what will you do?

Will you play it safe?  Or will you play it fast and loose?