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Last week my colleague Marshall Burroughs provided a succinct good analysis of the current banking crisis and previous crises going back to the 1980s. Since then, the situation has deteriorated. Credit Suisse, one of the world’s largest international banks, was rescued by the Swiss government, and now Deutsche Bank in Germany is looking troubled. In this country First Republic Bank is still under the microscope despite a $30 billion rescue package given to it last week by a group of larger banks.
How did the banks get into this situation? Excessive government stimulus in response to the Covid pandemic, by both the monetary and fiscal authorities, which continued after it was no longer needed. By the end of 2020 GDP growth had already snapped back to 4% with a mere 1.4% inflation. Yet the US treasury kept on issuing bonds, banks bought the bonds, then the Fed Reserve purchased the bonds from the banks with printed money, to the tune of trillions of dollars, flooding the banks with cash. It also added billions more through new programs like the New Loans Facility and Expanded Loans Facility. The US Treasury issued the bonds through various programs, such as the 2021 “American Rescue Plan,” extended unemployment benefits, an increase in the Earned Income Tax Credit, eviction prevention programs, and so on. The number of programs was dizzying, as was the number of dollars.
With interest rates near zero banks held all this money costing them virtually nothing and invested it into long-term bonds yielding 1 1/12 or 2 %, making money on the spread. Now with short rates much higher, banks are paying depositors 5%, much more than their long-term bonds yield, but cannot sell them because they are worth much less than purchased two years ago (bond prices move inversely to interest rates). It was a classic mismatch between bank assets (loans and bond portfolios) and liabilities (deposits and debt). And as an added “bonus,” it led to forty- year high record inflation.
Enough on the basics of bank financing. How will this affect the economy? According to the chart below the largest up and down swings in GDP have been caused by huge government stimulus:
Chart Courtesy, Bank of America Merrill Lynch
The rapid withdrawal of the stimulus will cause a slowdown in economic growth and a contraction in GDP. The consensus is this will last through the end of summer. How will this end? The chart below shows the enormous amount of cash is being held in money-market accounts. No surprise, these are a paying 5% with very little risk. This will persist as long as short-term rates remain high.
Chart Courtesy, Bank of America Merrill Lynch
That cash hoard that will be looking for a new home when rates drop, and much of it will go into stocks. And as I said in my December 30th Update, when stocks do recover, they will do so with a vengeance:
Chart Courtesy of The Hartford
Right now continue keeping a good portion of your assets in cash and short-term liquid fixed securities. I cannot say when the next bull market will arrive but can only say that it will.
Wishing You a Profitable Week.