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The squawk boxes and news feeds have been relatively quiet over the last few weeks, even as we are hearing that PacWest and a couple of other banks are feeling some pressure. A clever screen on Finviz, using the right parameters, could turn up for you who might be next, such as CARV, EBC, OZK, PACW, PDLB, PVBC, SBT, and others.

This banking crisis is far from over.  In fact, it has only just begun.  There are big problems with this crisis too, the biggest of which is policy response from the Fed, Congress, Treasury, and other government offices and officials. Let’s not forget that these are the same officials who missed the entire GFC, claiming that it was contained to subprime mortgages, without the risk of contagion.  The same government officials more recently said that they don’t think there will be another crisis in our lifetimes.  The same officials say that they are seriously concerned about retirees and pensioners.

The current crisis should produce a deflationary event in assets, similar to that of the Great Depression. While I don’t think we will see a crash similarly shaped to that of 1929 with a more gradual fall to the bottom (think of those YouTube videos of balls being thrown off a dam to demonstrate the Magnus Effect), what the end result will be is ultimately the same. The path we take from point A to point B is yet to be determined. 

If the government would allow it to play out, the ensuing recession would be far more brief than the dislocations we are still experiencing since 2008, and perhaps quicker than 1920 as well. A deflationary event in asset markets would produce some pain for some time. On the other side would be a restructuring of the economy with capital, cash, and manpower redistributed more efficiently to that which is more deserving of your dollars, especially in light of the power of AI that we are seeing come to fruition now with new cures for diseases, solving engineering questions, and much more. As I have said many times, money flows to where it is treated best.

The Fed doesn’t want contractionary deflation because of what happened in 1920 and the Great Depression. Worse than fearing death, the Fed fears deflation because America is the biggest debtor in the world, and paying off all that debt will be all the more difficult in a deflationary event. The Fed is actually causing one as we speak, but I digress.

Just saying the two words “Great Depression” still sends chills down most people’s spines if they had paid only minimal attention to their history teacher in high school. The simple explanation is that when there is a credit expansion that is faster than the growth of the real money supply, it creates wealth, but also creates inflation. Subsequently, what happens is when the economy begins to flush out bad investments and some of that money is destroyed, so too some of that wealth will be destroyed along with it. This creates a contraction of available credit, deflation, and the destruction of wealth. That is what the Fed is more afraid of than death itself or even public speaking.

The growth rate of the money supply leading up to 1920 was around 13%. In the pandemic, it was more than double that at 27% here in America. Since mid-2021, it has actually been shrinking for the first time since the Great Depression. There have been times when the growth rate approached 0% since then, but until now it has never dipped below into shrinking territory. And this is the very definition of deflation, which in turn will cause prices to drop.  Yeah, you also need to have the people thinking prices will fall, and you also need to slow the velocity of money. Velocity has been slowing for quite some time, and in fact, that is the reason that it was so difficult for the Fed to get prices to rise more quickly until the pandemic.

One of the results will be the government will take in less income because if prices are falling, that means businesses will take in less money at the cash register, which means lower profits, and in turn less taxes collected. It also means that you and I will earn less, and therefore less income taxes will be collected. This will force the government to borrow even more money to meet expenditures, just at a time when interest rates are rising.
 

Policy Response

Congress, Treasury, and the Fed will have a few choices for their policy response. One is outright default, which they will never allow. It’s actually the best option to say “Hey, we screwed it up, we’re offering 78 cents on the dollar to repay you now for everything you lent us, we need to start over, and let’s talk about restructuring our debt load as well as how we will spend tax receipts.”

I know what you’re thinking. “Pbbt! What a freakin fantasy.  You’re no genius, but you sure are mad!” Look here, it’s an option, and the best one, but I acknowledge that it will never be the first or even second choice of action. It won’t even be the last resort. Another policy response could be austere spending plans and allowing the interest rate on debt to float in the free market. This too is just a pipe dream.

The real policy response that we can expect, will come in two parts. The first part, according to most opinions including my own, (I have already written about extensively), is more inflation. The deflationary response we are seeing now, that the Fed is allowing bonds to mature without rolling them over as well as buying back up to $95B of bonds and MBS per month, will come to not only a screeching halt but an about-face. I just don’t think that will happen this year, as the Street seems to think. It will require far more time than anticipated and/or a serious black swan event.

There is actually another possibility for the first part of the policy response. That is, Jay Powell’s Fed will continue to reduce the balance sheet and leave rates elevated for some time in an effort to give the appearance of tight monetary policy. At the same time, Congress will resolve the manufactured debt ceiling crisis and go back to more and more spending. That is the status quo, after all.

Another possibility is an extension of the second part above. In addition to the elevated rates and bond buying, the Fed will be forced into a more targeted policy response to more banks failing. It won’t be only regional banks either. In addition to bailing out depositors, regardless of FDIC limits, the Fed will be forced to bail out failing banks by supporting the bank(s) that swoop in to buy up the bad assets at a discount.

In my last post, I mentioned that you can use a free bond valuation calculator and see that if a bond was paying 1%, 24 months ago when issued at par, and now rates are at 4%, the same bond will decrease in value to $0.80 on the dollar so that it’s yield will be the same 4% as can be found in the open market. But there is a risk that rates in the open market will rise further, causing bonds to lose even more value, and that is where the Fed will step in to support the value all the way back to par. Silicon Valley Bank, Signature Bank, and others have already been taken over, using this method. Depositors will always be made whole and the buyer-bank will be supported by programs like the bank term funding program, which is already up to $87B as of May 18, 2023. There are other programs as well, such as the PDCF, CPFF, MMLF, and others.
 

What the Fed Already Knows

And that brings me to a report that was recently published for the public, with the names of the authors redacted (it’s only 11 PowerPoint slides and less than 10 minutes to read). The Fed already knew in late summer 2022 that 722 banks (and rising) are at threat of failure because of unrealized losses exceeding 50% of capital.  To put that into perspective, SBV was looking at $21B in unrealized losses against $208.6B in total assets. That is just over 10% and the bank went under!

According to FDIC data, during the GFC the number of banks that failed was 3 banks in 2007, 25 banks in 2008, 140 in 2009, and a peak of 157 in 2010 before falling off to 92 and 51 in 2011 and 2012, respectively. By the end of 2017, a total of over 530 banks failed. That’s a lot of banks, and far more than we have seen so far, however, the situation is not getting better. It is getting worse. Much worse. There are already almost 40% more banks ready to fail than we saw in the entire GFC.

If SVB failed at 10% in unrealized losses and the Fed is looking at 50% in unrealized losses as of 9 months ago, I can only imagine where we likely stand now.  For a little more perspective, in 2008 we saw the biggest bank failure in the history of the country, which was Washington Mutual (WAMU), plus another 24 banks. The combined total assets of those 25 banks were $524B. This year, we saw SVB, SBNY, and FRB fail to the tune of $532B in total assets. SVB was about $21B in unrealized losses, SBNY was around $3B, and FRB was around $5B (up from about $53M a year earlier). The total unrealized losses were $29B on $532B in assets, or 5.45% (and the Fed is looking at 50% as the bar to clear to be considered at risk). These three banks already surpass 2008 in size.

As if this isn’t enough to scare you, guess what the Fed is doing? According to the very same slide deck, the Fed is increasing monitoring of the same banks in question. That’s right, they’re watching out for the boogie man. That didn’t do any good for SVB, SBNY, or FRB, and it won’t do anything for the other banks either. 31 of the banks reported negative tangible equity levels, which according to the Fed means that if depositors want their money, those banks will lose their ability to borrow more money from federal home loan banks and may not be able to sell any of their loans to have the cash on hand to pay back depositors.
 

Recession Indicators

In the last few weeks, as the heat has turned up on the debt ceiling theatrics, and as the banks have taken to second fiddle, we are concurrently hearing analyst opinions coming out that we are on the cusp of recession. If you listen to them speak or read what they write, they all pretty much 1) rely on one or two indicators, and 2) leave you more confused.  Besides leaving you more confused, they all rely on different indicators, so it makes it hard to piece together the puzzle.

An additional problem is looking at backward-looking indicators, which tell you what already happened. If you look at those you might say we are in recession, but that is already after the fact. You have to look at forward-looking indicators as well to help you recognize when it is coming. In turn, this helps you adjust your asset allocations and make preparations for when it hits the fan, thereby protecting your gains and possibly profiting through the contractionary period.

One of those forward indicators is initial jobless claims, now beginning to rise in earnest, and in the post-pandemic era, now catching up to other labor market indicators. We don’t really want to look at the week-to-week numbers though. More important is the delta off the bottom, now in excess of 30% and quickly jumping off those lows. In the last 7 recessions going back to 1970, this looks like the cutoff point of going into recession without too much delay. Related is layoffs, and usually, tech startups are the proverbial police that ends the teen drinking party when your parents go on vacation. The tech sector has been announcing layoffs for months, and since January this year, the rest of the economy has spiked by two-fold from about 25K per month to over 50K per month.

When we see the unemployment rate jumping by half a percent off the low, this is also a pretty good indicator that recession is nigh. This implies that 4% is the number to watch. Once we rise above that level, especially if it is either a firm move above or more than one month in a row.

We also see new truck orders are off the highs, shipping is beginning to fall, inventories are rising, and several big box retailers and regional retailers have either lost their credit rating or are on bankruptcy watch with the factor banks. A factor bank buys your receivables and then collects them from the customer. This indicates that credit is tightening and banks are less willing to take on the risk of not being able to collect.

The most watched-forward indicator is probably the yield curve. Typically we watch the 2Y/10Y. And typically you will see it invert several months before the recession begins, then spiking back towards normal levels coincident with the start of the recession. In fact, it typically dips to inverted, very briefly testing the waters, about 10 months before the recession. Then it reverts to positive before inverting again with determination and staying power about 5-6 months before the recession.

If you think about it, this makes sense.  In an expansionary period, the spread is around 250-300 bps, with the 10Y being higher. As the near-term rate rises, which typically affects business, we begin to see lending from banks tightening and businesses pull back both borrowing and capital expenditures on things like plants and equipment. The business naturally begins to contract because of this relationship between the interest rate and borrowing to spend in these areas. To make a long story short, eventually, banks ease their short-term rates to attract borrowers and raise their long-term rates in anticipation of higher long-term risks. This reverts the yield curve and steepens it back towards a normal spread.

Strong as the case may have been in the past for a recession, indicators are telling us that it is no longer on the horizon. It now looks like we are but a few months out. Let's bring it on and wipe out all the bad investments of the last 15+ years, and let's realign the economy for more prosperity for all.
 

Safety Moves

There is a lot to be said right now, in fact, several billion reasons, about the merits of demand deposits paying above 4% interest. Thousands made that decision already, and there is still more to come. Don’t get caught up with the difference between 4.13% at one institution versus 4.17% at another.  It’s pointless. What are you waiting for? Move your cash to where it’s treated best. If you are terribly concerned with the tax implications, speak to your accountant about the benefits of owning short-term treasuries of 90 days or less until maturity, which you can continually roll over as needed.

Even if you aren’t a gold bug, there are big merits to owning gold and silver. I think gold could see $1930/oz as it bottoms, and if it moves strongly thru that area we can easily see $1800/oz. I strongly recommend owning physical gold rather than an EFT that merely tracks spot prices.  Silver will follow gold, but once the next bull move begins you will see silver outperform.

You can read more about other positions I am in and recommend in my prior articles, so I won’t belabor that here. Those include long on energy, healthcare facilities, utilities, and shipping; short on housing and junk bonds.

I also think it to be worthwhile to make your shopping list now and check it twice. When everything really hits the fan, I don’t agree with the Street that we will see the S&P down to 3500-3600 for a bottoming range. It will be much lower, below 3000, and more likely below 2000. Valuations are currently still so far gone by all metrics, that even a return to past normal levels for an expansionary period indicates 3000. We will have the chance to pick up the bluest chips at the steepest discounts in 15 years.  Names like Apple, Microsoft, Chase Bank, Intel, Starbucks, WalMart, and others will be on sale at 50-75% discounts from current levels.

And remember, there’s always a bull market somewhere in the world, and on the opposite side of every crisis, there always lies opportunity.

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