Bank Term Funding Program: A Primer On The Fed’s Shiny New Tool

The debate around whether or not this policy is a form of quantitative easing misses the point: Liquidity is the name of the game for global financial markets.

The article below is an excerpt from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

QE Or Not QE?

The Bank Term Funding Program (BTFP) is a facility introduced by the Federal Reserve to provide banks a stable source of funding during times of economic stress. The BTFP allows banks to borrow money from the Fed at a predetermined interest rate with the goal of ensuring that banks can continue to lend money to households and businesses. In particular, the BTFP allows qualified lenders to pledge Treasury bonds and mortgage-backed securities to the Fed at par, which allows banks to avoid realizing current unrealized losses on their bond portfolios, despite the historic rise in interest rates over the past 18 months. Ultimately, this helps support economic growth and protects banks in the process.

The cause for the tremendous amount of unrealized losses in the banking sector, particularly for regional banks, is due to the historic spike in deposits that came as a result of the COVID-induced stimulus, just as bond yields were at historic lows.

Shown below is the year-over-year change in small, domestically chartered commercial banks (blue), and the 10-year U.S. Treasury yield (red).

TLDR: Historic relative spike in deposits with short-term interest rates at 0% and long-duration interest rates near their generational lows. 

Banks saw a spike in deposits with short-term interest rates at 0% and long-duration interest rates near their generational lows.
The rise in Treasury yields led to massive unrealized losses for banks holding bonds.
Source: Bloomberg

The reason that these unrealized losses on the bank’s security portfolios have not been widely discussed earlier is due to the opaque accounting practices in the industry that allow unrealized losses to be essentially hidden, unless the banks needed to raise cash.

The BTFP enables banks to continue to hold these assets to maturity (at least temporarily), and allow for these institutions to borrow from the Federal Reserve with the use of their currently underwater bonds as collateral.

The impacts of this facility — plus the recent spike of borrowing at the Fed’s discount window — has brought about a hotly debated topic in financial circles: Is the latest Fed intervention another form of quantitative easing?

In the most simple terms, quantitative easing (QE) is an asset swap, where the central bank purchases a security from the banking system and in return, the bank gets new bank reserves on their balance sheet. The intended effect is to inject new liquidity into the financial system while supporting asset prices by lowering yields. In short, QE is a monetary policy tool where a central bank purchases a fixed amount of bonds at any price.

Though the Fed has attempted to communicate that these new policies are not balance sheet expansion in the traditional sense, many market participants have come to question the validity of such a claim.

If we simply look at the response from various asset classes since the introduction of this liquidity provision and the new central bank credit facility, we get quite an interesting picture: Treasury bonds and equities have caught a bid, the dollar has weakened and bitcoin has soared. 

Treasury bonds and equities caught a bid while the dollar weakened.
Bitcoin soared with the liquidity being added into the system from the BTFP.

On the surface, the facility is purely to “provide liquidity” to financial institutions with constrained balance sheets (read: mark-to-market insolvency), but if we closely examine the effect of BTFP from first principles, it is clear that the facility provides liquidity to institutions experiencing balance sheet constraint, while simultaneously keeping these institutions from liquidating long-duration treasuries on the open market in a firesale.

Academics and economists can debate the nuances and intricacies of Fed policy action until they are blue in the face, but the reaction function from the market is more than clear: Balance sheet number go up = Buy risk assets.

Make no mistake about it, the entire game is now about liquidity in global financial markets. It did not used to be this way, but central bank largesse has created a monstrosity that knows nothing other than fiscal and monetary support during times of even the slightest distress. While the short-to-medium term looks uncertain, market participants and sidelined onlookers should be well aware as to how this all ends.

Perpetual monetary expansion is an absolute certainty. The elaborate dance played by politicians and central bankers in the meantime is an attempt to make it look as if they can keep the ship afloat, but in reality, the global fiat monetary system is like an irreversibly damaged ship that’s already struck an iceberg.

Let us not forget that there is no way out of 120% debt-to-GDP as a sovereign without either a massive unforeseen and unlikely productivity boom, or a sustained period of inflation above the level of interest rates — which would crash the economy. Given that the latter is extraordinarily unlikely to occur in real terms, financial repression, i.e., inflation above the level of interest rates, appears to be the path going forward.

CPI continues to run hot at the same time the debt-to-GDP ration is incredibly high.

Final Note

For the layman, there is no dire need to get caught up in the schematics of the debate whether recent Fed policy is quantitative easing or not. Instead, the question that deserves to be asked is what would have happened to the financial system if the Federal Reserve didn’t conjure up $360 billion worth of liquidity from thin air over the last month? Widespread bank runs? Collapsing financial institutions? Soaring bond yields that send global markets spiraling downwards? All were possible and even likely and this highlights the increasing fragility of the system.

Bitcoin offers an engineering solution to peacefully opt out of the politically corrupted construct colloquially known as fiat money. Volatility will persist, exchange rate fluctuations should be expected, but the end game is as clear as ever.

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Silvergate Solvency In Question As Crypto Banking Troubles Brew

Silvergate clients flee as stock price plummets and regulatory questions mount across the industry. Options for crypto banking partners are dwindling.

The article below is an excerpt from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

Trouble Brewing In Crypto-Land

Developments around crypto on- and off-ramps have been heating up, as Federal Reserve Member Bank Silvergate Capital watched its depositors flee and its stock price plummet. Along with Signature Bank, Silvergate is the other key U.S. bank that works closely with the crypto sector.

The reason for the extreme concentration of banking interests that are willing to deal in the crypto sector is the general lack of regulation around know-your-customer and anti-money laundering (KYC/AML) policy that exists in the industry for offshore entities, as well as the issues with the broader industry being rife with unregistered security offerings and plenty of fraud.

Of course, we believe there is a clear distinction between bitcoin and the broad term colloquially referred to as “crypto”, but the lines remain blurred for many regulators and government agencies.

Thus, there have historically been very few entities in the regulated U.S. banking system that have been willing to work with crypto firms to access established USD on- and off-ramps, which presents a unique challenge to companies who are in the business of moving money and/or processing payments and transactions.

In regards to Silvergate, we have been monitoring the situation closely since November — after the collapse of FTX — as it became apparent that Silvergate played a role in serving FTX and Alameda by giving them access to USD rails.

As we wrote on November 17, (emphasis added):

“Who else is at the center of many institutions in the market? Silvergate Bank is one of those. Since the beginning of November, their stock is down nearly 56%. Silvergate Bank is at the nexus of banking services for the entire industry, servicing 1,677 digital asset customers with $9.8 billion in digital asset deposits. FTX accounted for less than 10% of deposits and the CEO has tried to reassure markets that their current loan book has faced zero losses or liquidations so far. Leveraged loans are collateralized with bitcoin that can be liquidated as necessary. Yet, the ongoing risk is a complete bank run on Silvergate deposits.. Although the CEO’s comments sound reassuring, the stock performance over the last two weeks tell a much different story.” — The Contagion Continues: Major Crypto Lender Genesis Is Next On The Chopping Block

Since the implosion of FTX, shares of Silvergate Capital have fallen by 83%, putting the current drawdown from the all-time high price at an eye-watering 97.3%. 

As referenced in the November 17 article, Silvergate’s share price isn’t imploding due the performance of a crypto token as was the case for many companies in the crypto winter of 2022, but rather from a deposit exodus that has forced the firm to liquidate long-duration securities at a loss in order to remain liquid.

Link to embedded tweet.

As a traditional fractional reserve bank, Silvergate took client deposits — which drastically increased in 2021 — and lent them out over a long duration, into U.S. Treasury bonds, in particular. In practice, firms would lend their money to Silvergate by depositing at 0% in order to utilize their Silvergate Exchange Network (SEN), and Silvergate would then lend out those same dollars at a higher interest rate over a long period of time. This is a great business model — as long as your loans don’t fall in value at the same time as clients go to withdraw their funds.

“Customers withdrew about $8.1 billion of digital-asset deposits from the bank during the fourth quarter, which forced it to sell securities and related derivatives at a loss of $718 million, according to a statement Thursday.” — Silvergate Tumbles After FTX Implosion Prompts $8.1 Billion Bank Run

As commentary has ramped up about the incompetence and irresponsibility of Silvergate’s management, we need to interpret some of the nuance surrounding the situation.

Link to embedded tweet.

A majority of Silvergate’s deposits came during a world of zero-interest-rate policy, where short-duration Treasury securities offered 0% yield. This phenomenon is one of the core reasons why Silvergate invested in longer-duration instruments. The bonds fell in value as global interest rates rose throughout 2022.

With long-duration debt securities, money isn’t lost in the case of rising interest rates as long as the bond is held to maturity (and not defaulted upon), but in the case of Silvergate, fleeing deposits forced the firm to realize the unrealized losses on their securities portfolio — a nightmare for a fractionally reserved institution. 

With solvency worries mounting in recent months, companies frontran speculation about exposure to the bank, with names such as Coinbase, Paxos, Circle, Galaxy Digital, CBOE and others communicating about their banking relations with Silvergate. Coinbase explicitly announced their move to Signature bank.

“We are facilitating fiat withdrawals and deposits using Signature Bank, effective immediately.” — Coinbase memo

One concern is that many of these firms are turning solely to Signature bank, which further centralizes the off- and on-ramps currently utilized by the crypto industry, even though Signature has a much larger market capitalization and more diversified depositor base than Silvergate.

The current state of Signature’s digital asset deposit base is unknown, as the firm communicated its desire to reduce reliance on crypto-related deposits in early December.

“Signature Bank (SBNY) will shrink its deposits tied to cryptocurrencies by $8 billion to $10 billion, signaling a move away from the digital asset industry for the bank that until recently had been one of the most crypto-friendly companies on Wall Street.

“We are not just a crypto bank and we want that to come across loud and clear,” Signature Bank’s CEO Joe DePaolo said at an investor conference in New York hosted by Goldman Sachs Group on Tuesday.” — Coindesk

The timeline of these events is important because of the recent developments regarding the industry’s flight from Silvergate coming at the same time that Signature appears to be handcuffing the use of its rails with key industry players.

Final Note

Following a disastrous 2022, regulators are ramping up their careful examination of the crypto sector, and one of their main targets is the connection between the industry and the legacy banking system. As Silvergate looks to be all but dead in the water with nearly every major industry player announcing plans to sever ties, the increasing reliance on Signature Bank, a bank that has announced its intention to distance itself from the space, remains… worrisome.

While this poses no fundamental risk to the functioning of the Bitcoin network or its properties as an immutable settlement layer, the clampdown and increasing centralization of USD on- and off-ramps is a key risk for short-to-intermediate term liquidity in the bitcoin and broader crypto market.

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The Big Flip: Interest Rate Expectations Repricing Upward

The Big Flip thesis has been gaining traction in the financial world and describes the market’s misplaced belief in the path of inflation and policy rates.

The article below is a free full piece from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

The Big Flip

In this article, we break down a macro thesis that has been gaining an increasing amount of traction in the financial world. The “Big Flip” was first introduced by pseudonymous macro trader INArteCarloDoss, and is based on the market’s apparent misplaced belief on the path of inflation and subsequently the path of policy rates. 

Link to embedded tweet.

To simplify the thesis, the Big Flip was built upon the assumption that an imminent recession in 2023 was wrong. Even though the rates market had fully priced in the belief that an impending recession was likely, the big flip and recession timeline may take longer to play out. In particular, this change in market expectations can be viewed through Fed fund futures and short-end rates in U.S. Treasuries.

In the second half of 2022, as the market consensus flipped from expecting entrenched inflation to disinflation and an eventual economic contraction in 2023, the rates market began to price in multiple rate cuts by the Federal Reserve, which served as a tailwind for equites due to this expectation of a lower discount rate.

In “No Policy Pivot In Sight: "Higher For Longer" Rates On The Horizon,” we wrote:

“In our view, until there is meaningful deceleration in the 1-month and 3-month annualized readings for measures in the sticky bucket, Fed policy will remain sufficiently restrictive — and could even tighten further.”

“While it is likely not in the interests of most passive market participants to dramatically alter the asset allocation of their portfolio based on the tone or expression of the Fed Chairman, we do believe that “higher for longer” is a tone that the Fed will continue to communicate with the market.

“In that regard, it’s likely that those attempting to aggressively front-run the policy pivot may once again get caught offside, at least temporarily.

“We believe that a readjustment of rate expectations higher is possible in 2023, as inflation remains persistent. This scenario would lead to a continued ratcheting of rates, sending risk asset prices lower to reflect higher discount rates.”

Since the release of that article on January 31, the Fed funds futures for January 2024 have risen by 82 basis points (+0.82%), erasing over three full interest-rate cuts that the market originally expected to take place during 2023, with a slew of Fed speakers recently reiterating this “higher for longer” stance.

As we drafted this article, the Big Flip thesis continues to play out. On February 24, Core PCE price index came in higher than expected.

Fed fund futures continue to reprice higher as interest-rate expectations rise.

Shown below is the expected path for the Fed funds rate during October, December and in the present. 

Source: Joe Consorti

Despite the disinflation CPI readings on a year-over-year basis during much of the second half of 2022, the nature of this inflationary market regime is something that most market participants have never experienced. This can lead to the belief of “transitory” pressures, when in reality, inflation looks to be entrenched due to a structural shortage in the labor market, not to mention financial conditions that have greatly eased since October. The easing of financial conditions increases the propensity for consumers to continue to spend, adding to the inflationary pressure the Fed is attempting to squash. 

Unemployment is at 53-year lows.

With the official unemployment rate in the United States at 53-year lows, structural inflation in the workplace will remain until there is sufficient slack in the labor market, which will require the Fed to continue to tighten the belt in an attempt to choke out the inflation that increasingly looks to be entrenched.

While flexible components of the consumer price index have fallen aggressively since their peak in 2022, the sticky components of inflation — with a particular focus on wages in the service sector — continue to remain stubbornly high, prompting the Fed to continue their mission to suck the air out of the figurative room in the U.S. economy.

Sticky CPI measures inflation in goods and services where prices tend to change more slowly. This means that once a price hike comes, it’s much less likely to abate and is less sensitive to pressures that come from the tighter monetary policy. With Sticky CPI still reading 6.2% on a three-month annualized basis, there is ample evidence that a “higher for longer” policy stance is needed for the Fed. This looks to be exactly what is getting priced in.

Sticky CPI remains elevated.

Published on February 18, Bloomberg reiterated the stance of disinflation flipping back toward a reacceleration in the article “Fed’s Preferred Inflation Gauges Seen Running Hot.”

“It’s stunning that the decline in year-over-year inflation has stalled completely, given the favorable base effects and supply environment. That means it won’t take much for new inflation peaks to arise.” — Bloomberg Economics 

After inflation seemed to be abating, January PCE comes in hotter than expected.

This comes at a time when consumers still have approximately $1.3 trillion in excess savings to fuel consumption. 

Source: Gregory Daco

While the savings rate is extremely low and aggregate savings for households is dwindling, the evidence suggests that there is plenty of buffer to continue to keep the economy piping hot in nominal terms for the time being, stoking inflationary pressures while the lag effects of monetary policy filter through the economy. 

Personal savings are dwindling.

It is also important to remember that there is a section of the economy that is far less rate-sensitive. While the financialized world — Wall Street, Venture Capital firms, Tech companies, etc. — are reliant on zero interest-rate policy, there is another section of the U.S. economy that is very much insensitive to rates: those dependent on social benefits.

Those who are dependent on federal outlays are playing a large part in driving the nominally hot economy, as cost-of-living adjustments (COLA) were fully implemented in January, delivering a 8.3% nominal increase in buying power to recipients.

Year-over-Year change in Social Security benefits. Source: FRED

Social security recipients are actually not in possession of any increased buying power in real terms. The psychology of a nominal increase in outlays is a powerful one, particularly for a generation not used to inflationary pressure. The extra money in social security checks will continue to lead to nominal economic momentum.

Core PCE Comes In Hot

In Core PCE data from February 24, the month-over-month reading was the largest change in the index since March 2022, breaking the disinflationary trend observed over the second half of the year which served as a temporary tailwind for risk assets and bonds. 

Source: Nick Timiraos
U.S. Inflation gauges reaccelerate.

The hot Core PCE print is vitally important for the Fed, as Core PCE notably carries a lack of variability in the data compared to CPI, given the exclusion of energy and food prices. While one may ask about the viability of an inflation gauge without energy or food, the key point to understand is that the volatile nature of commodities of said categories can distort the trend with increased levels of volatility. The real concern for Jerome Powell and the Fed is a wage-price spiral, where higher prices beget higher prices, lodging itself into the psychology of both businesses and laborers in a nasty feedback loop.

Inflation is lasting longer than hoped as shown by the Sticky CPI.
The job market is still too hot for the demand destruction needed to bring inflation down.

“That’s the concern for Powell and his colleagues, sitting some 600 miles away in Washington, and trying to decide how much higher they must raise interest rates to tame inflation. What Farley’s describing comes uncomfortably close to what’s known in economist parlance as a wage-price spiral – exactly the thing the Fed is determined to avoid, at any cost.” —- “Jerome Powell’s Worst Fear Risks Coming True in Southern Job Market

The Fed’s next meeting is on March 21 and 22, where the market has assigned a 73.0% probability of a 25 bps rate hike at the time of writing, with the remaining 27% leaning toward a 50 bps hike in the policy rate.

Source: CME FedWatch Tool 

The increasing momentum for a higher terminal rate should give market participants some pause, as equity market valuations increasingly look to be disconnected from the discounts in the rates market.

A lead Morgan Stanley strategist recently expressed this very concern to Bloomberg, citing the equity risk premium, a measure of the expected yield differential given in the risk free (in nominal terms) bond market relative to the earnings yield expected in the equity market.

“That doesn’t bode well for stocks as the sharp rally this year has left them the most expensive since 2007 by the measure of equity risk premium, which has entered a level known as the ‘death zone,’ the strategist said.

“The risk-reward for equities is now ‘very poor,’ especially as the Fed is far from ending its monetary tightening, rates remain higher across the curve and earnings expectations are still 10% to 20% too high, Wilson wrote in a note.

“‘It’s time to head back to base camp before the next guide down in earnings,’ said the strategist — ranked No. 1 in last year’s Institutional Investor survey when he correctly predicted the selloff in stocks.” — Bloomberg, Morgan Stanley Says S&P 500 Could Drop 26% in Months

The S&P 500 equity risk premium is in the "death zone."

Final Note:

Inflation is firmly entrenched into the U.S. economy and the Fed is determined to raise rates as high as needed to sufficiently abate structural inflationary pressures, which will likely require breaking both the labor and stock market in the process.

The hopes of a soft landing that many sophisticated investors had at the beginning of the year look to be dissipating with “higher for longer” being the key message sent by the market over recent days and weeks.

Despite being nearly 20% below all-time highs, stocks are pricier today than they were at the peak of 2021 and the start of 2022, relative to rates offered in the Treasury market.

This inversion of equities priced relative to Treasuries is a prime example of the Big Flip in action.

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