For traders, a FED rate cut next week is a done deal, and portfolios have already been positioned accordingly. This is the narrative force-fed by MSM to the public that everyone is expected to embrace. However, today I would like to offer you a different perspective. What if this strong bid we are seeing for T-Bills is yet again a harbinger of a banking crisis as we saw in 2022? Follow me here.
The first thing important to understand is the role of US T-Bills in the plumbing of the financial system, especially the 1-month maturity ones. T-Bills are effectively “better than cash”. Wait, what? Yes sir, T-Bills are what’s called in jargon “pristine collateral”, meaning that by pledging them, you can borrow 100% of their value in cash. Collateral is segregated on your lender’s balance sheet, meaning that if that counterparty goes bust, you can receive your assets back in full as long as you repay the cash borrowed. On the other front, if the borrower goes bust, the lender can sell the T-Bills in the market, recovering the full amount of cash lent without being part of the bankruptcy estate. The Achilles’ heel of borrowing using T-Bills as collateral is that these assets can be re-hypothecated, meaning the lender can pledge those assets as collateral to borrow money itself from a third counterparty. So paradoxically, the borrower will be exposed to the default of the lender, being asked to repay its debt in full with the uncertainty it will be able to recover 100% of its collateral if this wasn’t properly segregated. Let me be clear though, this is an extreme scenario, and in many agreements, there are specific clauses under which the borrower has leeway to keep the cash borrowed if the lender doesn’t return the collateral to a third-party custodian. If the lender lends cash against any other form of collateral, or even without collateral, the risk it incurs is clearly much higher. Furthermore, “holding cash” in reality means holding a deposit in another institution, and unless this is a Central Bank, the credit risk in case that institution starts facing liquidity issues is significant. If the institution goes bust, the cash effectively becomes part of the bankruptcy estate with the risk of not receiving back 100% of it since the deposit insurance only covers amounts up to $500k. Then why don’t banks keep all their cash with Central Banks?
As a matter of fact, that is what they are doing, especially in Europe, because they don’t trust each other and they aren’t confident to lend to the economy (reason why Europe is going through a very prolonged stagnation). While this might sound like a win-win for banks, in reality, it stops working well when their depositors start asking for higher rates, denting the profitability of the institution as is happening across the board today when many lenders don’t enjoy anymore the luxury of paying 0% on customer deposits. Furthermore, holding too many deposits triggers significant regulatory charges, especially for liquidity, ultimately denting banks’ ROEs. This is why banks prefer to hold pristine collateral like T-bills since it can be used efficiently to manage the risk of their operation without impairing the bank’s strength and profitability as holding cash does. I know that what I just described is hard to digest, but it’s very important to set it straight. Please accept my apologies nevertheless.
We can move to the second part now and focus on the market dynamic, in particular when banks start to bid heavily for T-bills. Please have a look at the first chart below from the end of 2022; as you can easily notice, T-Bills yields rallied significantly (rallying in yields means they go lower).
Why were banks stashing so much pristine collateral? Because Credit Suisse was already showing signs of distress: “Credit Suisse Saw $88 Billion Outflows as Confidence Slumped”. Basically, banks were “running for the hills” and pulling their cash from the global system and redeploying it in T-Bills since this is a much safer alternative, even considering that, contrary to what everyone believes, not all banks have direct access to Central Banks, hence the possibility to “park” their cash there.
A few months later, SVB goes bust, kicking off the US regional banks crisis. At this point, T-bills start to sell off quickly. Why? Because banks started to liquidate the collateral they held from their counterparts failing to meet margin calls. This is when the FED stepped in, setting up the BTFP because it couldn’t afford to cut rates (similar to what’s the case today “IF THE FED CUTS RATES, THE DAMAGES WILL BE FAR GREATER THAN THE BENEFITS“).
The BTFP wasn’t enough to avoid Credit Suisse’s collapse in March, and as you can see in the second chart, T-Bills were once again heavily bid. However, the situation precipitated when First Republic Bank was going bust one month later, and the relief provided by the Swiss Central Bank bailout of CS didn’t last long, with T-Bills bid even stronger and then starting to be dumped when margin calls weren’t met. Despite FRC bailout, T-Bills liquidation kept going until they peaked around 6% before normalizing once the troubled banks started to borrow heavily from the BTFP, ultimately restoring the liquidity balance in the system, although at a higher level since now banks couldn’t ignore anymore the inherent risks in the system along with the fact the Fed wasn’t in a position to rescue everyone with an emergency cut while inflation was raging.
Fast forward to today, we are seeing again the dynamics of November 2022 unfolding, and while everyone likes to believe it is simply a sign of markets taking a fed rate cut for granted, I suggest monitoring the situation carefully.
If T-bills keep rallying at this pace, it might well be a sign of at least another big financial institution showing signs of distress to its counterparts. There are plenty of candidates out there from US and Europe (“WHICH BANKS ARE AT RISK OF GOING BUST IN A LIQUIDITY CRISIS? – EPISODE 2“) to Japan (“NORINCHUKIN BANK CHAOS CAN TRIGGER AT ANY MOMENT“). Furthermore, it is impossible that no lender suffered big losses on the 5th of August (“DID A CREDIT EVENT TRIGGER ON MONDAY?“), but regulators learned very well the lesson of one year ago and, in order not to trigger a bank run, are now keeping their mouths sealed.
However, unfortunately for them, signs of liquidity stress are mounting, especially at the Bank of England that just recorded a record 40bn GBP borrowing from its short-term emergency liquidity facility (“Surging UK Bank Borrowing From BOE Adds to Liquidity Debate“) that, as we observed, is clearly linked to troubles with the JPY carry trade unwinding (“THE JPY CARRY TRADE IMPLOSION CONTAGION IS ALREADY SPREADING INTO THE UK“). All in all, the situation looks quite shaky; better to be careful.
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