What is the FED POWELL TRAP?
Posted on 03/18/2023
SWFI is dubbing these series of events as the Fed Powell Trap or Powell Trap – named after current Federal Reserve Chairman Jerome “Jay” Powell. Powell is the first Fed Chairman to deal with a scenario of a global coronavirus pandemic accompanied by company shutdowns and quarantine policies. In essence, it is the rapid printing of money (expansion of the Federal Reserve balance sheet) causing rampant inflation, and the counteraction of quick rate rises leading to the need for more quantitative easing (QE) as financial institutions break. The Powell Trap scenario works by the Federal Reserve releasing bazooka-like quantitative easing during a crisis in which the background is really a supply shock versus lack of aggregate demand. Once the bazooka gets put away, the resulting action is that the Federal Reserve balance sheet doubles, inflation eventually becomes non-transitory as movement restrictions ease, and the central bank decides to raise rates. The raising of rates is aimed at controlling wild inflation in basic items such as energy, housing, food, and services. As banks absorbed deposits from more “printed” money in the system, they stuffed it into long-dated government bonds. However, when depositors flee and a bank run ensues, the Federal Reserve is instructed to step in and create more facilities and lending to increase the balance sheet, thus creating QE. It is important to note that a direct inflationary impact would be felt later if the banks increased their lending after the backstops versus maintaining strict lending requirements and not lending as much.
Remember, even the safest of perceived investments have risk. U.S. Treasuries have been a core part of modern financial theory – the dubbed risk-free rate. Many investors failed to see the relationship between bond prices and interest rates. In reality, all bonds have interest rate and duration risk. More than 50% of Silicon Valley Bank’s (SVB) assets at the end of 2022 were in bonds issued by the U.S. government or federal mortgage institutions, which they had purchased before the Federal’s tightening policies began. Treasuries are “safe” from default risk in most scenarios, but not from fast-rising interest rates. In the case of a bank run when technology enables people to transfer millions out a bank in seconds, SVB had to start selling off bonds at a loss to satisfy depositor demands until it couldn’t. A bond’s yield is not the same as the interest rate coupon promised at maturity on that instrument.
SVB
A major risk for SVB at the time before collapse was the continued high cash burn of venture capital-backed companies, leading to a large decline in deposits. On March 8, 2023, Silicon Valley Bank completed the sale of a portfolio of available for sale securities with a book value of approximately US$ 23.97 billion for net proceeds of approximately US$ 21.45 billion (resulting in an after-tax loss of approximately US$ 1.8 billion). The portfolio was sold to Goldman Sachs & Co. LLC at negotiated prices. SVB failed to raise capital from investors including General Atlantic and then soon after federal regulators took over the bank. The Federal Reserve coordinating with other the U.S. Treasury’s Exchange Stabilization Fund created the Bank Term Funding Program, to make short-term loans to banks on generous terms. The Federal Reserve also eased conditions at the Fed’s traditional overnight bank lending arm, the so called “discount window.”
U.S. banks borrowed a combined US$ 164.8 billion from two Federal Reserve backstop facilities in the most recent week. This is a sign of rising funding strains in the aftermath of the failures of Silicon Valley Bank and New York-based Signature Bank. For the week ended March 15, 2023, Federal Reserve published showed a record high of US$ 152.85 billion in borrowing from the discount window, the traditional liquidity backstop for banks. This is compared to US$ 4.58 billion the previous week. To put the severity into context, the prior all-time high was US$ 111 billion reached during the 2008 financial crisis.
Moral Hazards
On March 16, 2023, U.S. Treasury Secretary Janet Yellen attempted to reassure lending markets, equity markets, and lawmakers. Yellen testified in Congress reiterating that the U.S. federal government is committed to protecting U.S. bank deposits following the failure of Silicon Valley Bank and Signature Bank. The majority of SVB’s clients were venture-backed startups, biotech firms, wineries, venture capital funds, wealthy executives, and smaller technology companies who use the bank for day-to-day cash management to run their businesses. Those customers had US$ 175 billion on deposit with tens of millions in individual accounts. That left SVB with one of the highest share of uninsured deposits in the U.S. when it collapsed, with an estimated 94% of its deposits landing above the FDIC’s US$ 250,000 insurance limit. Yellen informed senators that government refunds of uninsured deposits will not be extended to every bank that fails, only those that pose systemic risk to the financial system. Under questioning from policymakers, Yellen admitted that not all depositors will be protected over the FDIC insurance limits of US$ 250,000 per account as they did for customers of the two failed banks.
Janet Yellen, the Federal Reserve Chair before Jay Powell, has been working with the Federal Reserve to create measures to refund billions of dollars in uninsured deposits held by clients of the failed SVB and the shuttered Signature Bank. The unintended consequence is showing as depositors are fleeing to larger banks. A run on regional and community banks would have deep implication for rural and suburban economies, as well as real estate developments in the U.S.
Keywords: Federal Reserve System.
