We remember Guy Fawkes as the last man to enter Parliament with honest intentions. But I don’t think central bankers will get away with the same moniker, even if their intentions are good. After all, they’re supposed to be regulating and rescuing the banking system, not blowing it up with bond bombs!
If you feel like the Bank of England governor Andrew Bailey has nailed you to a cross and is pressing down a crown of interest rate thorns, check out yesterday’s Fortune & Freedom before reading on. It provides some important context for today’s discussion of the bank crisis in the US and the bond bomb behind all the carnage.
As ever, I’m going to blame everything on central bankers. But they are, after all, the only real central planners left in our society.
If the government controlled the price of coal and the coal market went haywire, we’d blame the government.
If the government controlled the price of electricity and we got blackouts, we’d blame the government.
So, given the central bank still controls the price of money (the interest rate), why wouldn’t we blame them for the chaos in financial markets and the banking system?
And hasn’t there been chaos!
Double-digit inflation was bad enough. That was caused by creating too much money and keeping interest rates too low – both central bank mistakes.
Then came the UK’s pension meltdown, which was also caused by central bankers. Their interest rate hikes forced down government bond prices far more rapidly than anyone had anticipated, triggering chaos for the pensions that owned them.
And now we have a US banking crisis that just won’t go away, however often the authorities declare it to be over. But how is that the central bankers’ fault?
For much the same reason the UK pension blow-up was. I call it a bond bombing.
US banks hold vast amounts of government bonds. And interest rate hikes reduced the value of those bonds. This drop in value left banks holding less in assets than is safe, and so a bank run began.
At least, that’s the simplified version. There are several nuances to note in this story…
The first is that banks were required to hold large amounts of government bonds by regulation. This wasn’t quite an outright requirement. But banks were forced to hold a lot of safe assets. And government bonds were defined as safe by regulations, because governments are so incredibly unlikely to default.
This means that governments and central bankers loaded up banks with gunpowder and then lit the fuse by hiking interest rates rapidly…
Sure, default risk might be near zero on government bonds. But that’s not the only risk a bond faces. They also have price risk, meaning the price can go up and down. And when central bankers hike interest rates fast, bond prices fall fast.
The solution to this was supposed to be simple. If a bank simply assumes it’ll hold a bond to maturity (when the bond is repaid by the government) then there is no price risk.
This makes sense and I’ve advocated that investors do much the same thing in their personal portfolio by building what’s called a bond ladder.
But a bank is not the same as a personal portfolio. It has vast liabilities which are on call. Meaning that a lot of people lent banks a lot of money under the agreement that they can withdraw that money at any time. Those people are called depositors.
In order to meet depositor’s redemptions, the bank must sell something to raise the money to give to depositors. And they tend to sell things that are easy and quick to sell – government bonds.
Indeed, a good chunk of the whole point of having banks hold so many government bonds is that they can sell them easily to meet rapid withdrawals of deposits quickly and easily. It’s not like they can sell your home loan tomorrow.
But do you see the contradiction? It’s a three-way contradiction, making things confusing, but it’s an important one, so let’s review…
Banks hold a lot of easy-to-sell government bonds in order to shore up their reserves and in order to meet deposit withdrawals by selling those bonds.
But government bonds have price risk, which can put the bank at risk if they hold too many bonds and those bonds fall in value.
This price risk can be overcome by simply assuming the bonds will be held to maturity, meaning they won’t be sold.
The three factors, each designed to reduce risk, actually increase it on an overall basis once you combine them.
The combination encourages banks to hold too many government bonds, encourages them to presume they won’t need to be sold and then encourages to sell them quickly when there’s a deposit flight, which tends to happen when bond prices have fallen.
The line of dominos is lined up perfectly. Banks hold too many government bonds and assume they won’t have to sell them. When the price of the bonds fall, the bank gets into trouble because the value of their assets has fallen. This is precisely when they do have to sell the bonds in order to meet deposit flight.
In other words, the bonds that are supposed to de-risk the bank actually add risk precisely when you need their low-risk characteristics to shine.
It’s the ultimate house of cards, just waiting for a spark. And rapid interest rate hikes from the central bank was precisely that spark.
Which brings us to the second point. The deposit flight we’ve seen in US banks so far, which is spark that ignites the bond bomb, may also be the fault of central banks. The combination of unleashing inflation and then hiking interest rates rapidly triggered an unusual type of bank run which forced banks to sell the government bonds at a loss.
The likes of Northern Rock in 2008 were facing a deposit flight because depositors feared for their money. They rushed to the bank to get it out because they knew that if the bank failed, they’d have to wait for the government to sort out the mess and pay out deposit insurance.
Today, bank deposits are largely insured. And so depositors are staging bank runs for a different reason. In fact, it’s not really a bank run per se. It’s not deposit flight, but deposit slight. Money is leaving for greener pastures.
Inflation is running far ahead of interest rates. Especially interest rates on bank deposits.
But over in something called the Money Market, and in some government bonds, depositors can earn a far higher rate of interest.
What’s got banks into trouble is that their depositors are fleeing low interest rate bank accounts for other homes which pay better interest rates. It’s a run into money market funds and bonds, not out of banks.
The gap between the interest rates at banks and in money market funds and bonds is caused by central banks tightening monetary policy too quickly.
It takes a bank years to pass higher interest rates on to borrowers, especially in the US, where mortgages are largely fixed interest. Because of this, banks can’t increase deposit interest rates fast enough to keep up with the central banks’ recent interest rate hikes. It would increase their cost of raising money from depositors faster than the revenue from lending it can be raised.
And so people are fleeing bank deposits for places that can pass on higher interest rates from central banks. Especially people who manage large deposits, like those of mid-size corporations. Which is why the banks at which such companies bank are the ones going bust in the US.
It’s also why the US bond market is anticipating rapid interest rate cuts over the next few months. Investors think that central bankers have had their Wile E. Coyote moment. They realise they’ve blown themselves up with their bond bombs too, not just the Road Runner of inflation, which always seems to be one step ahead. And so they’ll soon have to cut interest rates.
We’ll have to wait and see if central bankers have woken up. Bond markets had predicted they wouldn’t make the mistakes they have so far in blowing up the US banking system.
What about us? Do the same dynamics apply?
Even if the UK is quite a few interest rate hikes behind the US, this is an international problem. If the Bank of England keeps hiking interest rates, which is the equivalent to lobbing bond bombs around the UK banking industry, look out…
All of this is a good reminder why bank stocks are worth avoiding. They have an uncanny ability to blow up. And sometimes avoiding losses can be enough to improve your overall returns in a portfolio.
But it doesn’t answer the question of what you should buy instead. To discover how you could squeeze more out of the stock market than your neighbour’s passive investing style can hope to generate, click here.
Editor, Fortune & Freedom