Believe it or not, one of the discussion points lately on Wall Street is why haven't things been even worse as a result of the Fed's massive tightening?
Think about it: we just had at least $12 trillion of wealth wiped out in roughly twelve months' time, and one of the biggest interest rate spikes in modern history. The 1994 rate spike, for instance, which wasn't even as bad as this one, resulted the bankruptcy of California's Orange County. The collapse of the housing market that started in 2006 sparked the great financial crisis. So far this time around, we have...the downfall of FTX?
Things could, and arguably should, be a whole lot worse. So why aren't they? David Zervos of Jefferies offers one possible answer: the Federal Reserve's massive balance sheet. One of the subtle changes that's happened over the past decade is that the Fed has morphed into a "buyer of last resort," mopping up financial products that no one else wants.
You can see the value of this in a panic: the Fed takes the hot potatoes the private market doesn't want, therefore preventing a bigger crisis. But as a standing policy, it could end up leaving the Fed itself, and therefore taxpayers, on the hook for losses.
"A massive chunk of the losses that would usually occur during a rate-hike cycle [are] being socialized on the balance sheets of global central banks," Zervos wrote in a client note this morning. Recall, it was losses on mortgage-backed securities during the rate spike in 1994 that bankrupted Orange County. Fast forward to 2023, and it's the Fed holding those products (some $2.6 trillion worth) because it swallowed so much of the market while doing its purchases for "quantitative easing."
If banks or other financial players held those products--now worth let's say 10% or 20% less or even more because of the rate spike--they'd be facing huge losses, especially if leverage were involved. But because the Fed is holding them, the losses are "hidden" from society. "That's why financial markets and the economy have held up so well after this tightening," Zervos argues.
But that's not all. This also "implies that monetary tightenings are now much less potent than in the past," because rate hikes don't have as much sting. If Zervos is right, and the Fed reacts accordingly, it means higher-for-longer rates than people might be expecting. It also suggests that "QE" is actually a very potent tool--especially since any gains from the portfolio go back to the Treasury, while losses are deferred.
So we're left with a better-off private sector, and a worse-off central bank. The big bank-like companies of the world make more money from higher rates, Zervos argues, while avoiding losses by "shoving products" back to the Fed. And the Fed and other global central banks who have the same policy are "left with mounting portfolio losses and a much less powerful inflation-fighting toolkit."
To which I might just add: this is the best-case scenario. The last time we all debated "why things weren't even worse" was in spring 2008, after the Bear Stearns collapse. By that fall, things were a lot worse. Let's hope we aren't in a similar situation now.
See you at 1 p.m!
Kelly
