In a new paper prepared for the Handbook of Financial Integration, edited by Guglielmo Maria Caporale, Hiro Ito and I examine bond based measures of financial market integration (so, no quantity stock/flow measures, nor banking integration).

In short, covered interest differentials have risen, but uncovered interest differentials seem to have shrunk. There is ambiguous evidence regarding real interest differentials.

Figure 1: Covered interest differentials, bps. Source: Cerutti et al. (2021).

See some discussion of this phenomenon in this 2016 post.

Figure 2: Average absolute uncovered interest differential for advanced economy currencies (blue), for emerging market currencies (tan), annualized. Calculated using survey data.

See discussion of using survey data to infer what is happening with expectations, and how this changes our view of uncovered interest parity, here, and here; see Chinn and Frankel (2020).

Figure 3: Average absolute real interest differentials (3 month rates, using ex post inflation rates)

We conclude:

• Covered interest parity which was previously thought to hold, up to transactions costs, no longer holds post global financial crisis. At one juncture, part of this is due to default risk (so that measured yields no longer relate to assets of same default risk), and more recently to the change in the regulatory regime that now makes hedging costly.
• Uncovered interest rate parity needs to be distinguished from the unbiasedness hypothesis – i.e., the joint hypothesis of uncovered interest parity and unbiased expectations. Once this is done, the evidence in favor of uncovered interest parity (and hence perfect capital substitutability) is much greater.
• Government bonds are not only differentiated by the degree to which their yields covary with wealth or consumption, but also by their convenience yield. Given this, it is unsurprising that nominal financial integration, defined as nominal yield equalization in common currency terms, has been incomplete.
• Ex post short term real returns have shrunk over time, but are still far from being equalized (and seemingly reversed during the pandemic and its aftermath).

The entire paper is here.

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The past week of volatility exhibited in the banking sector was epic.

It was along the lines of a redux of 2008, when some high-profile mortgage lenders and investment banks dealing in risky practices went bankrupt, filed for Chapter 11 or were acquired for pennies on the dollar. To say the recent events in the regional bank sector and with Credit Suisse are surreal would be an understatement.

Oh, how history does repeat itself — in various forms — but with the same pattern of hubris, greed and sheer stupidity.

Take Barney Frank for instance. As one of the authors of the Dodd-Frank Act enacted to prevent the excessive risk-taking that led to the financial crisis, it appears there is some twisted irony as to how Mr. Frank was a sitting board member of now-failed Signature Bank that was one of only a handful of banks allowing customers to deposit and transact in cryptocurrency assets 24/7 beginning in 2018.

One can look at the demise of FTX and the fall-off its leader Sam Bankman-Fried as the spark that led to the collapse of crypto-centric Silvergate Bank and the further chain reaction that ignited fears of depositors at Silicon Valley Bank and Signature Bank for their exposure to start-ups, crypto and commercial office space. From there, the market was taking down shares of banks with large uninsured deposit bases. First Republic Bank (FRC) is the newest poster child of this contagion.

No sooner than one day after 11 banks transferred $30 billion over to First Republic to shore up its deposit base, news reports indicated that top executives at the struggling financial institution sold millions of dollars of company stock in the two months prior to the regional bank panic. So, the rally in FRC shares last Thursday on the rescue plan fizzled Friday on news of the timely stock sales by company insiders.  

The other deadly transgression by bank executives was reaching for yields on their bond portfolios. The banks invested in long-term bonds where the difference in yields compared to short-term bonds was minuscule, thereby taking huge risk of principal.

When money rained on the bank system from the roughly $4.7 trillion created in pandemic stimulus, banks invested heavily into long-dated government bonds. When the rate on the 10-year Treasury briefly rose to 1.75% in March 2021, banks rushed to buy.

The decision to do so by “risk managers,” instead of accepting 0.40% on 3-year T-Notes, is proving to be pretty short-sighted. At 1.75% for 10-year paper, there is really only one direction yields of that duration can go (higher), and only one direction for long-term bond prices to go — lower. To the extent these risk managers didn’t ladder their bond holdings borders on reckless, as if printing trillions of dollars wouldn’t somehow be inflationary down the road. And all for trying to bank a spread of 1.3% between the 3-year and 10-year Treasuries. 

2-year T-Note www.cnbc.com

10-year T-Note www.cnbc.com 

The obvious question sweeping the markets is how many, and to what extent, other banks are also underwater with their bond portfolios, their uninsured deposits and their exposure to commercial office space. In recent days, there have been numerous CEOs of small to mid-size banks putting forth statements that what happened at Silicon Valley Bank, Signature and Silvergate is unique, since those institutions engaged in non-traditional activities. They go on to say that all is well and their institutions are safe and sound, yet there is no mention of their Treasury holdings and a maturity schedule, a breakdown of commercial real estate loans and the level of uninsured deposits. 

Transparency is what investors and depositors want most. Banks should immediately make public their current holdings and details of their financials and balance sheets amid this crisis. The warm and fuzzy statements do nothing to shore up confidence.

Caution takes hold when banks announce “there is nothing to worry about,” and then don’t back it up with internal numbers. With first-quarter earnings season approaching in April, investors will have ample opportunity to investigate the details of each bank during the earnings calls that follow the posting of quarterly results. 

“Smaller banks are crucial drivers of credit growth, the fuel that powers the economy,” the Wall Street Journal reported on March 19. Banks smaller than the top 25 largest account for around 38% of all outstanding loans, according to Federal Reserve data. They account for 67% of commercial real estate lending. The possibility that other banks have similar problems has triggered a sell-off of financial stocks as investors scrutinize bank solvency. This, in turn, stoked public alarm about the safety of deposits and the size of unrealized losses.

This week will hopefully begin to provide some much-needed clarity of the risks within the wider banking sector. It is widely accepted that lending standards just tightened up for both businesses and consumers to raise capital ratios. Additionally, some pundits are suggesting recent events could trigger a wave of weaker banks being swallowed up by bigger banks to avoid the potential of further bank runs. These mergers could be voluntary or at the direction of state bank regulatory agencies.

What the market seeks most is a rapid response by the bank industry, the Fed and Treasury to prevent a further ripple effect. The fact that the Fed and Treasury jointly agreed to guarantee all deposits above the $250,000 FDIC level of insurance at Silicon Valley Bank is fueling a fresh debate about the moral hazard of universal deposit insurance. The potential for unintended consequences is high. If all funds are guaranteed, there’s at least some incentive to take on higher risks with depositors’ funds to chase profits. 

What should come of recent events is that there should be more stress testing, more often with stricter mandates about where capital is concentrated. I think if these directives were made known to markets sooner than later, the ground under the banking sector might stop shaking. Let’s hope sound minds and proper decision making prevail in the days ahead.

P.S. Join me for a MoneyShow virtual event where I’ll be on a panel moderated by Roger Michalski and will be joined by my colleagues Jim Woods and Mark Skousen. In addition, the entire event focuses on investing for income, real estate, Master Limited Partnerships, dividend-paying stocks, bonds and more.

To sign up for this free event taking place March 21-23, click here now.

The post A Crisis of Clarity Rippling Through Regional Banks   appeared first on Stock Investor.

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The debate over the Federal Reserve’s proper course of action for the rest of 2023 was getting a little stagnant in recent months. The argument centered on whether inflation’s persistence was really a sign of an overheated economy that still needed cooling or if it was due to stubbornly large—but dampening —ripples stemming from the huge pandemic and war shocks of previous years. The recent failures of Silicon Valley and Signature banks and chaos in other corners of the banking sector definitely provide a new twist to this debate.

My view on what the Fed should do now in the wake of banking failures is relatively straight-forward:

• Before the Silicon Valley Bank (SVB) failure, it was already clear that the Fed should pause interest rate hikes at this week’s meeting, based largely on consistent cooling in the labor market.
• The SVB failure and subsequent banking turmoil are far more likely to be demand-destroying events than not. If one thought the Fed already should be reducing the pace of their rate hikes (or even pausing entirely) due to labor market cooling, the fallout from SVB just means this cooling will happen more quickly and hence the case for halting further rate hikes is stronger.
• It is a genuine problem that interest rate hikes of nearly 5% in a year cause this much distress in the financial sector, indicating a clear failure of bank management and supervision. These failures should be addressed going forward. But they exist today and the fallout of them clearly provides another argument for standing pat on further rate increases.

Even before SVB failure, labor market cooling argued for no further rate hikes

The January consumer price index (CPI) data came in uncomfortably hot after months of good readings. The February CPI data showed a largely sideways movement in inflation. Worse, revisions to 2022 CPI data showed more disinflation in mid-2022 and less in late 2022—providing slightly weaker evidence of consistent disinflation over the course of the year.

However, nominal wage growth—what many have called a “supercore” measure of inflation—has consistently cooled over the course of 2022 and early 2023. Occasionally a single month of data has shown an uptick of wage growth and concerns are raised, but new data then show continued cooling. Figure A below shows annualized rates of wage growth for the latest three months relative to the prior three months. It shows these rates of wage growth for the initial releases of this data from December 2022 to March 2023. While wage growth blipped up in the December 2022 and February 2023 reports, the most recent report shows a clear pattern of consistent nominal wage deceleration.

This deceleration of nominal wage growth should be near-dispositive for arguments about the proper path of interest rates. If the Fed is insistent on 2% price inflation in the long run, this implies that nominal wages can grow at this 2% inflation rate plus the rate of productivity growth, which we will take as 1.5%. This 3.5% wage growth target, however, assumes no increase in the share of total income accruing to labor rather than capital. Given the large decline in labor’s share of income so far in the pandemic-driven business cycle, this means that several years of wage growth as high as 4.5% could be sustained while still seeing price inflation at the Fed’s 2% target. Nominal wage growth (as shown in Figure A) has been running at or below 4.5% for several months now. In short, wage growth is now running where it should be given the state of the business cycle and the Fed’s 2% inflation target—meaning the Fed should stand pat on any further interest rate hikes.

Besides the fact that current wage growth is consistent with the Fed’s inflation target on the cost side, the rapid normalization of nominal wage growth should also lead to rapid normalization of nominal aggregate demand. Essentially, if overheated demand is not being buoyed by above-target wage growth, it is hard to see how it could continue. The allegedly excess fiscal boost from the American Rescue Plan (and even the “excess savings” banked from this aid) is long gone. Financial and housing markets have lost significant value in recent months. Without excess wage growth, any excess of demand growth is unlikely to be sustained.

Banking stresses are likely to destroy demand in coming year

The failures of SVB and Signature banks and the associated increased stress in the banking sector are far more likely to reduce economy-wide demand in coming months than to increase it. As lending standards tighten and risk premiums rise for private lending, both consumer spending and business investment are likely to be curtailed. In short, whatever your estimate of the path of demand over the next year before SVB’s failure, your estimate now should be significantly lower. This has been recently acknowledged explicitly by the president of the Federal Reserve Bank of Boston, Eric Rosengren, who noted: “Financial crises create demand destruction. Banks reduce credit availability, consumers hold off large purchases, businesses defer spending. Interest rates should pause until the degree of demand destruction can be evaluated.”

There has been a recent debate in macroeconomic circles about the lags of monetary policy. Traditionally, these lags were thought to be “long and variable.” This would mean that a large part of the contractionary effect of the interest rate increases undertaken in 2022 and earlier this year had yet to hit the economy and would slow growth going forward even if the Fed stopped raising rates today. A newly fashionable view argues that these lags are shorter in today’s economy, meaning that the full contractionary effect of recent rate increases had already been absorbed by the economy and that a pause in rate-hiking would implicitly provide a substantial spur to demand growth. Whatever the outcome of this debate in normal times, the SVB failures clearly show that fallout from past rate increases is ongoing.

Yes, it’s a problem for macroeconomic stabilization that the banking system is this fragile

If one was worried that macroeconomic overheating remained a problem in the U.S. economy and was a key driver of inflation, the pressure to stop raising rates imposed by recent banking stress is extremely troubling. From this point of view, the recent banking stresses are demanding the Federal Reserve sacrifice efforts to cool the economy to control inflation in favor of the needs of financial stability.

It is especially perverse that increasing interest rates has appeared to throw much of the banking system into chaos. It is extremely well-documented that bank profitability is higher when interest rates are higher. However, it seems that banks cannot even make the transition to a new interest rate regime that would be highly favorable for them without substantial turmoil.

For all these reasons, if one was an inflation hawk who thought interest rates needed to be raised further, the imperative to stop raising rates now based on stresses in the banking system is an extremely dangerous development. And, in fact, even if one did not think that rates needed to be raised further in order to contain inflation, it’s still a bad thing that our financial system has become so fragile that raising rates causes these kinds of tremors. Even if I don’t think the economy needs higher interest rates today, there may be a future where higher interest rates would benefit the economy—and it would be very bad if macroeconomic stabilization options were held hostage to a fragile financial system.

These considerations argue strongly for improved regulatory and supervisory actions moving forward. The rollback of Dodd-Frank regulations in 2018 was a terrible step backwards in this regard. Further, the Federal Reserve rolled back regulatory safeguards even further than the 2018 law made necessary. Today’s hawks (and those like me who want to preserve the option of raising interest rates at some point in the future) should be among the most strident proponents for tightening these regulatory standards back up, and for holding the Fed accountable for supervisory failures.

But for now, the banking system is fragile and recent rate hikes have put stress on the system (as maddening as all of this is). This fragility is likely to cool the economy in coming months. Given this, any reasonable estimate of where interest rates should have gone in 2023 made before the SVB collapse should be marked down since.

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