A Fed/Treasury Compact? If So, Rate Rises are Mostly Done. The Logic Of Mutual Assured Destruction.

This was supposed to go out Tuesday night, but the power went out here.  It still holds pretty well. 

Addendum:  The Fed did raise rates 25 bps, but made noises about slowing down etc…. In “potential bar fight” terms, the guy is still shouting threats and looking tough, but his feet are ever so slightly edging backwards.  Market sees that – now pricing in rising probabilities of rate cuts between September 2023 (77%) to December ’23 (95%).

By that time headline CPI is probably fading and the Fed will have an excuse to rush to rescue of the banks and commercial Real Estate.  Maybe labor markets and wages have tanked, but that would have to be a pretty dramatic deceleration over a a very short time period.  More likely the economy is humming along and maybe we just have to get used to (gasp) 3% inflation….

Tuesday Night Post

The fix might be in. The Treasury and Fed have now both placed mutually self-destructive bets on the table.  They don’t want to lose those bets.  That suggests the Fed’s rate-raising campaign peters out from here.

If US regional banks go bust, both the Fed and the Treasury face embarrassing, publicly obvious losses.  Cue howls of protest and (maybe literal) pitchforks, and torches.  That  might happen if we tumble into a banking crisis, but regulators do set the odds of their own success.

What were those bets?

  • The Treasury just stated they will guarantee the deposits of all US regional banks.  Writing a blank check (OK, the FDIC is writing the blank check but the Treasury’s neck is now stuck out).  Betting it never gets cashed (in a bank failure).
  • The Fed (in its role as bank regulator) is buying (OK, “guaranteeing”) bank’s debt holdings at 100 cents on the dollar.  Knowing full well the fair market price today is (say) 85 cents.  They are deliberately over-paying to pad the banks balance sheets.  Betting that over-payment (and/or losses) never gets marked to market (in a bank failure).

Neither the Fed or the Treasury wants to lose these bets.  How do they avoid losing?  By ending rate rises sooner vs later.  Reducing the pressure on the banks.

After the Treasury announcement today, chances of a Fed rate cut in December 2023 went from 98% (2 days ago) to 58%.  We now go out to May 2024 before the betting is near-certain (96%) for rate cuts.

Is there an explicit deal here?  Probably not.  Is there an implicit deal between the two entities responsible for protecting the banks and financial system?  Probably.

The Fed (who controls rates) moved first.  The Treasury (who has a very big bully pulpit and a lot to do with banks and the Treasury market) moved second.  Now they are both publicly committed.  Tidy bit of game theory.

Mapping it out, the bank regulatory dyad (Fed/Treasury) have two paths forward.

  1. Make damn sure the banks don’t go bust on, for example, soured real estate loans, rising deposit rates, and a major economic downturn.
  2. Press on with rate rises – increasing the risk on those bets.  The blank check guarantees get cashed and the over-payment valuations get busted.   Cue howls of “bailout” from people who like to howl about things that rile up their base – Elizabeth Warren and Marjorie Taylor Greene for example.

My bet is they go with #1. In which case the fix is in.  The Fed steps off the gas from here and the Treasury does its bit along the way.

This might all sound a little too “political.”  But that is because it all is political.  Watch Yellen squirm here.  Powell never wants to find himself squirming alongside her.  This Oklahoma Senator does a great job of getting that point (and threat) across.  Senator Warren (originally from Oklahoma) will be happy to do the same to Powell and his precious place in history.  A few days later, Yellen says all the banks get their deposits guaranteed.  Pure politics well played,


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