Sowing The Seeds of a Revolution

SVB, Retail Debt, and Repo Markets

Our attention is fully in the present. A state of supreme focus and awareness. 

We are in the zone as our feet press against the starting blocks. A false start can leave you on the sidelines.

The crouched bodies of traders prepare for Jerome Powell to fire his starting gun.

And as we wait on this day. We wonder if that bazooka will fire Monday and signal the race to something that can be described in many ways as …

Financial destruction, ultimate centralization, risk-on asset buying.

We’ll soon see.

But before the race begins, let’s quickly look back on a few items we’ve written about here in Espresso. This way we can remind ourselves where we are at in the big picture.. before our attention becomes laser focused on the headlines in the weeks to come.

The is Not A New Problem

The Market’s cyclical behavior can help us gain perspective.

We went ahead and took this step back to gain perspective over a year ago in a series called Macro Cycles. This three part series went through various macro topics like Eurodollar contracts (which is a federal funds rate expectation market), U.S. Treasury yields, and inflation going back over a hundred years. 

The main takeaway that is relevant for us right now is how we look to be at or near the end of a rising rate environment. Transitioning to what was mentioned as ‘phase 2’ to ‘phase 3’.

This change is very significant.

In a rising rate environment, market conditions are choppy and historically semi-bullish. This latest rate hike environment never got semi-bullish due to the speed of the hikes. And reading back on the piece from January 2022, I did not expected markets to be this bearish. 

But then again, rate markets didn’t expect it either. In January 2022 they were only pricing in a federal funds rate of 1.5-1.75% for December 2023. As of Thursday this has since changed to 5.75-6%.

Massive change. And the reason for such a rough 2022 is this change in rate expectation - thanks for the forward guidance Jerome.

But when we move from one of the fastest rate hiking periods to no rate hikes, it becomes a major moment of change. 

And based on Friday’s movement of December 2023 Eurodollar contracts, the market is moving to minimal rate hikes. Specifically, the December 2023 expectations changed by nearly three rate hikes in 48 hours. That’s the type of move that you pay attention to.

To paraphrase from the article mentioned earlier, what happens when we go from a rate hike regime to a plateaud rate…

“Futures expanding with plateauing rates → very bullish / meltup incoming”

The reason this happens is the FED tightens so much, the financial foundation can no longer handle the stress. It begins to crack as things get overly tight. 

And due to the FED’s actions being a lagging effect on the economy, it’s only a matter of time before rates need to become more accommodative. 

The market is also acutely aware of this, and causes a sort of euphoric, all you can eat Buffett for the next 20 minutes, attitude. 

And once the buffet is closed, the music stops. 

Now, we aren’t at that blow off top, euphoric stage yet. We are before that. Rates are just about to stop rising thanks to the issue around the bank you are reading about on Twitter and in headlines, SVB. 

I’m assuming many of you are reading Twitter and get a general idea of what is happening.

So to offer a unique take on the disruption, I want to remind readers of what we talked about when JPow went to Jackson Hole in August of last year. It was the batch of papers that were discussed at the conference.

This paper in particular hit on a topic of banks and time deposits.

Time deposits are essentially cash, locked up in instruments like a CD (certificates of deposit). In locking it up, you earn a yield. This is how banks pass yield to you and also make some cream. 

This works great as long as the FED isn’t rising rates. Rising rates cause dollars to be worth more since the cost to borrow is higher.

Overtime, as excess cash starts to get removed from the system due to higher rates, banks begin to run into an issue…

Their customers are demanding their money more and more. Eventually, banks get low on cash and need to sell time deposits at a discount.

This helps them shore up capital to repay customers their money. The bank takes a haircut, and all is relatively ok.

SVB did this with some Mortgage Backed Securities, and this set the Twitter world ablaze.

What makes SVB interesting, it is a bank for tech startups. And nearly all tech startups use social media like Twitter. This means many influencers on Twitter are being impacted, causing this issue to seem very big. It’s an agora where one person can yell fire, and the stampede begin.

I say this not to minimize the issue, just to make you aware of why you are reading so many hot takes on the bank this weekend.

Now, SVB’s selling of MBS was a warning to the market that cash on hand was low. The bank run started, and now we are here.

SVB is likely not alone. Many other banks are likely dangerously low. And we will likely see banks go to the FED to borrow money against their collateral (ie - MBS). This takes place in the standing repo facility. 

If I wasn’t writing this essay on my mobile I would drop some helpful links here. Yes, my thumbs are very mad at me right now and its why I don’t have any charts in this essay. I just need to organize my thoughts on the situation. Anyways, I’m sure some of you know what links to SRF that I’m referring to, so please drop them in the comments.

This borrowing facility is one to watch. SVB probably should have gone to it, but this is frowned upon in finance circles. But now that the cat is out of the bag, this should change.. which is why Jpow and Co. look to be meeting on Monday. 

Furthermore, if banks are trying to meet customer requests, expect to see MBS and bond markets reflect this stress via higher spreads. 

In response, I’d expect the $2Tr in reverse repo market to unwind to calm the concerns of higher spreads. Watch for this figure to have a massive drop. The bigger the drop, the bigger trouble the system is in.

This liquidity will ease pressures in the markets so smaller banks can find buyers for their time deposits. It’s likely the reason so much money was sitting in this facility in the first place - this issue is not unique historically.

Its release into the market is a form of QE that actually shrinks the FED’s balance sheet. 

As our vision narrows in the coming week as we start our sprint off the racing blocks… those are the areas to watch - standing repo facility and reverse repo facility when it comes to the FED. 

Finding Hope

Ok, so we have a bank run… there are likely more banks in similar situations… we are likely shifting from rate hike regime to a plateauing rate regime… 

What does it means? What’s the big takeaway here?

Several things. 

I’ll quickly hit on the conspiracy angle first, and then move to what I think will be the story to follow for the rest of this decade. 

For the conspiracy stuff, I’ll just do it in note form as Twitter will be spewing it for weeks… including myself. 

• Wall Street has financial intelligence on many banks and companies due to ownership rights.

• Silvergate was purchased by Wall Street entities just before it closed, likely for financial intelligence.

• Banks knew SVB was in trouble and likely struck the match when JP Morgan and Peter Thiel told their clients to withdraw.

• The bank runs happen, concentrating capital at the largest banks.

• Further consolidation in banking just before markets realize QE and bullish conditions.

• TD’s triple inflation theory looks primed for its second wave later this year.

Now the more important piece. 

The FED can’t reach you. This was written early January. 

In it, we discussed how QE does not reach the person straddled with debt. A debt figure that is going parabolic. 

And we don’t even know how bad the situation is with Buy Now Pay Later companies. Imagine if one of those get whacked from the SVB issue. Yikes. It would be a major warning sign as the details of that business model’s balance sheet would surface. 

This is a worrying demographic for the FED because their stimulus does not reach them. Not the BNPL company, but you and me. The individual, the tiny borrower.

Which means the high paying workers at the tech jobs… the same jobs from the companies impacted by SVB issues… an issue that might lead to more layoffs… could make this debt issue much worse.

This group - again, on mobile so not able to link the stats - is straddled with debt. And it’s a demographic that does not want a service job. They are highly skilled at building technology products and services.

Not to mention will they even have the desire to try and pay off their massive mound of debt with such dire conditions? Or will they work an hourly pay instead of the six figure developer job with a favorable stock compensation plan? 

My guess is the motivation will be low. They’ll instead look somewhere else.

That place is one where they can build new products. Where barriers to entry are low. The innovation in this environment would not be in Web2 anymore. It’ll be in Web3.

We will likely witness in short order these developers stack protocols together to create new products. This is the polygon + Arweave + spheron type of solution among thousands of other stacks. This example here was a Layer one, storage solution, and front end. 

It would have payment, accounting, automation, storage, and a front-end all easily accessible.

Again, this is something people won’t need major amounts of capital to get started in doing… It’s a low barrier to entry for this highly skilled class.

It’s an opportunity to make something of themselves. The beacon of light to get out of debt through building… and not refilling the machine that flips burgers with a fresh stack of frozen patties at McDonalds since the burger flipping job will be done by a robot soon. 

This is how Web3 gets a new wave of builders… builders with a chip on their shoulders.

And if web3 is a revolution, the seeds for it were just sown.

If financial markets - after going euphoric, crash. And you see this demographic punished more so than others… crypto is the sector to watch.

It’ll be a new paradigm.

Your Pulse on Crypto,

Ben Lilly