Crypto markets have experienced a surprising surge over the past few days, with bitcoin and ether rising by around 20% since late Sunday. Stock markets are down sharply Wednesday morning as banking’s woes expand to Europe, but the Dow Jones Industrial Average was actually up a little over 1% between Monday’s open and Tuesday’s close.
Those breezes of bullishness came despite a wave of bank failures within the last week that would seem to suggest a rocky road ahead for the economy. That reflects the current “bad news is good news” environment, in which anything that makes a Federal Reserve interest rate hike less likely – including negative news about the real economy – is bullish for asset markets.
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But markets may still be overlooking a specific provision of the Fed’s recent bank bailouts that could undermine that conventional wisdom. The Fed has created a program called the Bank Term Funding Program (BTFP) that is, on its face, about backstopping banks.
But the BTFP will also make it easier for the Fed to further raise interest rates.
The new and improved Fed ‘put’
At the most obvious level, of course, the crypto surge and early-week steadiness in equity markets were reasonable first-order reactions to the Fed’s decision to designate Silicon Valley Bank (SVB) and Signature Bank as “systemically important.” That emergency declaration suspended the normal rules of the Federal Deposit Insurance Corporation (FDIC) and allowed all deposits to be made entirely whole.
While West Coast venture capitalists have been rightly excoriated for their irresponsible panic-mongering about the consequences of a normal unwind for their precious SVB, it’s certainly true that some amount of short-term turmoil has been avoided. The rescue of Signature in particular seems like good news for crypto, as Signature banked some operators in the sector.
But positive sentiment may also have come, perversely, from the fact that the banks collapsed in the first place. The collapses could be taken as a sign that the Fed’s aggressive interest rate hikes over the past year are having their desired effect of slowing the economy. In turn, that might mean rate hikes would slow or even reverse, which would be good for everyone still in the game.
This is the essence of the “bad news is good news” logic of a market hanging on the Fed’s every twitch. But the specifics of the SVB and Signature insolvencies made the logic even more compelling. The banks were quite directly undermined by the Fed’s interest rate hikes, which undercut the value of existing Treasury bonds, leading to big losses when the banks had to sell those underwater bonds to cover withdrawals.
While SVB and Signature faced industry-specific withdrawal pressures, this erosion of the market value of pre-2022 bonds is an issue for a large number of banks across America. Continuing rate hikes would likely make it worse and could cause more bank failures. At the same time, as we found out Tuesday, inflation is still very much alive and well in America, now running at 6%.
So the Fed needs to keep raising rates to curb inflation, but such a hike could put more banks at risk. That looked like a bit of a trap for the Fed, and maybe a barrier to continued aggressive rate hikes. An appealing source of hopium, if nothing else.
Keep it rolling
But the Federal Reserve has printed itself a get-out-of-jail-free card on the underwater-Treasurys dilemma. The change could also constitute a large and somewhat stealthy federal subsidy of the entire U.S. banking industry.
As excavated in detail by Bloomberg’s Matt Levine, the new Bank Term Funding Program, announced alongside the SVB and Signature bailouts, will offer loans of up to one year against U.S. bonds issued before March 12, 2023. This includes bonds issued before interest rate hikes began in 2022, bonds whose market value has been driven down on the order of 10%-15% by the issuance of higher-yield bonds since then. That’s what forced both SVB and crypto bank Silvergate before it to take huge losses on bond sales when customer withdrawals accelerated.
The key feature of the BTFP is that it will offer loans against those underwater bonds at their face value, rather than at their current market value. The intention seems to be to offer banks a bridge between the shaky, old, low-yield bonds and safer ground.
The duration of the loans is notably just one year, which is not exactly generous, so there’s at least some restraint on display here by the Fed. But it still means the Fed could wind up shouldering a lot of risk for banks: three have just blown up in rapid succession. Some level of default on these BTFP loans seems very plausible.
That would leave the Fed holding Treasury bonds that might not regain their market value for years, or even decades. The Fed doesn’t face the same duration risk as private banks, so it can afford to hold, even all the way to the bonds’ 10-, 20- or 30-year maturities, when their face value can be redeemed from the U.S. Treasury Department.
It will take further analysis to figure out exactly what costs and risks this effectively transfers from private banks to the Fed, and ultimately to the U.S. dollar and American public. For instance, defaults on BTFP loans could amount to some kind of stealth money-printing. But the BTFP certainly smells like a sector-wide banking backstop, or even bailout, if nothing else, trading on faith in the Federal Reserve.
See also: Should I Keep My Money in Bitcoin or a Bank? | Opinion
The important takeaway for markets, meanwhile, is that interest rate hikes are still entirely on the table because the new BTFP will prevent further harm to banks. That seems particularly worth the attention of crypto market participants. The factors driving the current BTC and ETH rallies are still a bit opaque, but another rate hike would add substantial downward pressure.
The next meeting of the Fed’s rate-setting Open Market Committee is scheduled for March 22-23, just over a week from now. The Fed knows it has headroom to raise rates, but if traders have missed that fact, the current crypto surge could turn out to be a dangerous bear trap.