NOTE: This article serves as a primer on the current state of the financial system for beginners and those looking to refresh their knowledge.
Earlier this week, in a historic move, the Federal Reserve ‘broke the internet’ by lowering the overnight bank rate to 0%.
As the financial markets faced a downturn, Wall Street maintained its party line of “it feels more like a 9/11 – not 2008.” Unlike 2008, where large institutions were dealing in mis-structured derivatives, this argument seeks to absolve Wall Street of all responsibility in a ‘this happened to us’ statement, likening it to the unforeseen circumstance of a plane flying into a building.
Both the government and the financial sector maintain that there is no ‘systemic’ risk, and nothing was broken, until coronavirus got here and sent us all home on quarantine. Behind the scenes, however, as evidence begins to mount to the contrary, the public is showing concern that this may be yet another global financial crisis.
Could coronavirus be merely an accelerant that is revealing what was already broken within our financial system? Could our economy have real and un-fixable issues masked by a few years of a bull cycle and unlimited consumption?
As financial professionals, business owners and blue-collar American families are all feeling uncertain about our collective financial futures, many are looking to sell assets and sit on cash for a rainy day, causing a liquidity crisis in the market.
To combat this fear, the Federal Reserve issued several new policies this week, which left most of us more confused than optimistic. As reading the financial news becomes more and more an exercise in frustration, we hope this article can help.
What does the Federal Reserve do?
The Federal Reserve (“the Fed”) is America’s central banking system, first created in 1913 to deal with financial panics and crises. During the Great Depression in the 1930’s, its powers were significantly expanded.
The Fed’s main job is to monitor and control our money supply, which is the total value of money available in our economy at any point in time.
How does the Fed control money?
Think of the economy as a rubber band that expands and contracts. When the band contracts, the Fed seeks a way to apply pressure.
To achieve its goals, the Fed uses tools from the Keynesian school of economics. Keynesian economists argue that aggregate demand is volatile and unstable (especially during a pandemic!), and that recessions can be mitigated by monetary policy actions to stabilize the business cycle. If you are thinking that this sounds like ‘big government’ and anti free-market, you are not entirely wrong.
To accomplish its goals, the Federal Reserve has two main levers to pull during turbulent times: lowering the federal funds rate and issuing stimulus into the economy in the form of quantitative easing.
The Federal Funds Rate
The federal funds rate is the rate at which banks and credit unions lend funds to each other overnight. Why do banks lend money to each other? Because banks are required to maintain 10% of their total balance in reserve at the end of each day. This is done so that if someone wants to withdraw a balance the next morning, the bank has the funds available. The banks lend out and invest the other 90% in order to make a profit (more on this later).
When a bank is short on its capital reserves at the end of the day, it may ask the neighboring bank to lend it money at the overnight rate, which often has a range. For example, last week the range was 1.00-1.25%, and as of yesterday, the range is 0-0.25%. By contrast, before the financial crisis of 2008, the rate was 4.75%.
This overnight rate serves as a basis for all other credit products such as mortgages, auto loans, credit cards, business loans, student loans and more. For example, say your mortgage lender has a business model where he makes a 3% spread on top of the overnight rate. If the overnight rate goes down, you should be able to get a cheaper mortgage.
Lowering the cost of borrowing across all products is the most obvious way of stimulating activity within the economy. When the cost of borrowing goes down, you are more likely to buy a house, start or expand a business or even use a credit card for the shopping spree you can’t afford. In a debt-driven society, low interest rates keep the wheels turning. But how do you stimulate the economy further when the rates are already 0%?
During times of uncertainty such as the ‘dot-com bubble of 2000’, the ‘financial crisis of 2008’ or what will be known as the ‘pandemic of 2020,’ businesses and workers start to panic. They are unsure of what the next three to six months will look like, so their instinct is to hoard as much cash as possible. The economy starts to slow down and head into a recession.
To increase activity and alleviate fear, the Fed needs to put more money into the system. The Fed currently may not have enough sitting in its vaults, so it decides to create new money to put in the markets. This process, known as ‘quantitative easing’, is implemented by the Fed buying government bonds and treasuries directly from large financial institutions, thus raising the prices of those assets, lowering yields and increasing money supply.
Let’s take a look at previous quantitative easing events.
During the financial crisis of 2008, the Fed started buying $600 billion in mortgage-backed securities (‘MBS’) and by March of 2009, it held $1.75 trillion of bank debt, MBS and Treasury notes.
The financial crisis of 2008 was largely caused by banks and other financial institutions dealing in mis-priced bonds and derivatives which represented a fraudulent mortgage-lending system. To stabilize the economy, the Fed chose to bail out several large institutions including AIG, Goldman Sachs and JP Morgan. Similar measures were enacted in the UK.
During this crisis, unemployment went up to 9.3%, and many lost their homes and life savings. With frustration, the same people watched the institutions that caused the crisis being propped up by a government that should have protected them from fraudulent financial practices in the first place.
QE2 & QE3:
The Federal Reserve continued to engage in several more rounds of quantitative easing in 2010 and 2012, pumping trillions of dollars into the system, and tapering the program in 2013 as the economy began to ‘recover’.
Things started to get more interesting this past year.
On October 11, 2019, in response to a slowing U.S. economy and ahead of reports of any virus in China, the U.S. decided to issue additional stimulus into the economy of approximately $60 billion in Treasury bills per month. This was the first alarm that our economy might once again be experiencing a liquidity crunch.
Just a few weeks earlier, on September 18th, the Fed lowered the overnight rate from 2% to 1.75%, and again from 1.75% to 1.5% on October 30th, indicating that we could be heading towards a recession. Critics began to argue that we never recovered from the financial crisis of 2008 and the economy was being propped up by continued stimulus and low interest rates.
On January 5, 2020, the first case of coronavirus was discovered in Wuhan, China.
By the end of February, several cases had appeared in the U.S. and by March, it had become clear that we were past the point of ‘containment’. Fear and panic ensued, the economy slowed down, and the Fed was once again tasked with solving a new problem.
On Sunday, March 15, 2020, in its most historic move yet, the Fed dropped overnight interest rates to 0% and issued a $700 billion stimulus package to mitigate the economic effects of the coronavirus. The Fed stated that it would increase this number to $1.5 trillion as needed.
But it did not stop there.
The Fed has now decided to pull a third and lesser known lever, and that’s the overnight reserve requirement.
Simply put, banks are required to hold 10% of their total money in the vaults at the end of each day. The 10% is a requirement chosen based on the statistical possibility of how many people might want to pull out their funds at any given time. During a financial crunch, this number may increase to prevent a ‘run on banks’, something we have seen in many countries during a liquidity crunch. Think of lines at ATMs in Venezuela, Hong Kong and Lebanon, to name a few.
Stated on the Fed’s website, “As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.”
This news was barely discussed by major media, yet this third lever is perhaps the one most relevant to the average American. If too many people choose to pull out cash too quickly, the institution may temporarily suspend withdrawals or even become insolvent.
What happens next?
After all three levers were pulled on Sunday, March 15th, 2020, the markets awaited the opening bell Monday morning. Many were hoping for a profitable first day of trading after the decision, but that was not the case.
Futures fell by 5% ahead of trading. The Dow Jones fell nearly 3,000 points —its second worst one-day decline ever since the “Black Monday” crash of 1987.
The market essentially said – “not enough stimulus.”
The next day, the Fed made yet another announcement. To provide liquidity to a struggling system, the Fed would conduct an additional $500 billion overnight repo operation.
These multiple shocks to the market within days, caused the Volatility Index (“VIX”) to spike to its highest level since 2008. It seemed that our financial system has pulled on all of its levers, unsuccessfully.
What does this all mean for you?
One has to wonder why the Fed continues to pour all of this stimulus onto an economy while residents of all major cities are being asked to stay at home. Would it not have been wiser to hit a pause button on all activity, issue aid and then use stimulus to kick-start the economy when we get through this quarantine period? The Fed has now used all of its tools within a matter of days.
The markets have some time to go before any sort of recovery and are unlikely to respond to additional monetary stimulus at this time. For those sitting on cash, this creates great investment opportunities both in the private and public sector of undervalued assets.
For those who did not anticipate this crisis and are now in a tough spot financially, these monetary policies will be of little help. In fact, quantitative easing has been referred to as the ‘Universal Basic Income for rich people, as it does not directly affect those in need during a crisis.
The government is currently considering fiscal policy measures that do have a direct effect such as tax breaks, federally funded sick leave, and even checks mailed to Americans. Secretary of Treasury, Steven Mnuchin, warns that the American unemployment rate could go up to 20%. Mnuchin is also pitching up to $250 billion of checks sent directly to Americans. Despite these measures, it is certain that many citizens will come out of this crisis feeling once again betrayed by both their financial system and their government.
There is no one solution to what we are facing.
Flight to Safety – Bitcoin’s Ultimate Test
During times like this, investors often pull their capital out of public and private markets and store it in less volatile assets such as cash, gold and more recently, Bitcoin.
Although Bitcoin fell more than 30% last week with the rest of the market, as the Fed announced multiple stimulus measures, its price began to slowly recover.
Notably, Bitcoin was born as an antidote to the last financial crisis in 2008-2009. It was meant to represent a new digital unit of account, that was independent of banks and governments. Bitcoin was also created to be finite at 21 million units, and with its “production” to decrease over time, it was immune to monetary stimulus.
This new digital money was created as a direct response to quantitative easing as evidenced by a famous footnote in the very first block of coins, quoting that day’s headline from the UK Times:
“1/03/2009 – Chancellor on Brink of Second Bailout for Banks.”
Today’s perfect mix of chaos and mishandled monetary policy, could be Bitcoin’s ultimate test. Will it go down like many other assets in a liquidity crunch or will it hold true to its promise and become an antidote to a shaky financial system?
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