Daily Comment (March 30, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning!  It’s Opening Day for major league baseball.  In the financial markets, it’s a “risk on” day: equities and commodities are moving higher, while the dollar is weaker but interest rates have reversed higher.

In today’s Comment, we open with China news where Taiwan’s president has arrived in the U.S., and both China and the U.S. are hardening their blocs.  Markets are up next, with a look at banking.  International news follows, and we close with an update on the war in Ukraine.

China News:  Taiwan’s president is arriving in the U.S. today.  Steadily, China and the U.S. are pressing other nations to choose with whom they will align despite resistance from nations wanting to avoid such a choice.

Markets, Economics and Policy:  We update the latest on the banking issue.  There is also a growing realization that margins matter to inflation.

  • Fractional reserve banking is fraught with risk. Banks take deposits and, through leverage, expand the money supply through lending.  Depositors don’t think of their money in the bank as a loan; there is almost a belief that the bank has taken your money and is holding it in an envelope with your name on it.  Of course, that isn’t the case.  It instead lends that money into the economy, and, as long as depositors don’t demand their funds all at the same time, the system provides ample, low-cost credit to the economy.  However, if a large number of depositors decide to get their money back, chaos can develop.  Essentially, societies that use fractional reserve banking make a tradeoff—cheap credit but with the potential for occasional crises.
    • Over time, governments have tried to address this problem. Deposit insurance has been one response.  By ensuring that the money will be there, the impetus to “go get it” and thus triggering a bank run is dampened.  But by guaranteeing deposits, bankers can take excessive risks, leading to the moral hazard problem.  In the U.S., the response has been to limit deposit coverage, although in practice, all deposits are usually covered.
    • Another way governments have addressed this issue is to allow banks to avoid pricing their assets at market. This means that there is a bit of uncertainty as to the value of bank assets at any given time.  Since bank loans are often unique, it may be difficult to actually price these assets.[1] Although when banks have securities on their books, these can be priced.  To avoid asset price volatility, banks are allowed to claim that a security will be held to maturity.  Since bonds usually expire at par, there is no price risk as long as the bond doesn’t need to be sold in order to meet depositor demands.
    • It has become increasingly apparent that large banks become so important to the economy that governments can’t allow bank runs or failure. To deal with this situation, large banks are heavily regulated.  In most nations, large banks are the only choice, but in the U.S., due to our fear of economic concentration[2] (especially in banking), we have a strange mix of a few very large banks and a whole bunch of small ones.  Unfortunately for the small banks, there is some degree of uncertainty about how depositors will be treated.  Thus, we are seeing something of a “slow motion” run on small banks.  Although most financial crises occur quickly, some take a long time. For example, the savings and loan debacle took over a decade to resolve.  This problem of large vs. small banks might be similar.
    • Because small bank failures are rarely systemic, they tend to get a lighter regulatory treatment. But after recent bank failures, regulators are looking to expand regulation, which may lead to fewer banks.
  • In economic theory, inflation is usually addressed in simple terms; e.g., it’s all about the money supply or supply constraints. In reality, it can be devilishly complicated.  One factor gaining attention is that market power can lead to inflation if margins are maintained.
  • The debt ceiling issue has sort of fallen from the news, but it remains a threat to stability. The House GOP seems no closer to a plan on how to address it.
  • Young graduates are finding a tentative job market. As we note below, initial claims remain remarkably low and stable, which likely reflects labor hoarding.  Firms loath to lose current employees, fearing the cost of replacement.  However, it may be leading to a lower number of new graduates being hired.

International News:  Russia detains a Wall Street Journal reporter, Britain gets a trade deal, and Cargill stops carrying Russian grain.

War in Ukraine:  There are renewed concerns over the safety of the Zaporizhzhia nuclear plant.  Russia has been shelling the region around the plant and both sides are increasing troop strength around itThe IAEA is trying to work out an arrangement to prevent the plant from being directly attacked.  This is the largest nuclear plant in Europe and although the cores are in hardened containment units, a direct attack could lead to a potential catastrophe.

[1] Private equity does something similar.

[2] This is why we have 12 Federal Reserve districts, for example.

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