Weekly Kabezo Newsletter

Who Will Stop the Rain?

Kabezo's Newsletter offers an in-depth overview of the markets after another week of significant developments.

Pregnant Pause.

U.S. March unemployment data released Friday morning was once again the focus of macro traders, following a week of soft data releases in the U.S. and Europe that confirmed moderating economic activity.  Closely watched U.S. non-farm payrolls came in below consensus forecasts at +236,000.  But instead of continuing a downtrend, stock markets and bond yields both reversed course and trended higher after the release. 

This market response is convenient for my pet suspicion of the smoothing algorithm used by the Bureau of Labor Statistics (BLS).  I have no better method to offer BLS statisticians in their efforts to account for the obvious seasonality of this volatile series.  But on Friday there was some evidence of skepticism in markets that seem to respond to the raw data instead of the headline seasonally adjusted number. Market activity was generally muted due to exchange closures for the Easter holiday weekend.        

Source:  U.S. Bureau of Labor Statistics

“Those who don't believe in magic will never find it.” ― Roald Dahl

The really good news was that, yet another week has passed without a bank failure.  This fact probably makes the architects of the Fed’s new Bank Term Funding Program (BTFP) feel pretty good about themselves.  But that does not mean monetary system tensions have subsided.  Extreme stress was in evidence for the fourth week in a row, as the 8-week T-bill auction attracted bidders at par.

Why would anyone accept a yield of zero when they can just as easily park cash at the Fed via the reverse repo facility and earn 4.8%? 

Nobody knows. 

But extreme aversion to counterparty risk and a lack of access to a Fed master account could drive credit-constrained entities to acts of desperation.  In any case, there were $2.4 billion takers at par in Thursday’s auction that thought it was a good deal.  This is not a good sign.

Olympus Mons | Source:  European Space Agency

Olympus Mons, in the Tharsis Montes region of Mars, is the largest known volcano in the solar system.  At 374 miles in diameter, it is roughly the size of the U.S. State of Arizona, and nearly three times the height of Everest.  An observer standing at the top would not be able to see the base as it would extend beyond the horizon.

Likewise, monetary authorities may not be able to survey the size of the hole created by years of quantitative easing followed by rapid rate rises.  According to The Institutional Risk Analyst’s Chris Whalen, 40% of the entire U.S. residential mortgage market, over $5 trillion, was issued or refinanced between Q1 of 2020 and Q1 of 2021 at rates of 2%-3% and maturities of 15-20 years.  Total Federal debt increased $5 trillion over the same period.  With inflation peaking at 9.1% in June and the Fed raising interest rates 4.75% over the last 12 months, portfolios of Treasury and mortgage-backed securities are being marked down.  $ trillions in losses are lurking out there.

This might be good for certain classes of borrowers. Paying 3% on cash that eroded in value at 9% in the year to July makes for a real yield of -6%.  With a deal like that, borrowers will avoid rearranging their financing. 

Similarly, U.S. taxpayers are beating up bond investors who financed their government’s spending.  By some calculations, taking into account inflation and the decline in bond prices, the current value of government bonds issued to finance pandemic spending has declined by more than the deficit.

Those might be some of the winners.  The losers include banks.       

If the 6-month versus 10-year Treasury yield spread is any indication, the losses are ongoing.

Banks that are in business to borrow short (4.9%) to lend long (3.4%) and are sitting on massive portfolio losses are in a tough situation.  The former management teams of Silvergate Bank, Silicon Valley Bank, Signature Bank and Credit Suisse, which all had jobs a month ago, are being ridiculed as “idiots” for their poor management of interest rate risk.  I wonder if that description will stick if their number increases to dozens or hundreds.

Crypto Calm

The chaos in the banking system contrasts with relative calm in crypto markets.  Major protocols remained in an orderly range, maintaining substantial year-to-date gains.  That bullishness is spreading to the wider ecosystem as evidenced by an incredible week of venture capital activity.  Among the deals were several DeFi protocols, including M^Zero and Layer Zero.

M^Zero Labs raised $22.5 million at an unannounced valuation.  The product is described as an institutional grade middleware infrastructure layer for value transfer on the Ethereum blockchain.

This deal came off the back of another unicorn round for hardware wallet maker Ledger.  The industry leader raised €100 million at a valuation of €1.3 billion.   

A different zero, LayerZero managed to raise a $120 million Series B round at a valuation of $3 billion.  The cross-chain messaging protocol enables multi-chain decentralized finance without the need for a bridge.  That valuation would rank it as the 25th largest protocol by market capitalization.  The backers include major VC firms such as Sequoia and a16z that apparently still have the dry powder and the mandate to lead a round that seems more like something from the halcyon days of 2021 than the crypto winter of 2023.

In the face of an aggressive regulatory environment, and the 2022 cascade of scandals, fraud, and multibillion-dollar bankruptcies, major names are lining up to fund industry leaders as well as startups.  Could it be that crypto is beginning to attract investment for its transformative potential instead of vapid speculation?

Since the bailout of First Republic Bank and the takeover of Credit Suisse by UBS, blaming crypto for bank failures has abated.  Maybe awareness of problems in the banking system has made the prospect of investing in an alternative financial system more attractive. 

Whatever the reason, since Silvergate Bank went into voluntary liquidation on March 8th, cryptocurrencies have defied the obituaries written that these magic beans will die when cut off from the flow of dollars from the banking system.  Indeed, Bitcoin has sustained an orderly rally.

Markets for all the major layer-1 protocols appear to be an orderly contrast to the chaos enveloping bond markets and the banking sector.

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