Arthur Hayes discusses BTFP, warning that deflation triggered by the banking system will occur, and the Federal Reserve will soon cut interest rates.

BitMEX founder Arthur Hayes published a long article titled "Kaiseki Cuisine," in which he visited Japan during cherry blossom season and used the spirit of Japanese kaiseki cuisine to explain recent events in the U.S. financial markets and the introduction of the Fed's market rescue plan, BTFP. Arthur believes that BTFP is another form of Yield Curve Control (YCC), and everyone should be prepared for the onset of another era of money printing. With the progress of BTFP, deflation caused by the banking system will occur, forcing the Fed to quickly cut interest rates.

This article is excerpted and summarized from "Kaiseki Cuisine", and all views expressed are those of the author. For any questions, please refer to the original article.

Bank Term Funding Program

Following the collapses or takeovers of Silvergate, Silicon Valley Bank, and Signature due to a bank run, the Federal Reserve announced a new market rescue plan called the Bank Term Funding Program to provide liquidity to U.S. deposit institutions. Banks will be able to use eligible securities as collateral to borrow from the Federal Reserve, with the collateral valued at face value without accounting for any book losses, at a rate of the one-year rate + 10 bp.

The eligible securities that can be used as collateral are mainly limited to U.S. Treasuries and Mortgage-Backed Securities (MBS), with no specific cap, but the Fed, by setting a deadline until March 12, 2023, aims to limit the scope of the program to the current $4.4 trillion total size of U.S. Treasuries and MBS held by U.S. banks. The U.S. government has printed a total of $4.2 trillion during the Covid period.

Impact of BTFP

Unlike the 2008 financial crisis, the U.S. has not provided bailouts to banks this time. Banks must pay the one-year rate in exchange for cash. Currently, the one-year rate in the market is much higher than the ten-year rate, indicating an inverted yield curve. In normal circumstances, banks borrow short-term funds from depositors and lend long-term funds to the government by buying long-term bonds. However, when the yield curve is inverted, such transactions are bound to lose money. Similarly, any bank using BTFP will have to pay the Fed a fee higher than its deposit rate.

In other words, BTFP does not solve the current interest rate problem for banks. Deposits will continue to flow to money market funds or U.S. Treasuries to earn higher short-term rates, while banks can only fill the gap by borrowing from the Fed. From an accounting perspective, banks and their shareholders will suffer losses, but banks will not go bankrupt. Arthur predicts that bank stocks will severely underperform the market.

Rising Real Estate Prices Again

However, purchasing Mortgage-Backed Securities (MBS) is still profitable for banks, as the spread between MBS rates and the one-year rate is positive. Imagine a bank absorbing $100 in deposits in 2021 and buying $100 in U.S. Treasuries. By 2023, the value of the Treasuries drops to $60, putting the bank in a negative position. The bank can use BTFP to hand over its Treasuries to the Fed and borrow back $100, but it must pay 5% interest. However, if the bank buys government-guaranteed MBS with a yield of 6%, the bank can make a risk-free profit of 1%.

With banks engaging in arbitrage, MBS rates will approach the one-year rate. Loan rates will decrease, and home sales will increase. Therefore, Arthur Hayes believes that this move will once again boost real estate prices.

Stronger U.S. Dollar

Arthur Hayes believes:

If you can use a U.S. bank account and the Fed guarantees your deposits, why would you hold funds in other non-guaranteed banking systems? Funds will flow into the U.S. from abroad, leading to a stronger U.S. dollar.

However, with this scenario, all other central banks must follow suit and provide similar guarantees to prevent bank deposit outflows and weaken their currencies. The recent issue with Credit Suisse a few days ago forced the Swiss National Bank to provide a guarantee loan of 500 billion Swiss francs as an example.

Path Forward

Arthur believes that in the current unchanged interest rate environment, depositors will continue to withdraw funds to buy Money Market Funds (MMF) and short-term U.S. Treasuries. This will cause banks to lack funds for lending to businesses, leading to a severe economic recession.

Arthur expects the Fed to realize this outcome soon and start cutting rates at the upcoming March meeting; otherwise, a severe economic recession will force them to change course in a few months. Since the crisis erupted, the yield on the 2-year Treasury has dropped by over 100 basis points. The market is crying out for the deflation crisis caused by the banking system, which the Fed will eventually have to address.