The winter in North Asia is over. Warm weather, sunshine and the early blooming of cherry blossoms herald the arrival of spring. After departing from the beautiful mountains of Hokkaido, I spent my last weekend in Tokyo.

One afternoon, after a hearty lunch, I asked a very experienced employee about an aspect of Japanese cuisine that had always puzzled me. My question was: What is the difference between omakase and kaiseki cuisine? In both cases, the chef chooses the menu based on the most delicious seasonal foods. The staff explained that the whole purpose of kaiseki cuisine is to prepare for the matcha tea ceremony. The chef is supposed to make a meal that prepares your body to receive the tea.

When you sit down to enjoy a kaiseki meal, the destination is known, but the path is unknown. This is reminiscent of the current state of the world's major central banks, especially the Federal Reserve (Fed). Since the Fed began raising interest rates in March 2022, I have always believed that the end result would always be a major financial upheaval followed by a return to printing money. It is important to remember that the best interest of the Fed and all other major central banks is to perpetuate our current financial system - which gives them the power - so it is virtually impossible to clean up the huge amounts of debt and leverage that have accumulated since World War II. As a result, we can almost certainly predict that they will print money in response to any substantial banking or financial crisis and encourage another round of the same behavior - the very behavior that put us in danger in the first place.

I and many other analysts have stood on virtual soapboxes and predicted that the Fed will continue to raise rates until they have a breakthrough. No one knew exactly what would break first, but we were all sure it would happen. I don't want to get ahead of myself, but some ( including me ) insist that a break in some part of the U.S. financial system in 2023 will force the Fed to reverse the tightening cycle we've been in for the past year - and it looks like we're on the right track.

Back in the jungle, I sat down with my favorite hedge fund manager for a delicious Szechuan meal. We chatted about personal things and then spent most of dinner discussing the impact of the Fed's new Bank Term Funding Program (BTFP). BTFP also stands for Buy The Fucking Pivot! I thought I understood the importance of what the Fed had just done, but I didn't fully realize how big the real impact of this policy would be. I'll detail what I learned in a later post - but suffice it to say that BTFP is yield curve control (YCC) repackaged in a new, shiny, more satisfying format. It's a very clever way to achieve unlimited purchases of government bonds without actually buying them.

To fully understand why the BTFP program was so groundbreaking and ultimately destructive to depositors, let's review how we got to this point. We must first understand why these banks went bankrupt and why the BTFP was a very elegant response to this crisis.

The March storm

The beginning of the end began in March 2020 when the Federal Reserve pledged to do everything possible to contain the financial stress caused by COVID-19.

In the eyes of Western ( and especially American ) countries, the New Coronavirus was a Chinese / Asian thing with a little street-fried bat. The elites proclaim that everything is fine. Then, all of a sudden, people start getting sick. The specter of a US embargo began to rise and the US markets began to plummet. The corporate bond market followed suit and froze shortly thereafter. The dislocation spread quickly, and then to the U.S. Treasury market. Backed into a corner, the Federal Reserve moved quickly to nationalize the U.S. corporate credit market and inject massive amounts of liquidity into the system.

In response, the U.S. federal government racked up the largest fiscal deficit since World War II in order to pump money directly into people's bank accounts (in the form of stimulus checks - or, as I like to call them, "stimmies"). The Federal Reserve actually cashed the government's check. The government had to issue massive amounts of new treasury bonds to fund the borrowing, and the Fed dutifully bought those bonds to keep interest rates close to zero. This was highly inflationary, but at the time, it didn't matter because we were dealing with a once-in-a-century global epidemic.

It was at this point that an unprecedented financial boom began. Everyone had a check to spend, rich and poor alike. At the same time, the cost of capital for asset speculators dropped to zero, encouraging wild risk-taking. Everyone was rich, and everything became "numbers go up!

Bull Market

Because the public had all this new money, banks were flooded with deposits. Remember, when we buy goods, services or financial assets, the money doesn't leave the banking system - it just moves from one bank to another. As a result, most of the newly printed money ends up as deposits on the balance sheets of some banks.

For the large, systemically important, "too big to fail" (TBTF) banks, such as JPMorgan Chase, Citibank, and Bank of America, the percentage increase in deposits is significant but not absurd. But for small and medium-sized banks, the numbers are huge.

The smaller institutions in the U.S. banking industry ( sometimes called regional banks) have never been so rich in deposits. When banks take in deposits, they use those deposits to make loans. These banks need to find places to deposit all this new money in order to earn a spread, also known as the net interest margin (NIM). Given that yields are either zero or slightly above zero, keeping this money at the Federal Reserve and earning interest from excess reserves would not cover their operating costs - so banks would have to increase their returns by taking on a degree of credit and/or maturity risk.

The risk that a borrower will not repay a loan is called credit risk. The highest rated credit you can invest in (i.e., the credit with the lowest credit risk) is U.S. government debt - also known as Treasury debt - because the government can legally print money to pay off the debt. The worst credit you can invest in is the debt of a company like FTX. The more credit risk a lender is willing to take, the higher the interest rate the lender will demand from the borrower. If the market perceives that the risk of a company defaulting on its debt is increasing, credit risk increases. This causes bond prices to fall.

In general, most banks are very credit risk averse (i.e., they don't want to lend money to companies or individuals they think might default). But in a market where the most obvious and safest option - investing in short-term U.S. Treasuries - was yielding close to 0%, they needed to find some way to make a profit. As a result, many banks began to increase their yields by taking on duration risk.

Duration risk is the risk that a rise in interest rates will cause the price of a particular bond to fall. I won't torture you with the math of calculating the duration of a bond, but you can think of duration as the sensitivity of a bond's price to changes in interest rates. The longer the maturity of a bond, the greater the interest rate risk or duration risk of that bond. Duration risk also varies with the level of interest rates, which means that the relationship between duration risk and a given level of interest rates is not constant. This means that when interest rates rise from 0% to 1%, bonds are more sensitive to interest rates than when they rise from 1% to 2%. This is called convexity, or gamma.

In general, most banks limit their credit risk by lending money to various branches of the U.S. government (rather than to risky companies), but increase their interest income by buying bonds with longer maturities (greater maturity risk). This meant that as interest rates rose, they would quickly lose a lot of money as bond prices fell. Of course, banks could have hedged their interest rate risk by trading interest rate swaps. Some did, many did not. You can read about some of the very foolish decisions SVB management made in hedging the huge interest rate risk implicit in their government bond portfolios.

Let's do the math. If a bank takes in $100 in deposits, then they buy $100 in U.S. Treasuries, such as U.S. Treasuries (USTs) or mortgage-backed securities (MBS). So far, there have been no problems with this asset-liability management strategy. In practice, the ratio of deposits to loans should be less than 1:1 to have a safe margin of loan losses.

As the chart above shows, Bank of America is buying a lot of UST stock in 2020 and 2021. This was a good thing for the US government because they needed to fund these temporary checks. It's not so good for the banks because interest rates are at their lowest point in 5,000 years. Any small increase in the general level of interest rates would have resulted in massive mark-to-market losses in the banks' bond portfolios. The Federal Deposit Insurance Corporation (FDIC) estimates that U.S. commercial banks experienced a total of $620 billion in unrealized losses on their balance sheets as the value of their government bond portfolios shrank due to rising interest rates.

How do banks hide these huge unrealized losses from depositors and shareholders? Banks use many legitimate accounting techniques to conceal losses. Banks that lend money don't want their returns to fluctuate with the market value of their tradable bond portfolios. Then the whole world would figure out the trick they were playing. This could depress their share prices and/or force regulators to shut them down for capital adequacy violations. So if banks plan not to sell their bonds until they mature, they can mark them as 'held to maturity'. This means they mark the bonds at the purchase price until they mature. Thereafter, banks can ignore unrealized losses, regardless of the price at which the bonds trade in the open market.

Things are going well for the smaller banks. Their NIM is increasing as they pay 0% interest on customer deposits while lending those deposits to the U.S. government at 1% to 2% (UST) and to U.S. homebuyers (MBS) at 3% to 4%. This may not seem like much, but for hundreds of billions of dollars in loans, it's a meaningful amount of revenue. As a result of these "outstanding" earnings, bank stocks are soaring.

KRE US - SPDR S&P Regional Banks ETF

By the end of 2021, the ETF was up more than 150% from its low in March 2020.

But then inflation set in.

He's not Arthur Burns, he's Paul Motherfuck Volker.

A quick history lesson on the Fed's past governors. Arthur Burns served as chairman of the Federal Reserve from 1970 to 1978. Contemporary monetary historians don't think much of Burns. He is famous because he was a Fed governor who refused to nip inflation in the bud in the early 1970s.

Paul Volker was chairman of the Federal Reserve from 1979 to 1987. Contemporary monetary historians praise Volker's commitment to eliminating the inflationary beast that his predecessors had courted. Mr. Volker is portrayed as courageous and fearless, while Mr. Burns is portrayed as weak and ineffectual.

Do you know what's sad? If you held a gun to my head, I would probably list every chairman of the Federal Reserve since its inception in 1913. I can't do that for other important world figures. kabloom!

Sir Powell wants to be more like Walker than Burns. He cares a lot about his legacy. Powell didn't do this job to make money - he could well be a millionaire. It's all about cementing his place in history as a force for good money. That's why when inflation rose to a 40-year high in the wake of the pandemic, he put on his best Volcker outfit and walked into the Sailor Echols building, ready to make a splash.

At the end of 2021, the Federal Reserve signaled that inflation was a concern. Specifically, the Fed said it would begin to raise interest rates above 0% and reduce the size of its balance sheet. From November 2021 to early January 2022, risk asset prices top out. The pain train is about to leave the station.

The current Fed tightening cycle is the fastest on record ( that is, the Fed is raising rates more than ever before). As a result, 2022 will be the worst year for bondholders in centuries.