For those of you who would prefer to listen:
The hits just keep on coming. The Market has much to absorb these days. It was another consequential week with the highly anticipated Fed meeting in the wake of this new banking crisis. It was definitely Market moving.
I am well aware that covering interest rates, the financial system and the Fed is seemingly boring. I never want to bore you. But it’s really important stuff. You don’t think much about your plumbing on a regular basis either; Unless it stops working.
The Federal Reserve is walking a tightrope. They seek to balance one of their mandates – stable prices – with financial stability. There hasn’t been much of either the last 2 weeks. Leading up to its March meeting, the Market had been expecting America’s central bank to hike another 1/2-point because the Economy was still surprisingly robust. Inflation has proved to be stubborn and sticky. Prices have come down, but still remain elevated. It had seemed like business as usual for the Fed. Then three American banks failed.
The demise of Silicon Valley Bank, followed by Signature Bank of New York, sent shockwaves through the financial system. This, after Silvergate – the crypto bank – shut down a week prior. Fear of contagion spread fast. Money flowed away from the smaller regional banks, landing at the Big Banks. A coordinated emergency backstop for deposits from the Feds cooled the angst. But it hasn’t been eliminated.
In an instant, the Market re-priced expectations for a 1/2-point hike to a near certainty of no hike altogether. That was a week ago. As time elapsed, and responses took hold, things recalibrated yet again. The Market largely priced in a 1/4-point rate hike at Wednesday’s meeting, with an 83.4% probability just minutes before it was announced. And that it got.
The Fed has now increased its overnight rate at 9 straight meetings. That brought the Federal funds rate target range to 4.75%-5%. It’s the highest it’s been since 2007. The overnight rate influences borrowing costs for many things, such as mortgages, car loans and credit cards. Remember, it sat near zero since the depths of Covid.
Cheap and accessible money encouraged bad behavior. The money supply was loose. Bubble-like conditions developed. Then they burst. After being late to act, the central bank went big on tightening. There are fears that the Fed moved too far, too fast with its aggressive rate increases. Some see the current banking crisis as a direct result of tighter monetary policy. Silicon Valley Bank broke.
Fed Chair Powell acknowledged there is “so much uncertainty” out there but reiterated a year-end peak around 5.1%. That implies one more rate hike and then holding them firm for the rest of the year. Not everyone believes him. The Market thinks the Fed will actually start cutting rates by Summer, with the Fed funds rate ultimately under 4% by year-end. Talk about a disconnect. The Bond Market is clearly saying recession is closer than previously thought. The Fed doesn’t see it. The Fed Chair said, “rate cuts are not in our base case.” The Market thinks otherwise. This disconnect leads to increased Market volatility.
America’s banking system is in good shape. This, according to the Fed. Chair Powell described it as “sound and resilient.” It sure is being tested. There was a major shock to the system 2 weeks ago. Financial conditions have improved a bit since, with aggregate outflows slowing and stabilizing after a mass exodus from smaller banks last week. But a recovery is far from certain.
Below the surface, stress has been building. It spread beyond our shores. Credit Suisse was finally taken out in what looked like the slowest financial train wreck of our lifetime. It’s been challenged for a decade and a half. Deutsche Bank is the next global banking concern on the radar heading into the weekend. Stay tuned on that.
It’s important to point out that the Fed reversed its quantitative tightening campaign in defense of this banking crisis. Its balance sheet is back near $9 Trillion, approaching the peak level in response to Covid. Emergency borrowing under the Fed’s two backstop facilities (Discount Window Lending and the Bank Term Funding Program) surpassed $160 Billion this week. It’s the second consecutive week of such size. For perspective, borrowing under the weekly discount window is typically less than $10 Billion. The financial plumbing got clogged.
The Treasury Department was reportedly studying ways to guarantee all bank deposits if activity in the banking system spiraled into a full-blown financial crisis. Normal procedure requires an act from Congress. It’s been said that the authorities don’t believe full FDIC coverage is necessary, but they were exploring a legal framework using emergency powers that could bypass the deeply divided Congress. The fear is that if another regional bank falls, there will be another run on smaller banks. That runs the risk of knocking the regional banking industry over and sending more flows to the Big Banks. Treasury Secretary Janet Yellen refuted that her department was willing to do this while she was on Capitol Hill this week. The Market didn’t like hearing that. It had seemingly priced in a full backstop. Yellen pulled a 180 the following day to stem Market agitation.
Many are against a universal guarantee on all bank deposits. As we have been reminded, FDIC insures up to $250K. The thinking is that backstopping all bank deposits would be a dangerous precedent that simply encourages irresponsible behavior. In the end, it seems like bailouts get paid for by those who followed the rules.
What does this all mean for the Market? Well, for one, volatility is back big time. The wild swings keep shaking investor confidence. And there is a clear distinction again between what the Stock Market and the Bond Market are saying. The Bond Market is clearly saying that more trouble lies ahead and a recession is inevitable, if not imminent. We cannot forget that recessions are a necessary part of the cycle. Fighting it or pushing it out generally makes things worse. The Stock Market seems to be looking past all this, thinking that the 2022 correction ran its course and a soft economic landing is in store, but the Fed does have our back. We’re more inclined to believe the Bond Market over the Stock Market. Bonds have been a great place to be in 2023.
The thing is, the longer that financial conditions remain tight, the greater the risk that stresses spread beyond the banking sector. Despite Fed Chair Powell’s insistence of another rate hike ahead, the Market is pricing in a 79.8% of no hike at the May meeting. Taking it further, there is now a greater than 90% probability that the Fed cuts by ¾-points at a minimum before the year is done. It’s also important to point out, the Stock Market has basically gone sideways for the last 10 months. 4K on the S&P and 32K on the Dow have been magnetic levels that stocks have swung around for months.
Investor sentiment reflects the angst with some of the most negative readings in decades. This is a contrarian positive because it suggests that a lot of the negatives are priced in. But there are some great risks and further unknowns out there which give us pause. Here are both the Bull and Bear cases as it sits today:
Bull case:
The Fed is on track to pivot with the Market pricing in rate cuts later this year. It views lower rates as a sign of cheaper money and a return to growth investing. The Fed balance sheet is now re-expanding and QT (Quantitative Tightening) is coming to an end. The Bank turmoil is isolated, contained and not systemic. The regulatory response was rapid and more backstopping is likely. Retailers continue to point to a resilient consumer. Americans are still out and about and they’re spending. Travel and service companies still struggle to meet the sustainably strong demand. Sour investor sentiment is Bullish. Corporate cost-cutting continues, which could help stem the earnings slide.
Bear case:
The Fed won’t pivot on rates given sticky inflation pressures and perceived ability to deal with financial stability risks via balance sheet. The banking crisis proves the aggressive rate hike cycle has been damaging and the ultimate impact is still unknown. Bank turmoil will lead to a hard landing for US Economy. Earnings forecasts of 10-20% growth this year are too high. Companies will now be compelled to guide even more cautiously. Worries of a growth slowdown supported by commodity weakness, particularly in Oil. Stocks are already expensive with a P/E at 18x. Earnings growth from cost-cutting is not Bullish. It’s defensive. It’s part of the cycle, but the Bullish part is when companies increase spending and invest. That’s not happening now.
There are some pretty strong convictions on both sides. Of course, that’s what makes a market, matching buyers with sellers. One thing is clear, buyers have been hiding out in mega caps.
Money has been flowing back to a familiar area the past few weeks. The largest American companies, predominantly in Tech, have been carrying the load of late. The spread between the equal weighted S&P versus cap weighted keeps widening. Leadership has narrowed to just a handful of stocks. Apple and Microsoft combined account for over 13% of the total value of the S&P 500 index. This is the highest concentration for these top 2 holdings in history. The reason, of course, is never clear. But it’s logical to believe that investors are finding comfort in these 2 proven winners who are sitting on a mountain of cash and don’t need to borrow to continue to operate their massive businesses. The Tech Titans have been Stock Market darlings throughout this Digital Age. They lost the glimmer last year, experiencing some hefty downturns. But during this new period of heightened investor angst, for better or for worse, it’s been Apple and Microsoft to the rescue. These companies have the largest pipes in the Stock Market. The plumbing is full flow there, a diversion from the clogged areas. We shall see how long that lasts.
Have a nice weekend. We’ll be back, dark and early on Monday.
Mike
