Pro Perspectives 3/14/23

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March 14, 2023
 
Inflation data this morning was fairly uneventful, given the Fed is now more focused on the stability of the financial system.
 
The Fed meets on rates next Tuesday and Wednesday. 
 
With some relative calm in the financial sector today, along with an anticipated bounce back in inflation in the February data, the market is now pricing in about an 80% chance that they will go forward with a quarter point hike next week.
 
The much more important development, is that the interest rate market has now priced out about a 125 basis points of hikes by the end of the year, and has now priced in (at least one) rate cut.
 
Does this rate outlook imply more cockroaches will be discovered and/or the economy will go into contraction?  Or does this just signal the Fed has reached its limit on what the system can tolerate in this tightening cycle?
 
Maybe the better question is, did Silicon Valley Bank reveal a systemic problem in banks?  No.  

 
SVB was a unique bank.  It banked venture capital firms.  And it banked their portfolio companies.  It was a home-grown tool to enable Venture Capital firms to lever their investor capital. 
 
Most importantly, it had the highest percentage of uninsured deposits (at 97%).  
 
With that, it made SVB depositors most vulnerable to a bank failure. 
 
And the failure became self-fulfilling, by the depositors, via a bank run.  And that was driven by some noisy Venture Capitalists drawing attention to the mismatch of the duration of the bank's assets and the duration of its liabilities (which all banks have, to varying degrees). 
 
In that respect, what it may have most revealed, is the threat that social media represents as a tool to promote mob behavior.  In this case, depositor fear.
 
In short, the SVB had depositor capital tied up in longer-term maturity U.S. Treasuries and mortgage backed securities.  The only way it becomes a problem, is if they are forced to sell those securities (prior to maturity) at a loss to fulfill depositor requests for a return of their money (a run on the bank).  It happened.
 
Did it reveal pain in the system, driven by the Fed's rate hikes and quantitative easing?  Yes. 
 
But as we've discussed, there should have been no uncertainty about how the Fed would react to crisis. 
 
Intervention.  And they intervened quickly. 
 
This response by the Fed didn't create moral hazard.  The moral hazard took place long ago.  This is the product of moral hazard. QE begets more QE. 
 
The degree of intervention taken place over the past fifteen years, both by the central bank and the government makes comparisons to almost any historical crises almost moot, at this point.  They've proven to be able to manufacture their desired outcome.  
 
What's the ultimate cost?   The currency is the natural balancing mechanism.  Bad behavior should be penalized with capital flight, higher sovereign borrowing costs and a devaluation of the currency.
 
But it doesn't happen when everyone else is in the same boat.  No penalties.  And that has been the case, since the Great Financial Crisis.  Sovereign debt has ballooned, globally.  And central bank money printing and backstops have been globally coordinated.
 
It all works until global coordination fractures.
 
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Pro Perspectives 3/13/23

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March 13, 2023
 
As we've discussed often in my daily notes, in the post-2008 world, we know, with no uncertainty, that the Fed will do "whatever it takes" to maintain financial stability, and to manufacture their desired outcome. 
 
They (and other major central banks) crossed the line in response to the Global Financial Crisis, over the past fifteen years.  There is no going back.  It is now standard operating procedure to fix and manipulate.
 
Among the "fix and manipulate" strategies, is quantitative easing.  And for that (QE), we have no historical reference point of a successful exit.
 
The attempted exits have only led to more control and more intervention by central banks over markets – to plug new leaks in the global economic system. 
On that note, we talked about the blowup/ bank run of Silicon Valley Bank (SVB) on Friday (here).
 
Confidence in the banking system eroded over the weekend, and, sure enough, the Fed stepped in last night, promising to provide liquidity to depository institutions to backstop deposits.
 
Will they have to do more?  Maybe.  Will they do more, if needed? Yes.  "Whatever it takes."
 
So, we've hit the pain threshold for rates in the U.S. economy.  Something (big) has broken:  confidence in the banking system.
 
And the Fed has responded.     
 
Remember, we've seen similar fractures play out in other major economies.  And we've seen the response:  more intervention. 
 
In Europe, a sovereign debt crisis was building back in June, after the ECB announced they would end QE and start hiking interest rates. 
 
But yields had already spiked on the fragile Italian and Spanish sovereign debt, driven by rising U.S. yields. 
 
That was enough to make the ECB balk.  With Italian and Spanish solvency in question, they responded with an emergency meeting, and a new plan (same as the old) to buy bonds (more QE) of the weaker euro zone constituent countries, to defend against what they called "fragmentation" (i.e. an implosion of the euro zone, and of the common currency).  
 
Then in September, the Bank of England was forced to step in, after a doubling of the government bond yields in a little more than a month. 
 
UK pension funds were getting margin calls, where they were forced to sell UK government bonds.  When they sold bonds, yields went higher, which forced more margin calls, which required them to sell more bonds (and a self-reinforcing global sovereign debt spiral was underway).
 
The Bank of England responded, buying bonds (more QE), and reversing the rising tide of interest rates.
 
In both cases (ECB and BOE intervention), with the central banks absorbing stress in the system, yields resolved lower/stocks higher. 
 
This U.S. bank run/confidence crisis and the Fed's response, too, has reversed the tide of market interest rates.  Yields have collapsed.
 
This event should be a clear message to the Fed that they've done too much.   
 
On that note, the Fed Funds futures market has swung from pricing in a chance of 125 basis points of further hikes by June, to pricing in the chance of a rate cut.

Pro Perspectives 3/10/23

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March 10, 2023
 
As we discussed in my note yesterday, once again the 4% level on the 10-year yield seems to be the economy's Kryptonite.
 
We looked at this chart yesterday, of the 10-year yield…
Each of the events on this chart were driven by the level of interest rates.
 
The latest victim is Silicon Valley Bank, the specialty bank to venture capital and technology companies. 
 
It was taken over today by the FDIC.
 
As Warren Buffett has said, "only when the tide goes out, do you discover who's been swimming naked."  The "tide" in this case, is the easy money, low inflation era. 
 
The tide has gone out, and the mal–investment has being exposed.  That includes high valuation, no earnings tech companies, and now the biggest banker to those companies … SPACs … crypto currencies (to name a few).  Of course, what else makes that list?  Sovereign debt.
 
It's because of sovereign debt vulnerabilities (domestic and global), that a 70s and 80s-style inflation fight was never in the cards.  Double-digit interest rates were never an option.  Instead, the Fed used the bully pulpit, attacking inflation by verbally attacking jobs, wages and the stock market.
 
Now, will this bank failure in Silicon Valley turn into something more? 
 
Remember, it was just five months ago that rumors were going around that Credit Suisse, a major global bank, was on the verge of failing.  The market started placing bets on another "Lehman moment" for the world — where the failure of a major global trading bank could quickly result in a freeze of global credit.
 
But as we discussed back in my October 3rd note (when this Credit Suisse news was hitting) there is a big difference between now (into perpetuity) and 2008. 
 
A huge difference. 
 
The difference:  There is NO UNCERTAINTY about what central banks can and will do.
 
There are no longer rules of engagement for central banks.  The rule book was ripped up during the Global Financial Crisis.  We now know (no uncertainty), that they will do "whatever it takes" to maintain financial stability, and to manufacture their desired outcome. 
 
This comes with one very important condition:  The "no rules" era of central banking requires cooperation and coordination of the major global central banks. 
 
Indeed, they do continue to cooperate and coordinate very closely.
 
Now, with all of the above in mind, notice that each of the events of the past nine months have led to lower yields (today included).  And lower yields, have led to higher stocks (as you can see in the chart below).  

Pro Perspectives 3/9/23

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March 9, 2023
 
In my note yesterday, we discussed the significance of the level of the 10-year yield (around 4%). 
 
And in past notes, we discussed the historical spread between the 10-year yield and the Fed Funds rate.  The 10-year yield tends to run about 90 basis points (on average) ABOVE the Fed Funds rate, historically.
 
As of this morning, the 10-year was trading over 50 basis points BELOW the Fed Funds rate.
 
This has created the inversion of the yield curve, an historic predictor of recession.  And with that, people are expecting recession.
 
But as we discussed yesterday, the U.S. 10-year government bond market has been a highly (and overtly) manipulated market over the past fifteen years — by the Fed, and by global central banks.
 
It's fair to assume that this manipulation continues, to suppress this key global interest rate benchmark.  
 
Let's talk about why …
 
Throughout the past year, we've talked about the stress that rising global interest rates would put/and have put on the global financial system (global rates which have been pulled higher by the U.S. monetary policy anchor). 
 
History gave us reason to expect things to break as the world tried to escape zero interest rates and QE.  Remember, we've yet to see an example of a successful exit of QE.
 
The attempted exits have only led to more control and more intervention by central banks over markets — to plug leaks in the global economic system. 
 
This round looks to be more of the same.    
 
First, it was Europe's sovereign debt market, in June of last year.  European sovereign debt markets were breaking, as the U.S. 10-year yield was hitting about 3.30%.  The European Central Bank had to intervene to avert another sovereign debt crisis. 
 
Intervention.  Crisis averted. 
 
Then, in September, it was the UK bond market that broke.  The Bank of England had to intervene to avert a financial system meltdown.  U.S. yields traded up to 4% when that UK bond market crisis was revealed. 
 
Intervention.  Crisis averted.   
 
Then U.S. yields surpassed 4% and climbed sharply, to 4.34%, in just three days.  The dollar was racing, and the yen was crashing (driven by the aggressively widening interest rate differential). 
 
The Bank of Japan was forced to step in, to rescue the rapidly declining value of the yen.  
 
Intervention.  Crisis averted.
 
A month later, the 10-year yield was back above 4%.  And rumors started swirling that a major cryptocurrency exchange, FTX, was in trouble.  Forty-eight hours later, it was insolvent.
 
That was the last time the 10-year yield traded above 4%. 
 
Until last Thursday. 
 
And today, a big Silicon Valley bank (banker to major VCs and startups) is crumbling.
 
Below is the chart of the 10-year yield.  You can see the levels where these events triggered.    
So, as we suspected heading into this tightening cycle, another Volcker-like inflation fight was never in the cards.  Why?  Because even if the U.S. economy could withstand the pain of higher interest rates (which includes our government's ability to service its debt), the rest of the world can't.
 
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Pro Perspectives 3/8/23

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March 8, 2023
 
Yesterday, the Fed Chair gave prepared remarks and did Q&A with the Senate Banking Committee.  Today, he did the same for the House Financial Services Committee.
 
Markets are moving on the nuance of what Powell has said about the speed and ultimate stopping point for rate hikes.
 
Will it be another quarter point higher, than what they’ve already telegraphed?  Will they get there faster?
 
Does it really matter?  
 
They’ve taken the effective Fed Funds rate from roughly zero, to just over 4.5%, inside of one year.  And, at this point, they’ve telegraphed a few more hikes, to reach a stopping point above 5%. 
 
Still, after this perceived interest rate shock, the economy is running at 9% annual nominal growth (2.6% real growth, based on the Atlanta Fed’s model).  And unemployment is near record lows. 
 
Household net worth is 5% off of record levels, and 24% above pre-covid levels.  Debt service, as a percent of disposable income, is at pre-covid levels, which was the lowest on record.  
 
So, why isn’t an expected 5%+ Fed Funds rate choking off economic growth?  
 
Because of this chart …  
The tidal wave of new money (ten years worth of money supply growth, in two years) trumps the adoption of an historically normal interest rate.
 
That said the economy remains solid because the yield curve is inverted – not in spite of it. As long as the 10-year yield (the benchmark from which many consumer rates are set) is hanging around 4%, then consumer rates remain tolerable.  And government debt service remains tolerable, too. 
 
And no coincidence, this has been a highly manipulated market (i.e. the U.S. 10-year yield, the world’s benchmark government bond yield) by global central banks for the better part of the past fifteen years. 
 
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Pro Perspectives 3/7/23

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March 7, 2023
 
We heard from Jerome Powell today, at his semiannual Congressional testimony.
 
He released his prepared remarks, stocks went lower.
 
Before we get into what he said, let's talk about where he left off.  
 
The last Fed meeting was about five weeks ago.  Remember, this is the meeting where he talked over and over again about the disinflation in the economy (falling inflation).  He said they had "covered a lot of ground." And he said "real rates are positive," after telling us for the past year that "we'll want to reach positive real rates."  
 
From this meeting last month, he left good cues that the Fed was backing off its strategy of lobbing threats at markets and the economy.  As for rates, they also built in expectations that they would continue on, and go above 5%.
 
Let's step back and take a look at how markets have responded to that meeting, which was largely thought to be market friendly.  
 
The major U.S. index futures have traded in a 7%-9% range (a bit more volatile than average), but as of this morning, were (relatively) little changed compared to the morning of the February 1st Fed meeting. 
 
The benchmark 10-year yield, on the other hand, has gone from 3.5% (prior to the meeting) to 4% – a huge move.  
 
So, what did he say today? 
 
He started by saying "we've covered a lot of ground."
 
And he said the full effects of the actions they've already taken are "yet to be felt."
 
He countered this with acknowledgement that January data was hotter, though it could be attributed to "unseasonably warm weather."
 
And he warned that the stopping point for rates in this tightening campaign, is (now) likely to be higher, given the recent data.  And they will move faster if warranted.
 
"Higher" and "faster" were likely the keywords that triggered the algorithmic traders (i.e. if "______", then "sell"). 
 
Stocks finished down 1.5%.  
 
What about yields?  Little changed! 
 
What's the takeaway?
 
The Fed has already built in expectations of a terminal rate in the low 5% area.  Today, it gets moved up a bit, IF the data continues to show a bounce back in price pressures.  
 
Importantly, the open ended threats on where rates can go, on destroying jobs, and on tightening financial conditions (i.e. talking down stocks), are no longer present.  The use of that very effective tool of the past year (the verbal manipulation by the Fed) seems to be over.  
 
That's good news for the economy and for markets.
 
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Pro Perspectives 3/6/23

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March 6, 2023
 
On Thursday, we looked at this chart … 
Stocks were bouncing from big technical support — the big trendline (the yellow line) and the 200-moving average (the purple line). 
 
And, we finished Thursday with a strong technical reversal signal (an "outside day" – a good historic predictor of tops and bottoms).
 
Stocks have since rallied 4% from that Thursday low.
 
Here's what the chart looks like now … 
So, stocks are now down a little over 15% from the highs of early last year (which were record highs). 
 
And this decline from the highs wasn't just a garden variety correction in stocks, driven by a regime change in monetary policy (from easing to tightening). It was driven fear that the Fed would have to do a "Volker-like" attack on inflation, to get it under control — and with a 9% inflation rate last year, that would mean doubled-digit interest rates!  
 
Moreover, the decline was driven by the Fed's verbal threats on jobs and demand, and their explicit efforts to talk down the stock market (to damage wealth and confidence).
 
Lower stocks, and threats have done the trick.  They've gotten control of inflation (most importantly, inflation expectations are tame).
 
With the above in mind, when the Fed kicked off its tightening campaign a year ago, Jerome Powell said this about their plan: "Across the economy, we'd like to slow demand so that it's better aligned with supply; give supply time to recover, to get a better alignment of supply and demand.
 
On the supply note, the New York Fed said, today, that the global supply chain is "back to normal."

Pro Perspectives 3/2/23

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March 2, 2023
 
Just one month ago, the yield on the U.S. 10-year government bond (the world’s benchmark government bond market) was 3.33%.  That was one and a quarter percentage points LOWER than the effective Fed Funds rate.  
 
That was after the Fed’s most recent rate hike.  And it was before the January inflation data started rolling in.  The 10-year yield has since (driven by hotter inflation data) exploded higher.
 
Here’s a look at the chart ….
Now, here’s what I said in my note last week (Feb 21), in response to the move higher in yields, and the move lower in stocks:  
 
“Is this move in the bond market (yields higher), a signal to the stock market that the Fed might return to it’s game of a year ago, where it put a strangle hold on the economy (and consumer confidence)?
 
If so, yields would be going the other way (lower). 
 
The bond market would be pricing in an even deeper and uglier recession, in the form of an even steeper inversion of the yield curve (an historic predictor of recession).
 
That’s not happening.  The yield curve (2s/10s) is little changed from the beginning of the month.
 
What is happening?  Contrary to the consensus view that recession is looming, we’re seeing no signs that the economy is faltering (quite the opposite).“
 
Fast forward a little more than a week, and the inflation data has continued to show a bounce back.  And the 10-year yield has continued to rise, now above 4%, the highest levels since early November.
 
Again, looking back at my note from last week (Feb 21), we should expect the 10-year yield to be going the other way (lower), IF indeed the big, bad recession were looming.
 
With that in mind, I ended my note last week with this:  “Perhaps the bond market is beginning to price OUT recession (and a flattening of the yield curve).“
 
What happened today?  A flattening of the yield curve, by nearly 6 basis points (2s/10s).  
 
Stocks went up. 
We’re revisiting the chart above, from another note of mine last week (Feb 24). 
 
Remember, we talked about the big technical support in the stock market — this big trendline (the yellow line), plus the 200-moving average (the purple line).  Both were technical resistance, and since broken in late January, are now support. 
 
Stocks bounced today into this support, reversing sharply. 
 
And we closed the day with a bullish technical signal. 
 
It’s hard to see in the chart, but it’s an “outside-day.”  This technical phenomenon, is a very good predictor of tops and bottoms in markets, especially after long, sustained trends.  It’s driven by an exhaustion of the trend, as the market trades to new lows (in this case) on light volume, and then sharply reverses to close near the highs on high volume (with a range that engulfs the prior day).  
 
As you can also see on the chart, it was an outside-day that marked the bottom of the bear market, back in September.
 
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Pro Perspectives 3/1/23

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March 1, 2023
 
There was a lot of attention given to today's U.S. manufacturing data, specifically the inflation component.
 
We know price pressures bounced back in January.  This was the first clue on February inflation. 
 
Prices were higher.  New orders were higher.  But the manufacturing index itself remains in contraction territory.
 
This had people chattering today about stagflation (hot inflation, slow or no growth) and recession. 
 
But let's take a look at the price data from today's report with some context …
As you can see, price pressures in this manufacturing report are bouncing, but from low levels compared to this time last year.
 
On the note of recession risk: Remember, we had a recession.  It was last year.  And the two consecutive quarters of negative GDP growth in the first half of last year, were indeed driven by the very catalyst that many are ascribing an impending recession to:  a Fed tightening cycle.  The recession is not looming, it already happened.
 
At this point, they've already normalized interest rates, inflation has cooled, inflation expectations are tame, and the economy is on pace to put up another (consecutive) growth quarter in the 2.5% area.
 
And now we have the growth catalyst of China coming in, after they finally scrapped zero covid policies.  The composite PMI out of China for the month of February, which measures economic activity in the manufacturing and services sector, was strong, well into expansionary territory, and above pre-covid levels. 
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Pro Perspectives 2/28/23

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February 28, 2023
 
Let's take a look back at July 27th, and discuss how it relates to today's Supreme Court hearing on Biden's student debt forgiveness plan. 
 
As you may recall, the Fed met on July 27th, and raised rates by 75 basis points. This was the second consecutive 75 basis point hike, and it left the Fed Funds rate in the range of 2.25%-2.50%. 
 
If we look back at the prior tightening cycle (2015-2018), that's right around the level where the Fed was forced to stop and reverse on their tightening campaign, as things started breaking in the financial system.  And, indeed, on July 27th, it was already known that the level of global rates (led by the Fed) were putting stress on the financial system (the European Central Bank had to intervene to fix the European sovereign debt market a month earlier).
 
With that, and with the stock market having already been slashed by 20%, and with the bubbles in the economy having been pricked, Jerome Powell (Fed Chair) called the Fed Funds rate of 2.25%-2.50% NEUTRAL (i.e. not accommodative nor restrictive of economic activity).  
 
And he said they would no longer "guide" on policy, but take things meeting by meeting, dependent on the data.
 
This was a signal that had done enough:  time to sit back and watch.
 
Then the data changed, dramatically, the same day.
 
The Senate voted to approve the Chips Act.  That was well telegraphed.  But then the controlling party of Congress surprisingly announced a reconciliation process to ram home the remainder needed to fund the "Build Back Better" agenda.  In total, by late afternoon, the Fed was now looking at another $680 billion of new spending – poured on top of an inflation problem they thought they had a handle on.   
 
Then, the same day, the White House telegraphed Biden's intention to greenlight, by executive order, his plan to cancel student debt. That's potentially another half a trillion-dollars of consumer liabilities that could be turned into consumption. 
 
So, the Fed was forced to, not only quickly walk back on the "neutral" proclamation, but they went on full verbal attack on jobs and the economy (and therefore, inflation) over the next month.  Stocks took another, deeper plunge.  
 
So, fast forward a few months, and by November a Federal judge had struck down the student loan plan as unlawful.  That was good news for the inflation picture. 
 
Now the decision sits with the Supreme Court, and reports from AP tonight suggest they will rule against it.  Bad news if you were hoping to have your liabilities wiped clean.  Good news if you want a chance at stable inflation and strong economic growth.
 
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