Pro Perspectives 3/21/23

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March 21, 2023
 
The Fed will decide on rates tomorrow.
 
Given the events of the past two weeks, they should be done with this tightening cycle. 
 
Not only has the confidence shock from the events in the banking sector induced disinflationary pressures (if not deflationary pressures), for those that needed a signal, it is clear now that the level of interest rates are a problem.
 
Add to that, Powell was already setting expectations that they had done the job, in his February 1 post-FOMC press conference. 
 
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 that the full effect of their "rapid tightening so far are yet to be felt."   And he said "real rates are positive," after telling us for the past year that "we'll want to reach positive real rates."
 
In my view, with core PCE (the Fed's favored inflation gauge) trending lower and right around the level of the Fed Funds rate, Powell (at that time) thought they had done enough.
 
For good measure, they had built in expectations for a few more hikes, via their "economic projections."  Those expectations have a way of influencing consumer and business psychology, and therefore putting downward pressure on inflation (a tightening effect).
 
So, even though we had some hotter inflation data roll in to start the year, it's fair to argue that the Fed was already considering a pause.
 
Fast forward to tomorrow, and the Fed's concern should now be squarely on stability in the financial system AND the depth of impact this confidence shock will have on credit availability (i.e. the risk of a credit crunch).
 
Far worse than high inflation, is a deflationary bust (low or contracting economic activity and falling prices).  Deflation can be impossible to escape.  Ask Japan, now in a fourth decade of battling against it. 
 
The Fed knows this very well, which is why they made a policy change in late 2020.  Inflation had been (dangerously) too low for too long. Powell told us he would let inflation run hot, to bring inflation back to 2% on average OVER TIME.
 
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Pro Perspectives 3/20/23

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March 20, 2023
 
For all of last week, we heard chatter about a “banking crisis” and speculation about an imminent meltdown of the financial system, with comparisons made to 2008.
 
With that, as we’ve discussed often here in my daily notes, since 2008, there is one thing we know about the way central banks (and governments) will respond to crises:  They will intervene. 
 
They will stand “ready to act.”  The will do “whatever it takes” to maintain financial stability and confidence. 
 
This is the mantra we've heard from global central banks over the past fifteen years. 
 
With that, in a world full of uncertainties, that has been a certainty.
 
So, knowing this, it wasn’t a matter of “what should happen,” it was a matter of “what will happen.”
 
Here we are a week later, and the fallout remains confined to just a few banks that operate in a very specific niche of U.S. banking (bankers to venture capital firms and their portfolio companies), and Credit Suisse (an already very wounded bank, having been propped up for some time as systemically important).
 
The troubled venture banks have been buttoned up, via intervention by the Fed and the Treasury.  
 
And Credit Suisse, unrelated to the U.S. bank issues, was saved over the weekend, via intervention by the Swiss National Bank.
 
But what if the shock in confidence spreads, overwhelming the capabilities of the central banks and governments?
 
They've proven that it can't happen (as long as they're all coordinating). Remember, just three years ago the entire global economy was effectively closed.  What became THE life support for the entire global economy?  Coordinated action by global central banks and governments.
 
They crossed the line fifteen years ago.  They've become far more emboldened since the Pandemic response. 
 
Let's talk about another coordinated action they took over the weekend.
 
The Fed announced an "enhancement in currency swap lines." 
 
What does that mean? 
 
In times of uncertainty, global banks tend to scramble for U.S. dollars, to meet dollar-denominated liabilities.  And just as the Fed did in the Global Financial Crisis, they have to give these banks access to dollars, to avert a collapse in global banking.
 
That's what they did yesterday, relieving stress in global dollar liquidity (and they did so quickly), by giving global central banks (likely unlimited) access to dollars. 
 
This should result in a weaker dollar. 
 
With that, take a look at the chart of the dollar, which already looks vulnerable to a technical break lower …
What does a lower dollar tend to lead to?  Higher commodities prices.
 
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Pro Perspectives 3/16/23

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March 16, 2023
 
The European Central Bank met this morning and stuck with another rate hike.  This, in the face of a confidence shock in U.S. banks that had already spilled over into a major European bank (Credit Suisse).
 
Given that a liquidity problem has been exposed in the banking sector over the past week, driven by the level of interest rates, why would a major central bank add fuel to that fire?
 
Because they know the Fed (in the case of American banks) and the Swiss central bank (in the case of Credit Suisse) will do "whatever it takes" to restore stability, and quickly – no hesitation. 
 
And they have. 
 
In fact, Lagarde (ECB President) said today that they, too, will "always stand ready to act" to preserve stability.  And, moreover, she said they "can also exercise creativity in very short order."
 
As we discussed last week, this is the "no rules" era of central banking: Fix and manipulate.
 
With that, the liquidity holes appear to be plugged, for now.  And, importantly, those holes, at this point, are found only in a very specific niche of U.S. banking:  those that banked venture capital firms and startups (the tech ecosystem).
 
And in the case of Credit Suisse, it has been a very troubled bank (but important bank), that perhaps gets the excuse of another lifeline because of the U.S. banking confidence shock.
 
Given this context, markets are bouncing back.
 
Have they done enough?  Maybe.  Let's revisit my note from Friday on the significance of these "intervention" moments …
 
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).
Again, this chart above is from Friday.  Stocks closed today back above the big trendline (yellow line), and back above the 200-day moving average (purple line).
 
What's different today, relative to last Friday?
 
The Fed is back in the business of expanding its balance sheet. 
 
AND, the interest rate outlook has swung about 125 basis points LOWER by the end of the year.  That formula tends to be good for stocks.   
 
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Pro Perspectives 3/15/23

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March 15, 2023
 
The confidence shock in U.S. banks spilled over to an already fragile Swiss bank today.
 
Credit Suisse was already a very wounded bank, a fraction of its size and status of fifteen years ago. 
 
But it’s still important enough to stabilize (important to the preservation of stability in the European banking sector – and global importance, to a degree).  With that, the Swiss central bank (SNB) stepped in by the end of the day with liquidity support. 
 
This, again, highlights a big difference between the current environment, and 2008.  We know, without question, that the global central banks will act quickly, and in coordination, if needed, to maintain stability.
 
Will there be more dominoes (more trouble)?  Maybe.  Will they (the central banks) do more, if needed.  Yes.  “Whatever it takes.”
 
That said, the longer the uncertainty exists around the size and scope of this fallout – which started with a bank run on a niche Silicon Valley bank – the greater the damage will be to the economy.
 
With a shake-up in the banking sector,  we should expect credit to tighten.  When credit tightens, job creation slows.  When these two things happen, consumption slows.
 
Let’s hope it’s all short-lived and done out of caution.  Nonetheless, it’s a deflationary formula.
 
This deflationary formula comes as the Fed was already very near the point of putting downward pressure on inflation, from its level of interest rates. 
 
Remember, historical bouts with inflation have been won by taking the Fed Funds rate ABOVE the rate of inflation.  In this case, the Fed’s preferred measure of inflation (core PCE) was last reported at 4.7%.  The effective Fed Funds rate is 4.58%.
 
It’s fair to say following the last Fed meeting, with a solid economy, the Fed was looking to raise two to three more times, as “insurance hikes.”
 
Those are no longer needed. 
 
The interest rate market is not only communicating that, but it’s pricing in more persistent deflationary pressures (pricing in a 60% chance of a few rate cuts by the end of the year).
 
As we’ve discussed in my daily notes often, we need inflation.  We need an inflationary boom (high growth, hotter than average inflation), where the unsustainable government debt-load can be inflated away by growth. 
 
Far worse than high inflation, is a deflationary bust (low or contracting economic activity and falling prices). 
 
A deflationary bust is vulnerable to a self-reinforcing spiral, and very difficult to escape (ask Japan).  And it’s far more dangerous, given that we’ve already exhausted two deflation-fighting tools:  government spending, and expansion of the Fed balance sheet.  
 
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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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