Catalysts Everywhere - All Aboard The Rate Rollercoaster
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It’s time to talk about the Fed mandate.
The monetary policy goals of the Federal Reserve are to foster economic conditions that achieve both stable prices and maximum sustainable employment.
Heading into 2023, the market was glued to every macro reading around inflation, as CPI day became the most important day in everyone’s calendar.
This print always sent macro gyrations with volatility everywhere. The #1 laser focus was putting a lid on inflation. We got a recent reading of 6%, off from the high of 9.1% in June 2022, which shows inflation is steadily cooling.
Focus was starting to shift to jobs, as the labour market remained stubbornly resilient with historically low unemployment rates and strong NFP prints.
But there is a new mechanism at play here when thinking about the Fed - systemic risk.
While it’s clear there was gross mismanagement of SVB’s debt securities and Signature and Silvergate were caught up in crypto/FTX run, nothing ever happens in isolation. This week, we had a “too big to fail” bank, Credit Suisse crater.
All of this is causing a whipsaw in the real-time pricing of the terminal federal funds rate as well as moves across the yield curve.
This week, in <10 minutes, we’ll cover the banking crisis’ effect on rates:
Inflation 👉 CPI Reading
Jobs 👉 NFP, Unemployment
Update on Banking Crisis 👉 Problems at Credit Suisse, SVB Files Ch 11
Impact of Banking Crisis 👉 Built-in Tightening Should Cause Hesitation to Hike at the Fed
Terminal Rates 👉 Fixed Income Market Rollercoaster
Recession 👉 Landing: Hard? Soft? No?
Let’s get started!
1. Inflation 👉 CPI Reading
In what already seems like a distant memory, CPI printed 6.0% for the month.
What we had here was generally sticky core inflation (especially food), rent and shelter still increasing, used car prices falling, energy drastically pulling back, and goods inflation continuing its retreat. A still sticky part of the inflation picture is the services economy, with a bulk of the contribution coming from shelter as the housing market’s role in CPI continues to be sticky.
So we have overall cooling inflation, but the pace of disinflation matters as well as seeing if good inflation will return while services inflation remains sticky.
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2. Jobs 👉 NFP, Unemployment
On payrolls, sentiment had been volatile amid intense crosscurrents – January CPI hawkish, Services ISM dovish, and Powell’s commentary hawkish again. Recent Payroll data showed a firmer NFP (311k vs 225k survey) but a softer unemployment rate (3.6% vs 3.4% survey).
The sheer strength of payrolls at 311k confirms the signal of stronger economic momentum in the hot January data. But the 20bp increase in unemployment, 10bp increase in labor force participation, and surprise weakness in average hourly earnings up only 0.2 percent provide a substantial offset – suggesting healthy strength supported by improved labor supply with continued cooling of wages.
With inflation in the “cooling” camp and jobs in the “wait and see”, all eyes turned to the systemic risks…
3. Update on Banking Crisis 👉 First Republic, Credit Suisse, SVB Files Ch 11
Last week, I tweeted about an update at First Republic Bank:
Bill Ackman replied to my tweet with this, paired with an Elon Musk comment:
We are running into contagion and moral hazard territory.
The Swiss authorities moved from a statement of support to concrete action to try to stabilize Credit Suisse short of triggering a disruptive bail-in via $54B of Swiss National Bank (SNB) liquidity support.
The strategy focuses on the premise that this is a liquidity (not capital) event, so central bank liquidity should be able to push CS back from a bad funding equilibrium to a good funding equilibrium. There are three core elements to the plan:
By providing $54B of liquidity through a covered loan facility and standard central bank lending, the SNB shores up CS funding position preemptively in the hope that this backstop will keep private sector liquidity providers engaged with CS.
By providing more information on capital, liquidity, and asset portfolio, CS and its regulators hope to reassure investors and counterparties about its finances and assets – including limited unrealized losses on bonds net of hedges and the quality of the large loan book funders ultimately finance.
By taking advantage of its improved liquidity to launch buybacks of some debt securities, CS and the Swiss authorities improve equity at the margin and engineer a near-term short squeeze, reversing dynamics associated with bail-in risk.
This is a well-designed package, well worth trying before resorting to more drastic measures. The early impact on markets is notably positive.
But the day one central bank-sponsored short-squeeze is the easy part and the test will be whether wholesale funders, counterparties, and high net-worth depositors remain engaged or draw back in the weeks ahead.
The key vulnerability remains: the SNB can provide $54bn of liquidity and still be well collateralized. But given the nature of CS assets, it cannot escalate without taking on a lot of credit risk – which would have to be mitigated with additional equity, likely involving bail-in of CS debt. So we could quickly return to unstable dynamics.
On Friday, SVB Financial Group (SIVB) filed for Chapter 11 bankruptcy.
SVB Securities and SVB Capital's funds and general partner entities are not included in the Chapter 11 filing and continue to operate in the ordinary course as SVB Financial Group proceeds with its previously announced exploration of strategic alternatives for these valuable businesses.
SVB Financial Group is no longer affiliated with Silicon Valley Bank, N.A., or the bank's private banking and wealth management business, SVB Private. The bank's successor, Silicon Valley Bridge Bank, N.A., is operating under the jurisdiction of the Federal Deposit Insurance Corporation ("FDIC") and is not included in the Chapter 11 filing.
"The Chapter 11 process will allow SVB Financial Group to preserve value as it evaluates strategic alternatives for its prized businesses and assets, especially SVB Capital and SVB Securities," said William Kosturos, Chief Restructuring Officer for SVB Financial Group. "SVB Capital and SVB Securities continue to operate and serve clients, led by their longstanding and independent leadership teams."
Essentially what this does is strip out components of SVB to see which parts of the capital structure are a zero, and which parts can be sold for pennies on the dollar.
4. Impact of Banking Crisis 👉 Built-in Tightening Should Cause Hesitation to Hike at the Fed
At the core of the issue here is both real and perceived financial stability. Although some can write off SVB and Credit Suisse as mismanagement, there are clearly long-term lasting effects as higher rates ripple through the system.
The question we need to be asking when it comes to Fed decisions: Is inflation/over-employment a greater risk than real or perceived financial stability?
Seemingly the answer here is financial stability is the greater threat. To be blunt, if Powell wanted to get unemployment higher, then in the wake of the SVB crisis, he’d let venture funding fail and put the majority of the ~4mm workers of VC-backed portfolio companies out of work. Instead, the Fed/Treasury are moving to remove financial system risk.
From the latest Powell presser, we had this quote:
“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell told the Senate Banking Committee. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
This was pre-banking crisis. Now that we have systemic risk, it is incredibly likely that big bank failures will start to become more and more of a component of Powell’s “totality of data.”
A good indicator of how to envision this banking crisis is the Bloomberg US Financial Conditions Index:
The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
As you can see, we’ve had a sharp drop.
5. Terminal Rates 👉 Fixed Income Market Rollercoaster
Terminal rate expectations have changed drastically over the course of the year. At the beginning of February, the market was pricing in terminal rates to peak around 4.9%, with cuts coming at the end of the year.
By March 8th, the market shifted to a much more hawkish tone after Powell’s presser in Capitol Hill on March 7th, pricing in several more hikes, with a terminal rate of 5.6%.
Then… the bank crisis unfolded…
This is one of the most compelling series of charts that tells the story:
An utter collapse in interest rate expectations that forecast the next meeting to be the last (small) hike before cuts start in the summer, and deepen into the end of the year.
6. Recession 👉 Landing: Hard? Soft? No?
The string of banking failures has put the Fed in an extremely difficult position, with even more precision required to achieve the fabled “soft landing.” It’s looking much more like a hard landing now.
There are three primary recessionary bells ringing right now in the market:
This was the wildest week for bond markets since at least 2008. The question now is whether the real economy is headed for the same sort of slowdown that followed the global financial crisis.
The bond market’s fear gauge — ICE’s MOVE index of implied volatility — spiked to levels last seen in 2008. Actual yield moves reached the levels seen during the 1987 Black Monday equities meltdown and the Volcker-era swings of 1982, when record rate hikes set off a recession and tamed inflation.
The rollercoaster continues.
As I’ve written extensively, we are experiencing systemic issues in the banking system. This will ripple throughout the entire economy. Regional banks have provided a lot of key loan growth to thriving businesses:
The collapse of regional banks removes this access to capital to fund further growth. Increased hesitancy and scrutiny on originating loans will hurt all businesses. As goes the banking sector, so goes the economy.
Don’t forget - we still have a slowing economy, and companies still are in a massive deceleration of growth and lower earnings. While multiples have been crushed due to the rapid rise in weights, we still have the other piece of the puzzle to solve - fundamentals.
Everyone now is hiding out in defensive industries, as cyclicals are much more exposed to contracting economic conditions. Defensives to hide out in: Food producers, utilities, P&C insurance, and maybe even mega-cap tech.
The events over the course of the last 10 days have done Powell's job for him. Credit creation at banks will collapse and the economy will slow even in a good scenario. Inflation is almost certain to taper off as a result which should take a lot of pressure off of Powell but also means less focus on the backward-looking nature of the CPI data point and more focus on financial stability.
There will be volatility everywhere - which is a good time to get active.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
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