Meshuggah
“Paranoia is just reality on a finer scale.”?
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The bond market may be the only one speaking rationally.
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Key Takeaways:
·????????Follow the 2-year. When its yield crosses below the fed funds rate, as it did this week, it signals an end to central bank tightening—not an ease, but a prolonged pause before easing.
·????????The Federal Reserve’s scramble to correct its policy error in not tightening earlier has caused the yield curve to invert and has promoted the belief that it is willing to tighten rates regardless of a recession. However, the consensus unraveled in one week. The treasury yield curve reversed two-thirds of a nine-month inversion in one week, accelerating the countdown to recession.
·????????The markets have been chaotic and much of the investment analysis has been frantic. The quiet voices are coming from regional bank insiders, and they are buying heavily, not selling their own stock.
·????????There will be no emergency rate cuts coming, no collapse in the dollar, but deposit flight will continue and credit contraction will increase, leading to recession.
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Noteworthy:
o??Bank stats: The top 15 US banks have a 33% market share. The top 25 banks hold 62% of all loans, but only 33% of commercial real estate (CRE) loans. The remaining two-thirds of the banking sector’s CRE exposure is held at banks that are vulnerable to deposit flight.
o??Tiger Global marked down its private investments by 33% for 2022 and its newest venture funds lost 9%-25% in Q4. This brings up questions regarding US pension funds, which are not only heavily invested in bonds but have significant private equity holdings.
o??This week’s Federal Open Market Committee (FOMC) meeting will discuss the one-year inflation expectations numbers from the NY Fed Consumer Expectations Survey. They will focus on the drop in February to 4.23% from 4.95% in January, falling to its lowest reading in almost two years.
o??As we had anticipated, China revealed some policy stimulus this week by cutting the reserve requirement ratio (RRR) by 25 basis points for the first time in 2023. This represents a $75 billion liquidity injection. The 7.5% RRR is now half of what it was in 2018.
o??The Fed opened its discount window and its balance sheet increased by $300 billion. Although China and the US added liquidity this week, the liquidity will not solve the problems plaguing exports and the property sector in China, nor will it prevent looming commercial real estate defaults and softening private equity markets in the US.
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You Are Not the Boss of Me Dept: The 2-year Treasury note yield has always been the best indicator forecasting a Fed pause. Because the Fed follows the market, not the other way around, whenever the Treasury yield moves below the fed funds rate, it is an excellent signal that monetary policy will pause. In 2019 the Fed raised rates by 25 bp more after the crossover occurred, but any expectation of a sustained hiking campaign is highly unlikely. Only a fast reversal into the end of the month would nullify the signal shown below. The black line is the fed funds rate and it is clear that when the 2-year note tops (a red bar is a signal of a reversal lower on our model) and moves below funds, the Fed stops its hiking cycle:
There have been two major themes discussed in this commentary for months: An inverted yield curve always normalizes back to a positive slope before a recession occurs, and commercial real estate is going to be the flashpoint for this economy, not housing. Both are playing out.
Assuming the chart above marks an end to the tightening campaign, then short rates will come down further as the economy slows and the steepening will be accelerated if inflation remains sticky because long term yields will hold above 3%. The current inversion is now only 40 basis points (the 2s 10s yield curve was inverted by 110 bp on March 8). Steady inflation fits with a prolonged pause in the rate cycle matching previous periods in history.
The typical procession is unfolding from inversion to a positively sloped yield curve then recession. The recession set up is following the past pattern in the lead up into recession: Capital is not being deployed to productive projects but diverted to support those who made improper capital allocation decisions, which leads to a credit contraction.
Presently, banks have been paid to shift money from the long end to the short end as the curve inverted, but they have failed to do so. However, the real problem for the troubled banks is not coming from the asset side (their held-to-maturity bond portfolio) but from their liabilities (their concentrated deposit base). Nevertheless, those deposits would not be at risk of moving to the top-tier banks if there had been no blowup due to improper asset-liability management.
Capital flight from the lower capitalized segment of the banking sector that holds the bulk of CRE loans is problematic, especially because a good portion of these loans have floating rates and are coming due this year. These banks simply cannot take on defaulted loans, and this fact will push valuations of bank stocks and commercial property values down further, exacerbating the problem. This storm is pointing to a recession and severe equity market trouble, and it is yet another incentive to keep the funds rate stable. The question is whether this CRE crisis is at our doorstep now, or whether problems will be temporarily papered over by the $2 trillion Fed backstop. ?
The Fed has been centered on the strength of the labor market and the high wages propping up services inflation. That has been the case looking at the rear-view mirror, but what is the outlook? Hiring Plans in the NFIB Small Business Survey look bleak, and resemble previous periods that have preceded recessions. Remember, this is before the current banking crisis was on anyone’s radar.?
Is there any glimmer of hope? We think we have passed the point of no return, but we could see a relief rally similar to March-May 2008, and we are taking a hard look at bank insiders who have been conspicuously buying their stocks. They cannot sell any of these purchases for 6 months, so that is a solid vote of confidence.
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Groundhog Day—A note about analogs
We discussed the Bear Stearns analog, and equity indices have followed the action from 15 years ago remarkably well—with one exception. A crack in that rhyme is that financial stocks reversed higher with the indices in 2008, but now, continued crises are keeping banks at lows. 2008 created a false sense of calm that the government isolated the problem. For our current situation to track March-May 2008, bank stocks must snap back.
A consensus seems to be forming that perhaps the 1990s banking crisis is the better analogy, with an inverted curve and the Fed tightening sharply to contain inflation. We recognize the connection with the 1990-91 recession because it was caused by a double hit to the financial and real estate sectors. Back then it was savings and loans banks and residential housing, whereas now it is regional banks and CRE. However, the curve was already positive at the start of 1990 and CPI had been rising since the end of 1986. Crude more than doubled in three months starting in July 1990, which was the official start of the recession. The banking crisis of 1990 stretched from the early 1980s until the mid-1990s, and it was steeped in fraud and over-speculation. We don’t see fraudulent risk management causing our current woes, just investment foresight that left much to be desired.
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Regarding the markets, we wrote, “If the 3800 region holds this week, it will become our primary path, and that calls for a counter-trend rally.” Monday’s 3808 low turned out to conform to this scenario, at least for now.
The Bear Stearns analog targeting 4300 is still a possibility as long as 3800 support in the S&P 500 holds firm, but certainly we would not advocate for a sense of complacency here.
We will see reflexivity at play this week. If stocks are firm into Wednesday’s FOMC, then expect a 25-basis point hike and a Statement of Economic Projections (SEP) report that nudges the fed funds central tendency year-end forecast above December’s 5.1% -5.4%. If the market drops sharply into the meeting, the chances are good for an unchanged target of 4 ?%- 4 ?% and the December year-end forecast will hold steady. It will be interesting to see whether the 2024 funds forecast is moved up from its current 3.9%-4.9% level, in which case stocks would view that negatively.
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Bond Note
The flight-to-safety Treasury bid continued and pushed the 10-year yield below 3.60% for a long term buy signal. The lows for the year at 3.32% will bring in more buying, likely from shorts who have been stunned by this move. The real story is at the short end of the yield curve, with the 2-year note falling incredulously from 5.09% on March 8 to end Friday at 3.82%. The sharp drop in 2-year yields has tarnished the argument that money should be parked in short-term Treasuries rather than stocks, and stocks did perform better than the 2-year note this week, after sharply underperforming the week before. ?
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Dollar Note
People have declared the demise of the US dollar for decades. If rates remain unchanged, and the SEP does not reflect the “higher for longer” view, then the dollar may weaken in the short term. However, we expect that the dollar hits new highs for the year before any new lows are reached. Even though European rate hike expectations spiked 25 basis points higher for year-end after the ECB surprised the markets with a full 50-basis point hike this week, the euro did not have a breakaway move from the dollar. A drop below 100 in the Dollar Index would be a cause to reassess.
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Peter Corey
PavePro Team
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