Truth or Dare

“I lie when I need to, tell the truth when I can.”?

????????????????????????????????????????????????????????--Pedro Almodóvar’s Matador

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The rules of the game are that if you refuse the truth and the dare, then you must take a shot.

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Key Takeaways:

·????????Federal Reserve Chair Jerome Powell skirted any reference to recession, hoping the market would follow suit. Fed staff has forecasted a recession in Q3, so we will be looking for their updated view at the release of the March Federal Open Market Committee (FOMC) meeting minutes on April 12.

·????????Treasury Secretary Janet Yellen faced two challenges from the Senate on Wednesday that may coalesce into a toxic mix in the coming months. Republican Senators warned her against profligate spending and burdening the American taxpayer with any future bank selloff.

·????????Yellen’s message was that universal deposit insurance may not be in store, but in her response, she mentioned that a small community bank that fails could create the same contagion as a money center bank. Therefore, a smaller bank could be eligible for an emergency bailout, and thus the Treasury has stated that no bank is too little to fail. ?

·????????The Republican opposition to Yellen is foreshadowing what may happen down the road during the budget debate. We can foresee a failing bank that is rescued setting off a backlash to stop government spending that could lead to a shutdown.

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Noteworthy:

o??The Atlanta Fed Wage Growth Tracker spread for wages among those classified as “job switchers” has recently contracted sharply relative to “job stayers”, which is one sign of demand for labor cooling off. This supports the chart we highlighted last week showing the recent drop in NFIB Hiring Intentions.

o??The European March Purchasing Managers Index came in at 47.1 versus the estimate of 49, and the business outlook has become even less certain with the protests in France.

o??Fed swaps have priced out any expectation for a May rate hike.

o??Russia is considering lengthening its fertilizer exports through November, creating more inflationary supply pressure for agriculture.

o??The latest Statement of Economic Projections (SEP) showed the top inflation forecasts for the end of this year at 4.1% for both core and headline PCE inflation. Currently at 4.7% core and 5.4% headline, inflation pressures will be problematic until they move below 4.1%.

Not So Fast Dept: At the February press conference, Powell made it clear that the SEP would show a higher path of rate hikes for 2023. The intervening bank crisis changed that plan. At the March press conference, the Fed chairman stated that the onset of the banking crisis has tightened financial conditions and may finish the Fed’s rate hiking campaign for them. Further tightening of financial conditions (read: recession) would eliminate the Fed’s need to rates again. If the crisis can be avoided, one more tightening of rates is likely before the inevitable pause.

The median SEP projection for Fed funds did not change for 2023, although for 2024, its expectation of cutting rates four times was trimmed to three rate cuts.

Investor Reaction

The fixed income market quickly eliminated the possibility of a rate hike at the next meeting in May and priced in four rate cuts during the remaining five meetings in 2023. As we pointed out last week, the normal pattern is for the central bank to opt for a period of unchanged rates once the two-year yield falls below the Fed funds rate. Therefore, to price in a dramatic 100 basis point drop in the funds target for year-end is an overreaction.

Equity investors have not responded to the value of the Fed’s Bank Term Funding Program (BTFP, not to be confused with BTFD) because bank shares were flat last week while the S&P 500 rallied 1.7%. Borrowings under the BTFP more than quadrupled to $54 billion from its initial week borrowings. The BTFP represents a strong risk-mitigation tool to reduce the odds of a sustained liquidity crisis stemming from deposit outflows. However, the market is more focused on the forthcoming credit contraction due to constrained lending standards that are keeping a lid on bank stocks. The overhanging concern is about even fewer forthcoming loans, which will push us into a recession. As we mentioned last week, the new money at the Fed is not earmarked for productive flow into the economy. The additional borrowing by each bank pushes its leverage ratio even higher, constricting any opportunity for expansion.

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Truth

In recent FOMC meeting minutes, the Fed staff forecasted a recession for Q3, and some voting members have discussed the tighter lending environment. The Fed’s most recent Senior Loan Officer survey found “tighter standards and weaker demand for commercial and industrial loans, residential and commercial real estate…home equity lines of credit and credit cards, auto, and other consumer loans”.

Powell addressed this problem by stating, “Bank credit contraction is disinflationary.” What he really means is “bank credit contraction is recessionary.” Stocks will fall and credit spreads will widen, slowing economic activity as though the Fed had raised its funds target. Although he said that recent developments will weigh on economic activity, hiring and inflation, his unstated bottom line was that we are facing the very real prospect of recession as banks focus on their balance sheets rather than lending money.

Dare

The most important faceoff was not Powell against the press, but rather Yellen in front of the Senate on Wednesday.

Secretary Yellen opened her remarks by saying that the failure to raise the debt ceiling would cause an economic and financial catastrophe. It would be “a failure of the US government for the first time since 1789 to pay bills it incurred, cause a loss of confidence in the United States and bring untold, unbelievable economic damage.”

The next statement that caught my attention goes as follows:

“In my remarks to the American Bankers Association, consisting of community banks, when the failure of a bank when judged to create systemic risk—that is a risk of contagion bank runs—the government is likely to invoke the systemic risk exception which permits the FDIC to protect all the depositors. It is not a question of invoking it for large or medium sized banks. A failure of a small bank--of a community bank--could likewise trigger a run on other banks and lead to the same judgement that the failure of that community bank creates systemic risk” (my emphasis).

This statement warrants examination. If a small community bank fails, it will have the same impact as the failure of a big money center bank. Therefore, in the current environment, the Treasury may need to rescue any bank to avoid systemwide problems.

The problem with rescuing a small bank must be put in reference to the ongoing budget negotiations. I had expected a budget circus to occur from the splinter group in the House, but the firm front put forth by Senate Republicans in communicating their resolve to fight over the budget was overwhelming.

The trigger for a major market calamity could come from a congressional pushback on saving a small bank that would increase the chances of a government shutdown. From our perspective, this raises the cost of any future bank failure beyond just a temporary market adjustment. This is the terrain that has been set. Our hope is we do not traverse it.

One last note regarding the SEP

Given the problems with the banking system, the discussion of inflation has been swept under the rug. There is a clear range outside of which it could come back into the FOMC discussion. The top of the inflation range for year-end 2023 from the 18 central bankers forecasting in the SEP is 4.1% for both core and headline PCE. The range is 2.8-4.1% for headline and 3.5-4.1% for core. Therefore, sustained PCE prints above 4.1% will be seen as problematic for the Committee. Until the 5.4% current headline PCE and 4.7% core begin to move below 4.1%, we cannot be complacent about inflation.

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Regarding the markets, we stand by our statement from last week: “The Bear Stearns analog targeting 4300 is still a possibility as long as 3800 support in the S&P 500 holds firm.” Moreover, our expectation regarding the rate hike played out “If stocks are firm into Wednesday’s FOMC, then expect a 25-basis point hike.”

Furthermore, we wrote “For our current situation to track March-May 2008, bank stocks must snap back.” Regional banks showed a positive tone because their share prices held steady relative to the big money center banks despite a sharp deposit outflow of $120 billion at smaller banks while the largest banks saw $67 billion inflows. Watch JP Morgan, Citibank, and Wells Fargo on Monday because they gapped down Friday morning and then reversed strongly. If on Monday they open above Friday’s highs and remain above those Friday highs all day, it will be the first sign of investor relief in the financial sector.

The first sign of trouble would be a daily close below 3900, confirmed by a move below 3800. So far, the S&P has been tracking its seasonality pattern nicely, which calls for a mid-March low to be followed by a high into May.

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Bond Note

Mirror Images: When the market moves into a deflationary mindset, bonds and stocks move in opposite directions, because marginal changes in investors’ views about growth drive both asset classes. After Powell’s press conference stocks fell and bonds rose because the markets sensed his worry. See the 30-minute chart from this week with Treasury 10-year note futures in blue and S&P 500 futures in red, showing their inverse relationship. The red and blue arrows show where stocks and bonds were respectively as the FOMC statement was released. It is evident that the markets are rejecting any notion of an inflationary backdrop.?

The two-year daily chart closed below 3.83% support for the first time since September 2021. We will use this chart as an indicator for bond market sentiment regarding growth, inflation, and a flight to safety bid.?

Dollar Note

A positive sign for risk assets would be for the dollar to bottom. It hit a low for the week following the FOMC but rebounded, and we expect a continued rally. 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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