An Unsafe Haven?

“I’ve never freed myself of the suspicion that there are some extremely odd things about this mission.”?

???????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????-- HAL 2001: A Space Odyssey

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Bank deposits were suddenly seen as vulnerable last month. Fear of loss spreads or it does not. However, persistence of memory is not just a great painting.

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Key Takeaways:

·????????Average inflation expectations have fallen, but uncertainty around future inflation has increased due to the rise in sticky inflation despite the Federal Reserve’s tightening campaign.

·????????The Fed meeting minutes contain some nuggets that the media has ignored. Government bond dealers and other major bond participants do not expect a drop in the fed funds rate into year-end following a 25 basis point (bp) rate hike in May. This stands in stark contrast to general market expectations and could have negative implications for the equity markets.

·????????Waller, still a Fed voting member, and yes, a hawk, had been an advocate for continued tightening “longer than markets anticipate.” However last week he was open to the Fed staff’s suggestion that the world may have changed after Silicon Valley Bank collapsed. “There are still more than two weeks until the next Fed meeting, and I stand ready to adjust my stance based on what we learn about lending conditions”, Waller said.?

·????????An extremely high 40% of American Association of Independent Investors respondents are neutral, meaning they do not expect a meaningful market trend, also reflected in a compressed VIX reading near 17. This complacency is also evident in the comfort investors feel parking money in technology stocks, the only sector showing solid outperformance this year. We are beginning to lean against this view.

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Noteworthy:

o??The March National Federation of Independent Business (NFIB) survey reply to “Is this a good time to expand?” hit a five-year low, below the March 2020 pandemic reading.

o??NFIB Loan Availability also hit a five-year low, and the number of investors expecting easier credit conditions fell to a five-year low as well. Firms incurring higher interest costs relative to last quarter hit a five-year high. Even with those troubling readings, the economy was listed as the main reason for their poor expansion outlook, above concerns regarding tight credit or high interest rates.

o??The March New York Fed Survey of Consumer Expectations showed that 58.2% of consumers found credit was more difficult to obtain than last year, the highest level since the survey began in 2014. This number should rise in the aftermath of Silicon Valley Bank, along with the pessimism found in the NFIB survey.

o??Core PCE has been steady recently at around 4.6%, and the Cleveland Fed Nowcast Inflation forecast expects another 4.6% reading in March. Headline PCE over the last quarter has come in at 5.3%, 5.3% and 5.0%, respectively. However, when March PCE is released on April 28, the Nowcast expectation is for headline to fall below core to 4.1%, a full 2% below its reading six months ago.

o??New car inventories hitting two-year highs should put immediate downward pressure on both the demand for and price of used cars.

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You Say Potato Dept: I found it ironic that the same week that the Federal Open Market Committee (FOMC) minutes highlighted the risk of recession, The Economist magazine’s cover story is “Riding High: The lessons of America’s astonishing economy.” The cover illustration is a cowboy on a horse with legs so high it looks as though it is on stilts. Natural selection weeded out this equine version quickly as it was not the most stable model in the showroom. Life is imitating art because investors’ optimism is also on wobbly legs.

This cover story is an echo of the sense of relief (or astonishment) felt in April and May 2008 after Bear Stearns was starting to look like a one-off event. A May 2008 Los Angeles Times article written two months after the Bear Stearns crisis--in the teeth of a recession--and right before a 15% two-month selloff into July 2008 opined:

“Sliding consumer confidence and rising oil prices haven’t been enough to halt the market’s spring rebound. The bears need another story line to do serious damage to stocks. Of course, it has helped that the Federal Reserve has lent unprecedented sums to banks and major brokerages and pulled the financial system back from the brink. Investors’ mood also has been buffered by the economic data…it still isn’t clear that the U.S has actually fallen into recession” (my emphasis).

Sound familiar?

It is no secret that The Economist cover is manna for contrarian investors. Our optimism is measured in weeks right now, and that window is shortening.

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Inflation Expectations and Fed Policy

Former President Kocherlakota of the Minneapolis Fed co-authored a paper using interest rate caps and floors to generate a distribution of market-based inflation expectations five years into the future. I used the tool to evaluate how investors’ inflation expectations have changed during the Fed hiking campaign that began on March 16, 2022, versus their most recent reading on April 12, 2023. The distribution on the eve of hiking is displayed in red, and the latest distribution is in blue. Some interesting conclusions can be drawn from examining the two distributions.

First the good news: The average CPI expectation among investors has fallen dramatically from 3.4% to 2.5%, which aligns with the NY Fed Survey of Consumer Expectations 5-year inflation reading of 2.5%. What should be troubling to the Fed and to others is that although the market’s average long-term inflation expectation is moving toward the Fed’s 2% goal, the 90th percentile reading in the right tail has risen from 4.5% when the Fed started its inflation fight, to 4.65%. The range of expected inflation outcomes has also increased dramatically, with the standard deviation of today’s expectations at 1.7% versus 1.1% just before the first rate hike.

Not shown are the distributions over the past six months, but they have been remarkably stable and have not varied much from the current pattern of expectations.

The first question that comes to mind is, why, after 475 bp of rate hikes has inflation uncertainty increased, along with the top end of inflation forecasts? Second, after raising rates 300 bp six months ago, why hasn’t adding an additional 175bp of rate hikes affected top end inflation forecasts?

The Atlanta Fed CPI data contains the answer. The black time series is flexible CPI, and the orange line is sticky CPI:

One year ago, March 2022 flexible CPI peaked at a towering 19.7% y/y growth, while sticky prices were increasing at a 4.7% y/y rate.?Fast forward one year to March 2023, and flexible CPI has collapsed to 1.6%, but sticky has risen to 6.6%. Flexible CPI is already under the Fed’s 2% inflation target, but sticky inflation continues to move higher, away from their target. That is why the potential CPI in five years is also rising for the upper end inflation forecasts, and why the Fed will not be cutting rates in the second half of 2023. The longer these permanent aspects of inflation persist, the higher the odds that consumer inflation expectations will no longer remain anchored.

A Quick Minute on the Minutes

For all the headlines about strong recession warnings in the March FOMC meeting minutes, the details contained many uncertainties. Whereas this commentary has highlighted that the prior three publications of the staff outlook made it clear that the chances of recession were as likely as the baseline slow growth view, the March minutes underlined that the recent bank crises have elevated banking conditions to be the deciding factor between avoiding a recession or not. The staff wrote that if no further pressure occurs in the banking sector, then “risks around the baseline [forecast] would be tilted to the upside” for the economy.

As far as the policymakers are concerned, only three of the 18 Fed members and presidents saw the economy moving into a recession this year, and a mild one at that. The three of them were looking for a contraction of -0.1 to -0.2% real GDP growth in the March forecast for year-end, whereas two of those members were looking for a drop in real GDP as deep as -0.6% in the December 2022 forecast. Therefore, the fear of recession is far from prevalent among FOMC voters. The staff warned that the risk of a severe recession exists because historically recessions “related to financial market problems tend to be more severe and persistent than average recessions.” We have no argument there.

Two final points contained in the minutes: “Market contacts observed that the recent developments in the banking system will likely result in a pullback in bank lending, which would not be reflected in most common financial conditions indexes” (my emphasis). Therefore, FOMC members will need to broaden their view of financial conditions and not ignore the very definite possibility that tighter credit standards will cause hiring and wages to drop.

The Fed conducts a survey among primary dealers and market participants, and there is a stark gap between their expectations and “the market-based measures of policy expectations that suggested the federal funds rate would peak in May 2023 and would then move lower.” The surveys from the Open Market Desk at the NY Fed “did not show any declines in the target rate through 2023.” Therefore, the central players in the government market agree with our view of raising the target rate to 5%-5.25% at the May FOMC and then pausing, in contrast to the general market perception of two rate cuts in the second half of 2023.

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Regarding the markets, the state of the Bear Stearns analog is sound. It continues to forecast strength into May and a 4300 S&P 500 target. The market tone is positive above 4070 in the short term, with confirmation of a selloff below 4030. From a buy and hold perspective, 3800 is key support.

Complacency

The most recent American Association of Individual Investors survey reveals that its neutral reading fell just short of 40%. Neutral means a respondent expects no market trend over the next six months. That is a remarkably high reading, and an important one. Most of the attention is focused on the level of Bulls or Bears, but when the Neutral camp grows to an extreme, it can signal a market reversal. Only two readings have been above 40% since 2021, one in February 2022 and the other at the end of March 2022. An intermediate peak occurred in February and the March reading coincided with a secondary high in the S&P 500 at 4600, before a strong selloff.

Two weeks ago, we wrote “The VIX fell from 31 at the march lows to close Friday at 18.7—and could continue falling toward 17.” Friday’s close was 17.07. This also reflects a consensus of a tight trading range moving forward.

Weak Breadth

With the S&P up nearly 8% on the year, it is not as positive drilling down sector by sector, because the only area beating the S&P index in 2023 is technology. The consumer discretionary ETF XLY is outperforming, but another consumer discretionary ETF, XRT, is not.

Banks Lagging

KRE/SPY is still moving lower despite improving data:

·????????Bank Term Funding Program borrowings fell, as did borrowings at the Fed’s Discount Window

·????????Deposits and loans rose at smaller banks last week, as well as at large commercial banks.

This is puzzling to me because the Fed has provided liquidity through both tools, and the demand for both has diminished, which should be a sign of stability in the banking system. Yet, regional banks continue to languish. Therefore, either the market anticipates another round of deposit outflows, or yet another factor is depressing regional bank relative performance.

Tech as Safe Haven?

I was brought back to 1999 as I read last week that Morgan Stanley’s clients have asked whether the firm considers tech to be a defensive sector. The firm disagreed of course, affirming that tech is “higher beta and more pro-cyclical.” Given all the market negatives listed above, I find that the complacent view of tech being a bullet-proof choice for asset allocation may be as much of a contrarian indicator as The Economist’s cover.

Bond Note

Ten-year yields have oscillated in a 3.30%-3.70% daily closing range for the past month and finished Friday exactly in the middle at 3.50%. A longer-term view looks more negative using a technical tool used by large Japanese buyers of Treasuries. This weekly US 10-year note yield chart from 2018 suggests selling could be triggered on further increases in treasury yields.

Dollar Note

The dollar retested a major technical objective at 101, matching the February YTD lows. We believe that as the market starts moving toward the primary dealers’ consensus that no rate cuts will occur in H2 2023, the dollar forward rates will rise, making dollar shorts much less attractive and the dollar will 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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