It’s been an extraordinary week with three major data releases, two bank failures and one of the most extensive and expansive banking rescue packages since the GFC. The dust has not fully settled, but it is a good time to review the data, the upcoming Fed meeting and my four big takeaways for markets.
SVB and Signature Bank: Much (much!!) ink will be spilled in the coming months about SVB, banking regulation and the long-run impact of last week’s regional bank failure. The lens of this note is the impact on the macro landscape and Fed policy, and I will leave it to the bank industry experts to offer expertise on bank by bank insights and weigh in. The good news is that this is quite different from 2009 and the financial crisis. There is less leverage in the banking system and more transparency, both clear positives. The Fed and the FDIC’s announcements on Sunday, March 11, to fully insure depositors of any size seem to have stopped risk of flight of deposits that are the bedrock of our banking system.
But markets have been badly spooked. There is a more tangible threat beyond the existential crisis of confidence, which may slowly calm in coming days. By sharply raising rates 450 bps in one year, the Fed devalued Treasuries—a core safe haven asset and a part of every bank balance sheet—by around 15%. This, after keeping rates at zero for essentially 10 of the last 13 years, will fundamentally change allocation to risk. Additionally, regulatory changes have greatly reduced the capability of market makers that facilitate market function during times of turmoil. We aren’t here to debate the regulation, only to point out that lack of liquidity in the Treasury market—ostensibly the most secure, liquid market in the world—had been troubled before this episode.
Treasury volatility has soared: The shocking moves in the Treasury market are a direct result of this. Over the last week, we have seen the Treasury curve shift down 115 bps in the short end and 65 bps in the long-end. The 2-year Treasury went from 5.07% to 3.89% over the course of four trading days—it experienced a 60 bps move in one session. The MOVE Index, where traders can price expected Treasury volatility going forward, surpassed levels during the COVID-19 financial turmoil and has neared levels not seen since the GFC.
Fast end to a furious Fed rate hike cycle: Markets basically stuck a fork in the Fed’s plans to keep raising rates. As recently as March 8, strong macro data had caused markets to expect 100 bps more Fed rate hikes to over 5.50%. Markets had also washed rate cut expectations out of 2023 and most of 2024. That has undergone a massive shift with only 25 bps more rate hikes priced in (total) and 70 bps of rate cuts expected later this year. Over the past year, the Fed has dragged markets kicking and screaming along this rate hike cycle, having to fiercely push back when markets price a dovish outcome, or rate cuts. This time around, the avalanche of hawkish Fedspeak has not materialized. A rate hike at next week’s FOMC meeting on March 22—a foregone conclusion just 10 days ago—is now a coin toss. The ECB raised rates 50 bps this past week with a nod to watching financial conditions. This could be a blueprint for the Fed to raise and signal a more tentative approach going forward. If their intention were to hike, I would expect them to signal that very soon.
Fed rate hike expectations have undergone a huge repricing
Source: Federal Reserve, Bloomberg Finance, L.P., as of March 15, 2023.
An inconvenient truth: In an ideal world, the Fed’s inflation fighting and employment goals could operate independently of banking conditions and financial markets, but that is simply not the law of the jungle at the end of rate hike cycles when the two often commingle. One conclusion may be that given the outsized and disruptive volatility in the Treasury market, the Fed may choose to quickly wind down quantitative tightening.
On the macro side, three normally marquee data releases were out last week but did not make the mainstage. Looking at growth and employment, the economy is still firing on all cylinders. There is clearly improvement in the inflation picture from the middle of last year, when CPI was tracking a 40-year high. Input prices, wages and consumer prices are all decelerating, but the process is slow and uneven. This will be an enormous challenge for the Fed. The macro data are arguably too strong to justify a pause, even if financial market volatility and systemic uncertainty make a wait-and-see approach a no brainer.
Employment Situation: Still going strong, with easing wage pressure in February. The economy added 311,000 jobs, the 11th consecutive upside surprise, as the labor market remains unambiguously strong. The unemployment rate ticked up to 3.6%—still near a 40-year low—and in positive news the participation rate hit a post-pandemic high of 62.5%. This is welcome news as more labor supply means point to both more growth and less wage pressure, at the margin. Average hourly earnings rose to 4.6% y/y, but while too high for a 2% inflation target, remain on a broad downtrend. Layoff announcements have garnered a lot of headlines lately and are troubling. But at the macro level, the U.S. labor market continues to run hot.
CPI: The disinflationary process has started, but it’s slow going. The headline rose 0.4% m/m, on consensus, while excluding food and energy, core CPI rose 0.5% m/m. This leaves consumer price inflation at 6.0%, and core inflation at 5.5%, still uncomfortably above the Fed’s 2% target. Shelter inflation lingers as a powerful updraft to the monthly numbers, and in February, rent of primary residence rose 0.8% m/m. High frequency data point to a deceleration, but it has yet to materialize. Still, the Fed has specifically focused on core services less shelter (about 25% of consumer spending), an area theoretically sensitive to higher wages. In February, this sub-series also moved in the wrong direction, posting a 0.4% m/m gain (0.6% m/m when medical insurance was excluded).
Service focused measures are moving in the wrong direction
Source: Bureau of Labor Statistics, FS Investments, as of March 15, 2023.
Finally, goods prices may not be neatly reprising their pre-COVID deflationary trend. Used car prices fell in February, but wholesale used car prices are on the rise again. And prices for other durable goods like furniture and appliances are back to a spicier inflation rate than before the pandemic. I’ll say it again: A lot has to go right to get inflation consistently back to 2%.
Retail sales: February saw a downtick of -0.4% m/m, but this was after a surge of 3.2% m/m in January, a strong increase in spending supercharged by warmer weather and the COLA increases. When some of the more volatile components were excluded, the “control” measure that aligns with real GDP rose 0.5%. In the wake of the data, the Atlanta Fed’s GDPNow tracker moved up to 3.2% real GDP growth in Q1.
- No room for policy complacency. The Fed possibly (the March 22 FOMC meeting is still up in the air) going on pause should not be viewed as an “all clear” for policy risk. Inflation is still too high for the Fed’s policy framework and the Fed could yet need to tighten, should financial conditions ease once again. And don’t forget about the debt ceiling, the next storm cloud on the policy horizon. This could cause more tectonic shifts in the Treasury markets.
- Probability of (a mild) recession remains high. Some have asked if the end to the Fed’s rate hike cycle means we have successfully avoided a recession. Unfortunately, not yet. Indeed, six out of the last seven recessions have started around a year (on average) after the Fed has stopped raising rates. The fallout from these failed banks is likely to be tighter lending standards, which is not helpful. The fact that the banking system will—and this is very much my expectation—prove fundamentally sound reinforces my outlook that a recession is likely to be more mild. A banking crisis would change that outlook significantly.
- Treasuries are no longer the ballast. A core tenet of investing is that higher returns come with higher risk, and Treasuries are not immune to this. The Sharpe ratio of a 2-year Treasury in a world where return is 4% and volatility is 2.5% (volatility has been a moving target, but we will eyeball it for the purposes of this example) is 1.6—not bad but not historically compelling. And with inflation running at 6% and expected to end the year around 4%, your real return on income is still negative.
- Equity markets may still not be pricing in a recession. Even after everything that has transpired the past couple weeks, the S&P 500 trades close to 18x forward EPS, a historically high multiple. As we’ve discussed, this is a precarious perch given the confluence of fundamental and policy risks present today. Stocks have taken solace in lower interest rates over the past week—just look at what growth stocks have done—but make no mistake: The market can’t have its cake and eat it, too. If rates stay low, that means the Fed is seriously concerned with financial stability, a serious risk for the economic expansion. If the banking stress abates, the market’s pricing of the Fed today will prove far too dovish. All this suggests today is a poor entry point into passive equity strategies.