Plus ça change, Plus c’est la même chose — The Resurrection of the Fed Put
Pivotal
The Fed Put is back in play: pause, pivot or not… the admission by Powell that tighter credit and financial conditions act as de facto rate hike(s) means the risk markets are back in the driver’s seat. With a key caveat: there is no banking crisis and the Fed has admitted the recent effects have not yet had a causal impact.
The Fed pointedly doesn’t see lower rates this year — a direct contradiction to the market pricing the “dovish hike” with a series of lower rates by year end. Now terminal rates are still seen at 5.1% (or one more 25bp hike — unchanged from last quarter, despite higher guidance by Powell a few weeks ago). Inflation has gone up measurably, growth is tracking over 3%, unemployment remains at multi-decade lows and the markets have already substantially lowered rates, easing the burden of CET1 pressures and buffering to be tightening credit conditions. The international backdrop contains numerous risks besides the well-worn China/Russia geopolitical axis which includes sticky and rising inflation, ongoing central bank hiking regimes and a potential paradigm shift by Japan.
Primary asset markets are playing chicken and risk getting run over crossing the road to the promised land of easier policy where the bulls’ loll in the sun. Somewhat ironically though, this may mean risky assets can remain bid over the short run, even as the incessant drumbeat of recession fears get closer.
This is because in fact the banking stress is mostly idiosyncratic and the freak out in rates and spike in volatility is based more on muscle memory post GFC. There is no real crisis this time. The bond market has priced the end of the rate hiking cycle, and risky assets yesterday repriced following definitive news confirming a lack of blanket deposit guarantee across the land, but the selloff was specious. Yellen’s announcement was expected and perfectly consistent with the US authorities’ (Fed, Treasury, FDIC) assertions that the banking system is fundamentally robust, well capitalized and sound.
Presenting a blanket deposit guarantee would raise further the spectre of moral hazard, opening the door to extraordinary long term systemic USD risks as the US government would effectively backstop all risky behaviour, carte blanche…
While present stress in the banking sector has its own animus, because of the fundamentally sound banking system in the US, and distinction and actions taken to contain and isolate a handful of smaller troubled banks by both Fed and the FDIC, the Fed will remain focused on monetary policy and fighting inflation which was Powell’s message yesterday.
This linkage between financial stability and monetary policy was well communicated and understood and has been very effectively dealt with; easing anxiety will be proportional to removing rate cuts now embedded into the yield curve.
This also implicates the recent USD weakness, which may be short lived but also important to address in the context of sudden reflation of the Fed’s balance sheet amidst errant (and somewhat misinformed) speculation of stealthy QE.
Cryptocurrencies have been big beneficiaries of sharply adjusting bond yields and the pivoting yield curve as short term rates have declined by 100bp. The NIM pressure, related deposit outflow concerns impacting potentially impaired balance sheets of some US banks (its estimated that 28% of US$ 2.2T in the banking system’s HTM assets are underwater) are issues which are not in my view salient ones for systemically sustained weakness, at least not at this time. Vulnerabilities, yes, impairments, no. These issues in fact are direct implications and expectations by a central bank embarking on a rate rising campaign.
The charts below illustrate first from a wider perspective the relationship between BTC (white), the US 2y Treasury (beige/olive, yield inverted), the US 2yr vs 10yr yield curve (green), and the KBW Banking Index (orange,inverted), followed by the last 30 days, showing how sharply BTC, representing crypto as an asset class, has snapped into a high degree of correlation with the US yield curve, and inversely correlated with the US Banking Index weakness. BTC gained about 22% while the US Banking Index declined 28% over the last month. This is causal evidence of the current sensitivity and capital flows associated with BTC and changes in US monetary policy and banking risk. Accordingly we expect any amelioration of the US banking concerns to be likely associated with a sell-off in digital currency. How this relationship evolves as we work through the current situation will provide important clues.
The recent banking woes provided some sense of safe harbour and schadenfreude for crypto assets; as SVB’s demise was due almost entirely to egregious incompetence, and others such as CS (a great bank through the years), have had to have a ticket to every possible fiasco in their decade long slow motion trainwreck. The final ticket was UBS — the last stop on the sh*ttown express. These Ides of March were abrupt and unexpectedly malignant.
The extraordinary recovery in headline digital assets may reflect potential for alternatives with banking anxiety, yet the asset class while under pressure remains a growing presence in international financial markets and emerges ceteris paribus (which they never are) as the unbridled winner. Crypto assets gained nearly US$300bn while hundreds of billions were lost in the fiat banking system. That’s an extraordinary achievement, regardless of where you sit and maybe one of the most important realizations to come out of this mess.
We believe that based on the above, the temporary surfeit may remain or even expand in risky assets, but the medium to longer term outlook is not good. The rates market has over adjusted, the USD weakness and outré bid to gold may reverse in coming days as equities find increasing solace with the smoke clearing on banking concerns. This would be a false dawn, as Powell’s Legacy stands in the frame and it is dangerous to assume a reassumption of the 40 year bull market in rates which ended over a year ago.
Certainly growth and employment should break inflation but credit risk will keep on rising, and this will be reflected in higher costs to borrow, while expansion of monetary aggregates slows. This has many implications which we will dig into next time, but the conclusion today is that while avoiding moral hazard, the US Fed has in fact unwittingly embraced it; and animal spirits, seeing the will-o’-the-wisp’s green shoots, can party again… for a while.
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