Rightly or wrongly, Chairman Powell followed expectations and brought another quarter point hike to Fed Funds, bringing the upper range to 5%. Higher rates will make it even harder for banks to retain deposits unless they start rapidly increasing the interest paid on those balances which will crimp earnings power. It will also be difficult to approve loans at a time when deposits are rapidly moving around. Lending conditions are going to get even tighter from here. Financial conditions will worsen. While backward-looking inflation data is not improving as fast as the Fed hoped, they are not looking at the incoming deflationary freight train as closely as some wish.
It is a very tough spot for Powell to be in, albeit one that they (and massive government spending) put themselves in. Sticky inflation at such high levels is very destructive, especially to the middle- and lower-income classes. Quality of life deteriorates when every nickel is spent just to get by. The Fed does not have the luxury of hope anymore, after transitory inflation was proved to be wrong. Further, they have made it clear they will not repeat the errors of the 70’s where every economic hiccup was met with the easing of market conditions, and subsequently, inflation lasting through the decade. This Fed wants to beat inflation like Volker and put it to bed as quickly as possible. Accomplishing this with a soft landing and a minor recession is becoming tougher to envision with what has occurred over the past few weeks.
Some highlights from Chairman Powell’s press conference and his views:
• It is not clear to him if banks will tighten lending standards further, but if they do it will be equivalent to added rate hikes. From my vantage point, it is clear that smaller banks will continue to tighten, but larger banks, which took in upwards of $1 trillion in deposits over the past several weeks, may pick up some of the slack. They do not have to be aggressively lending though, as these deposits can be parked at the Fed and earn 5% while doing nothing.
• Goods disinflation is ongoing, but services inflation is still an issue. Housing impact will weaken over the coming months. In fact, rental rates are turning negative.
• The Fed’s base case is for no rate cuts this year. The street is pricing in cuts as soon as June and 100bps by year-end.
• Quantitative Tightening, the reduction in Treasury and Mortgage-Backed securities from their balance sheet, and the sudden increase in their balance sheet from Discount Window operations (banks running to borrow cash) are two very different things. A reduction in bond holdings will help raise real interest rates. The borrowing by banks is purely to provide assurance that deposits are safe. This is not inflationary, even though the balance sheet increases in size.
• The Fed believes the commercial real estate concerns are manageable (where have we heard that before?)
• They think a soft landing is possible.
• Deposit outflows at banks have stabilized over the last week.
Even though most of the scenarios laid out are contradictory from a historical perspective and periods of stress like banks are seeing today are usually met with Fed easing, stocks cheered the comments during Powell’s presser. He left open the door to ending rate hikes in May, and offered consensus thinking on letting the upcoming data dictate policy. Dot plots are back to being fiction, with Powell stating “policy is going to reflect what happens, rather than what we write down in the SEP (Summary of Economic Projections).” Yesterday there was a 50% chance of another quarter point hike in May, today it is down to 5%. Markets are dictating that the Fed is done. Many termed this a dovish hike. If there ever was one, this was it.
However, stocks reversed course with 2% drops across the board following Treasury Secretary Yellen’s rather unexpected comments, which occurred right at the end of Powell’s presser on Wednesday. She noted that the Treasury is “not considering a broad increase in deposit insurance.” This confused investors and black-box systems, especially after Powell clearly noted just minutes earlier “you’ve seen that we have the tools to protect depositors” and when there is a serious threat to the system, “regulators will use those tools.” In truth, a blanket guarantee of all deposits would take an act approved by Congress. In today’s fractured world, that is highly unlikely unless a larger blow-up occurs. What can be expected are piecemeal guarantees similar to the response to Silicon Valley Bank’s downfall. You cannot technically guarantee everything all at once. Playing whack-a-mole works just fine for now, but Yellen’s comments are hardly reassuring for investors. Markets want confidence and known facts. These two mixed up their message. Calmness and assurance are what’s required today from all sides. Bank stocks closed down yet again yesterday as well, with some making new multi-year lows.
All of that being said, somewhat calmer heads took the reins yesterday, noting that Yellen’s comments did not change the ultimate outcome. The end of this tightening cycle is at hand. Powell noted that this banking mini-crisis will serve as an equivalent to rate increases. A tightening of lending will impact growth, and therefore jobs, which will eventually hit spending power and bring disinflation. Together, it helps the Fed’s goal to approach 2% inflation. Getting the Fed out of this aggressive tightening cycle is the first step to recovering major losses already at hand.
Lower interest rates are back in vogue, allowing growth stock multiples to expand again. 2-year U.S. Treasury rates have collapsed from 5.1% to 3.6% in just two weeks. 10-year Treasury rates also dropped, from 4.3% to 3.4%. Mortgage rates will follow suit. While the earnings picture gets cloudier with an incoming recession, declining interest rates set up a higher valuation floor. Cash rich, high free-cash flow, and low debt-laden growth stocks continued their leadership roles yesterday as the Nasdaq, especially mega-cap and semiconductor stocks, approached their highs for the year. Taking a step back from the volatile daily action, one can see that the range for the past year is intact, but winners and losers are always changing.
It is still tough to see stocks breaking out of this tight range. Dot plots aside, talking tough today is about the only thing left for our central bank. Money supply is at multi-decade lows. An inverted yield curve and higher interest rates make new projects less attractive to lenders and borrowers. A mini-banking crisis adds fuel to the deflationary fire. It will not happen overnight, but I sense a recession is now a foregone conclusion either this year or next. Bond investors agree. While lower interest rates help stock multiples, they are also expecting a collapse for GDP. Earnings estimates have come down somewhat, but if a recession does occur, they need to go lower. After another week of wild swings in stocks and bonds, we are left with a similar scenario to where the week started. Patience, sticking to your discipline, booking profits at the upper end of trading cycles, and identifying favorable entry points are all encouraged. We will have a new bull market, but this process takes time.
March is quite the month for birthdays! Actors/Actresses Lara Flynn Boyle, Jim Parsons, Alyson Hannigan and Jessica Chastain, turn 53, 50, 49, and 46 respectively today. Peyton Manning is now 47. Designer Tommy Hilfiger is now 72. Former Microsoft CEO turned Los Angeles Clippers owner, Steve Ballmer, is now 67.
James Vogt, 610-260-2214