“Extraordinarily Sound”

Another humdrum week. The second largest bank failure in U.S. history – to start things off, making for three of the top four over just the past two months. Tuesday saw Treasury Secretary Yellen notify the world of a debt limit “X-date” possibly as early as June 1st. The Fed raised rates on Wednesday in the face of an unfolding banking crisis. The ECB does the same Thursday.

Friday brought yet another stronger-than-expected payrolls report, with the unemployment rate back down to the lowest level since 1969 (3.4%). As for the unruly stock market, the Regional Bank Index (KRX) dropped 2.6% Monday, sank 5.5% Tuesday, declined 0.9% Wednesday, slumped 3.5% Thursday, and then rallied 4.8% Friday. Two-year Treasury yields jumped 14 bps Monday, dropped 18 bps Tuesday, sank another 16 bps Wednesday, and finished the week with Friday’s 13 bps pop – with intraweek yields trading as high as 4.16% and as low as 3.65% (ended the week at 3.91%). The three-month/two-year Treasury yield spread inverted a further 25 bps this week to negative 132 bps (most inverted in four decades).

May 1 – Bloomberg (Jenny Surane, Hannah Levitt and Katanga Johnson): “JPMorgan… agreed to acquire First Republic Bank in a government-led deal for the failed lender, putting to rest one of the biggest troubled banks remaining after turmoil engulfed the industry in March… ‘This is getting near the end of it, and hopefully this helps stabilize everything,’ JPMorgan Chief Executive Officer Jamie Dimon said on a call with journalists Monday. Regional banks that reported first-quarter results in recent weeks ‘actually had some pretty good results,’ the CEO said. ‘The American banking system is extraordinarily sound.’”

Bank Credit default swap (CDS) prices jumped this week, with Bank of America CDS trading Thursday near the highest level (124bps) since March 2020 – ending the week up 14 to 117 bps. Bank CDS prices declined moderately Friday. Yet Wells Fargo CDS still jumped 13 for the week to 116 bps, trading Thursday to the high since March 2020. Morgan Stanley CDS jumped 14 bps this week, Goldman 10 bps, Citigroup eight bps, and JPMorgan six bps. High-yield CDS surged 26 bps this week, trading Thursday to a six-week high (516 bps).

It was an extraordinary backdrop heading into the FOMC meeting. There was a strong case for the Fed to hold off on another rate increase. The unfolding banking crisis ensures tighter Credit for an economy already downshifting. But the case for hiking rates was equally compelling. Inflation remains elevated, with recent data consistently pointing to sticky price pressures. Friday’s strong payroll data – including 253,000 jobs added and a 0.5% (4.4% y-o-y) gain in Average Hourly Earnings – confirm unrelenting labor market tightness.

Jay Powell’s much anticipated press conference was short on drama. It’s worth noting the fourth sentence from his prepared remarks: “We are committed to learning the right lessons from this episode and will work to prevent events like these from happening again.”

Hope springs eternal. The Fed is early in the learning process. Clearly, indefensible mistakes were made in bank regulation. Meanwhile, unpardonable inflation mismanagement is at risk of historic failure. As much as banking instability adds to downside economic risks, the Powell Fed today has little option other than to err on the side of ongoing measures to contain inflation. Powell has repeatedly underscored the risk of repeating past mistakes, where Fed inflation fights ended prematurely.

Bloomberg’s Mike McKee: “Markets have priced in rate cuts by the end of the year. Do you rule that out?

Chair Powell: “We on the Committee have a view that inflation is going to come down, not so quickly, but it’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates. If you have a different forecast – markets have been from time-to-time pricing in quite rapid reductions in inflation – we’d factor that in. But that’s not our forecast. And, of course, the history of the last two years has been very much that inflation moves down [gradually]. Particularly now, if you look at non-housing services, it really, really hasn’t moved much. And it’s quite stable. So, we think we’ll have to – demand will have to weaken a little bit and labor market conditions may have to soften a bit more to begin to see progress there. And, again, in that world, it wouldn’t be appropriate for us to cut rates.

End-of-week market pricing had the policy rate at 4.31% for the Fed’s December 13th meeting, 75 basis points below the current Fed funds rate (5.06%). With the expected December rate sinking 16 bps this week, the divergence between Fed and market expectations only widened.

Powell and the markets are speaking over each other. Markets to Powell: “Inflation? What about the banking crisis?” I’m skeptical the rates market is keying off expectations for declining inflation. In a replay of the pre-2008 dislocation backdrop, markets instead discount probabilities of crisis dynamics forcing the Fed into a dovish pivot. For example, an assumption of a 50% probability for a crisis eruption by December, which would force the Fed to slash rates 150 bps (1.5 percentage points), gets close to current market pricing.

The bond market over the past 15 years has been conditioned to discount the possibility of aggressive rate cuts and QE-related Treasury/MBS purchases. This has played an integral role in Bubble Dynamics. The crazier things get (i.e., manic markets and bank lending excess), the greater the probability of another bout of aggressive monetary stimulus.

There has basically been continual pricing of odds that faltering Bubbles provoke another aggressive monetary policy response – with market yields consistently lower than traditional fundamentals (i.e., debt supply/demand, inflation, growth) would dictate. Importantly, this dynamic negated the role of the bond market as the key system stabilizing mechanism.The bond market loosened on crazy, when it traditionally would have tightened.

Meanwhile, stocks (and other asset markets) feast on distorted low market yields. Why worry about the downside when you know you’ll have the bond market loosening at the first hint of trouble – with the mighty Fed and GSE backstops always there as needed. And while the banking predicament darkens prospects, it has meant big liquidity injections from the FHLB and Fed.

Mohamed El-Erian worded it succinctly in his pre-meeting commentary: The Fed “should resist validating market expectations of cuts in the next few months.” And while the bond market will dismiss the Fed’s professed inflation resolve, the last thing the Federal Reserve needs right now is for the stock market speculative Bubble to inflate further. Crash risk is rising.

The ECB is still criticized for its final 25 bps hike in September 2008 (to 4.25%) – as if it made much of a difference. I doubt history will be kind to the Fed for this week’s increase. For the record, it’s important to appreciate that markets have been forcing the Fed’s hand. Market conditions have loosened meaningfully over recent months. Not only does this work to counter the Fed’s inflation fight, it significantly intensifies systemic risk. We’re early in a momentous systemic adjustment to higher rates, tighter Credit, and restrained liquidity. Speculative and over-liquefied markets increasingly risk turning this process disorderly.

May 4 – Reuters (Andrea Shalal): “The American Bankers Association on Thursday urged federal regulators to investigate a spate of significant short sales of publicly traded banking equities that it said were ‘disconnected from the underlying financial realities.’ In a letter to U.S. Securities and Exchange Commission Chair Gary Gensler, the lobby group said it had also observed ‘extensive social media engagement’ about the health of various banks that was out of step with general industry conditions.”

I’ll never forget September 19th, 2008. “Given the importance of confidence in financial markets, the SEC’s action halts short selling in 799 financial institutions.” The KBW Bank Index surged 12.6% in frantic last day of the week trading. The Broker/Dealers (XBD) spiked 16.9%. Troubled insurer AIG rose 43%, and Washington Mutual jumped 42%. JPMorgan surged 16.7%, Citigroup 24.0%, and Bank of America 22.6%. Morgan Stanley rallied 21% and Goldman Sachs 20%. The S&P500 jumped 4.0% in chaotic trading.

While there was no short selling ban (yet), Friday was quite a squeeze day. Spectacular one-day gains included PacWest’s 81.7%, Western Alliance’s 49.2%, Zions’ 19.2%, Comerica’s 16.7%, and Keycorp’s 10.1%. The Nasdaq Bank Index and KBW Bank Index both jumped 4.6%.

It’s worth noting that after the big September 19th 2008 squeeze day, both the KBW Bank and Broker/Dealer indices collapsed 40% over the following 14 trading sessions. Short sellers did not hasten the 2008 crisis, and they’re not a key issue for the unfolding crisis.

Can aggressive shorting place major downward pressure on individual stocks? Of course. Does aggressive buying – including targeting large short positions – put major upward pressure on stocks? The key issue is that over-liquefied markets turned increasingly speculative over recent years, with today’s unstable financial environment a key consequence of years of Monetary Disorder. Arguably, the 2008 ban on financial stock shorting only exacerbated market instability. It definitely compounded the challenge of managing derivative portfolios and myriad hedging strategies.

There will be all kinds of measures suggested – and some implemented – in increasingly desperate attempts to hold Bubble collapse at bay. I am again reminded of the wise words from the late German economist, Dr. Kurt Richebacher, who stated that “the only cure for a Bubble is not to let it inflate.”

Many believe the “great financial crisis” could have been averted had the Fed saved Lehman Brothers. Ben Bernanke asserts that if only the Fed had printed money and recapitalized the banking system after the 1929 stock market crash, the Great Depression would have been prevented.

But the problem is always the preceding boom. Prolonged Credit expansions create systems that depend on enormous ongoing monetary expansion. Inflated asset market Bubbles become reliant on ever increasing amounts of speculative Credit. Economic structure becomes distorted by years of inflationary effects, including a proliferation of uneconomic enterprises and unsustainable boom-time, Credit-driven demand. This maladjusted structure becomes progressively vulnerable to waning Credit and spending growth.

The Fed could have printed four or five billion to recapitalize the banks in 1930 – but the number that mattered was multiple times this amount – the tens of billions of annual total system Credit growth necessary to hold collapse at bay. The Fed could have bailed out Lehman, but the number that mattered was the $2.5 TN or so yearly Credit expansion necessary to prolong the mortgage finance Bubble. The number that matters today is probably around $3.5 TN annually. And the inescapable problem is that to continue a massive late-cycle inflation of nonproductive Credit feeding a deeply maladjusted system risks a systemic crisis of confidence – crises of confidence in the markets, in policymaking, in debt structures, and the monetary system more generally.

There is no alternative. The system faces an extremely challenging adjustment period. Today’s banking crisis is only the initial phase. There are no easy answers or painless solutions. And I’m assuming a plethora of bad ideas (i.e., short selling bans, system-wide deposit guarantees, larger lending facilities, additional QE and who knows what) will only make for a more destabilizing day of reckoning.

Original Post 6 May 2023

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Categories: Doug Noland