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Since the failure of Silicon Valley Bank almost a month ago, interest rates have fallen dramatically. 2-yr Treasury yields are down 130 bps, 5-yr Treasury yields are down 100 bps, and 10-yr Treasury yields are down 70 bps. This amounts to a pronounced steepening of the yield curve, and that in turn is the market's way of telling the Fed that they are going to have to cut short rates soon, and by a lot. In effect, the bond market has priced in a strong likelihood of significant monetary ease. The only question seems to be the timing: will it come at the May 3rd FOMC meeting, or will it be at the June 14th meeting? I wouldn't be at all surprised if it happened before May 3rd. If I were Fed Chair, I would announce a cut in the funds rate of at least 50 bps way before May 3rd.
While it's very encouraging to note that swap and credit spreads are largely unchanged in the wake of the SVB failure (i.e., there are still no signs of an imminent recession, and liquidity in general remains abundant), there has been some significant capital flight out of smaller banks and into larger banks, and out of deposits and into money market funds and government securities. Since the end of February through March 22nd, commercial bank deposits have plunged by about $400 billion, according to the Fed. At this rate, it's reasonable to think that by now, deposits have plunged by at least another $200-300 billion, or almost $1 trillion since the end of last year. Depositors are voting with their feet, and they are almost running for the exits. Bank stocks have been hit hard, especially the regional banks. There's a strong whiff of crisis in the air.
As Chart #1 shows, the last time the bond market experienced something similar was in late 2007, just before the Great Recession. That's an uncomfortable parallel to say the least.
Chart #1
The top part of Chart #1 shows the Fed funds target rate (white line) and 2-yr Treasury yields (orange line), and the bottom portion shows the difference between the two. Leading up to the end of 2007, short-term interest rates had been rising as the Fed tightened, but then they began to fall precipitously. Notably, the Fed was very slow to follow suit, though eventually they did. By the end of 2008 the funds rate had fallen from 5.25% to 0.25% and financial panic had spread throughout the world. More recently, over the past year the Fed has been very slow to raise rates, always following the market instead of leading the market, since for way too long they thought that the big rise in inflation was just "transitory." Looking ahead, they will likely have to catch up to the reality of declining inflation and a slowing economy by lowering rates.
Unfortunately, the Fed is notorious for being behind the curve as rates rise, and behind the curve when rates fall. This serves to fuel inflation as it rises, and to crush the economy as rates fall. Today we apparently are watching another re-run of the same, unless the Fed soon wakes up.
For months I have been pointing to clear signs that monetary policy has become tight enough to make a difference in people's behavior. Higher rates increase the appeal of holding cash and bank deposits, and they discourage people from borrowing to buy, say, homes. The housing market has been hit hard: since early last year, applications for new mortgages have plunged by 50%, refinancing activity is down by more than 90%, and the supply of new homes for sale has more than doubled. Nationwide, home prices have fallen since hitting a peak about a year ago. Existing home sales are down 30%.
The nascent banking crisis only serves to tighten monetary conditions, thus adding to already-existing downward pressure on inflation. Whenever a crisis starts, the public's demand for money (and safety) spikes. If that is not offset by a relaxation of monetary policy (i.e., lower interest rates), then deflationary pressures are the result.
Chart #2
Quick update on mortgage rates:
Chart #3
Chart #3 shows the relationship between 30-yr fixed mortgage rates and the yield on 10-yr Treasuries. In normal circumstances, 30-yr fixed mortgage rates tend to be about a point and a half (150 bps) above the yield on 10-yr Treasuries. (Think of 10-yr Treasuries as the North Star of the world bond market: the standard against which all other interest rates trade.) If the current spread were 150 bps instead of today's 344 bps, 30-yr fixed mortgage rates would be 4.8% instead of today's 6.7%. Mortgage rates today are hugely inflated relative to where they should be, and that has a powerful and negative impact on the housing market. They will trade lower only as the market loses its fear of inflation and its fear of an unexpected tightening of monetary policy.
28 comments:
Thank you.
I think it's doubtful they would cut early unless there are clear signs of recession going on. The Fed is reactive, they do not act based on predictions. So, they will cut late after the recession has started because they were tight for too long, and then they will cut too much, maybe even with more liquidity. Which will of course reinflate, and then...
Roy, I would argue that your comment is representative of the thinking that pervades the market. Nearly everything and every analysis I see assumes that a recession is almost inevitable, and that the Fed will again make the mistake of waiting too long to lower rates.
I'm a contrarian by nature, so I look for the things that I believe could occur and could shake the market consensus.
What could be more contrarian than believing the Fed will cut early and the economy will avoid a recession?
One thing I failed to mention in this post is that a significant Fed cut/easing would have an immediate positive impact on the balance sheets of nearly every bank in the country, and that in turn would remove a major destabilizing force the economy is struggling to resist.
Another thing is that the Biden administration seems bent on hobbling the economy (e.g., shutting down drilling and pipeline projects, raising taxes on corporations and high net worth individuals, layering on more regulatory burdens, massively subsidizing the very inefficient green energy industry) and this will mean that future economic growth will be decidedly sub-par (1-2% per year) for the foreseeable future.
You say "Whenever a crisis starts, the public's demand for money (and safety) spikes. If that is not offset by a relaxation of monetary policy (i.e., lower interest rates), then deflationary pressures are the result."
You also say they should start cutting, asap. But isn't deflationary pressure what they want? So by delaying, i.e., not be met by lower interest rates, deflationary pressures will result (bringing down the inflation they are so worried about). Perhaps this is why they won't act the way you'd like them to?
"Unfortunately, the Fed is notorious for being behind the curve as rates rise, and behind the curve when rates fall. This serves to fuel inflation as it rises, and to crush the economy as rates fall. Today we apparently are watching another re-run of the same, unless the Fed soon wakes up."
The Fed SHOULD cut but virtually no one expects them too and we all know they'll be late. Bond market is absolutely screaming for a cut and moreover and very importantly banks would love to see it too. Even though long rates are coming in which is mollifying for small banks, their stocks keep getting crushed. Either there is fantastic value in IAT or we're in serious muck.
Great post Scott. Please use your influence and reach to get the Fed to cut. They should have cut rates by 50 bp on the Monday morning after the SVB seizure. Rates would still be at 4%+.
The Fed is going to look foolish if it raises rates only to be forced to cut them a month or two later. The Fed is damaging its own reputation and legitimacy.
Beyond the immediacy of the banking crisis and a bond market that is screaming for the Fed to cut, it needs to be emphasized that for much of the past three years, economic production has been significantly limited and hampered due to the pandemic and economic shutdowns. This is a big part of the inflation problem. Now the Fed is trying to engineer a soft recession, raise unemployment, and create more economic challenges by raising interest rate levels to unreasonably high levels, creating a lot more uncertainty/risk for businesses and capital allocators that are trying to plan for the future.
The Fed's policies are now directly harming the economy's ability to do the very thing that it desires--lower inflation by increasing production/supply of goods and labor, housing being one of the most important. It will take a while for housing production to start up again as it has a long lead time, so the Fed's actions will have a lingering negative effect here.
The yield curve between the Fed Funds rate and the 10-year is now 160bp inverted. For the Fed to still be considering an increase in rates is foolish, counterproductive, and dangerous.
https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/guide-to-the-markets/mi-guide-to-the-markets-us.pdf
The quarterly JPMorgan guide is really fantastic. Lots of context, data, and history all provided in chart form without any editorializing.
Slides 20 and 21 have good charts on the housing market. It becomes so obvious that housing has been underproduced since the 2008 financial crisis when you look at vacancies, inventory and housing starts. Housing starts had finally gotten to reasonable levels 1-2 years ago, but now the Fed has turned that off like a light switch.
The most significant part of the sustained inflation in the shelter/housing category. The country needs more housing supply, not less.
Scott, your writings are really solid, as I have followed you for years; great analytics. However, your comment about 'no signs of a recession' are confusing to me: see the following empirical evidence:
1) LEI has fallen eleven consecutive months
2) Atlanta GDP NOW now barely shows Q1 growth
3) Fed Reserve Bank of Cleveland Inflation Nowcasting shows increasing rate of positive monthly change from March to April in Core CPI and Core PCE
4) Earnings momentum remains negative, and earnings downgrades continue to outpace upgrades
5) Wage growth shows no evidential signs of slowing down meaningfully
Am I missing something?
Scott, for the record, almost every time I think you're wrong you turn out to be right. Having said that, unless tomorrow's NFP crashes to something like 100k or there is serious bank contagion I highly doubt they will cut. At most they will pause in May. If everyone is so bearish and expects this recession, how come S&P, Nasdaq, and Bitcoin are where they are? (liquidity pumping helped, no doubt). Fed looks at these headlines and just carries on. They are backward-looking.
Re my "no recession baked in the cake---yet" call: Employment-related data out today (weekly claims, continuing claims, and the Challenger layoffs) do show some emerging signs of weakness in what could prove to be the early signs of a developing recession. However, swap and credit spreads are still relatively low and flattish, and that is a powerful signal (to me) that the economic fundamentals are not deteriorating. Spreads have always moved higher in advance of a recession; they are the best leading indicator of economic activity that I know of and have followed over the decades.
I'll repeat again the one factor that is very different now that I think the market is missing: the Fed's operating procedure has changed dramatically. In prior tightening periods the Fed actively restricted the supply of bank reserves, and this caused liquidity to dry up and that accentuated other problems. This time the supply of bank reserves remains abundant and liquidity is plentiful, which means that markets are free to do what they do best: adjust to changing conditions, distribute risk from those who don't want it to those who do, and to generally act as a shock absorber to the overall economy.
Shane, re deflation/disinflation: Deflation is when prices fall and inflation turns negative. Disinflation is when prices rise at a slower rate and inflation declines. For the past year we've had disinflation, with inflation falling from a high of almost 10% to now 4-5%. I think disinflation is ongoing, so the Fed really doesn't need to do more. Doing more would raise the risk of deflation, an extreme version of disinflation and a fairly disruptive phenomenon.
We may end up with the best of both worlds. The next FED meeting isn't until May. Lots of data will come in between now and then. The FED has made clear (to me at least)that they are in "lets wait and see what happens" to the economy, and data coming is is getting softer and revised lower. I suspect we have seen the peak for this cycle; and Wall Street's job is to judge the impact on near future (next two quarters) profits and guidance.
Thanks Scott for your continuing work. I refer to your charts often and appreciate you publishing them.
https://www.ftportfolios.com/retail/blogs/economics/index.aspx
Interesting article by Wesbury. The “Abundant Reserve” System Crushes the Fed
(Leading) Indicators of Economic Weakness:
1. I use a couple of signals for bond investing, and both turned bullish several days ago (~70% accuracy rate). The signals are not highly correlated so when they turn bullish at the same time it indicates/predicts falling rates for "everything"- a leading indicator of economic weakness.
2. Bankruptcies ticking up (this seems very ugly for the main street economy, which a lot of elected politicians seem to care less about these days- at the peril of the whole country...)
https://www.abi.org/newsroom/bankruptcy-statistics
3. There are ~6 variables the NBER uses to monitor recessions, and from what I recall, three of them are employment-related; which are lagging indicators. So, by the time a recession is apparent, leading indicators have been flashing red for months to years.
Let's hope the monetary authorities get this right before the economy gets really bad.
Thanks for the post.
Ai,
The Wesbury piece is fascinating and reinforces the point about the Fed's credibility. The Fed already has a lot of haters and conspiracy theorists who want to see it abolished. What happens if the popular press and skeptical or partisan members of congress start to pick up on the notion that the Fed has "$1.1 trillion in unrealized losses on its portfolio" and is now borrowing money from the Treasury/taxpayers to fund its operations.
The Fed's foolishness on excessively high interest rates is causing harm to the real economy and to its own legitimacy.
Re Wesbury's piece: I hope everyone realizes that the Fed's operating losses (i.e., it pays out more in interest on reserves than it earns on the bonds it bought with those reserves) could be eliminated almost overnight if they cut rates meaningfully. All it takes to zero out those losses is a flat yield curve. A normal yield curve (upward sloping) would put the Fed back in the black,
I think I see a trend:
https://fred.stlouisfed.org/graph/fredgraph.png?g=12g7b
Unemployment is getting worse.
Dear Scott,
I’ve been sharing your blog for months with those who would understand the correctness of your analysis. This morning in the Bespoke Report there is this that nails your analysis:
https://bespokepremium.us11.list-manage.com/track/click?u=d9df05124e64a31cb695b0f70&id=a418124ca2&e=34d25d92c8
See the sharp drop in bank credit:
https://fred.stlouisfed.org/series/TOTBKCR
Contrary to Friedman, required reserves were never a tax, let alone excess reserve balances. and Volcker called all reserves a tax.
Banks aren’t intermediaries. Therefore, there is no tax based on reserve balances. Prior to when Bankrupt-u-Bernanke introduced the payment of interest on interbank demand deposits, the banks remained fully “lent up” between 1942 and 2008.
Bank reserves are “Manna from Heaven”, they are costless and are showered on the payment’s system. Between 1942 and Oct 1, 2008, the DFIs minimized their non-earning assets, their excess reserve balances.
They held no excessive amount of excess legal lending capacity to finance business, consumers, or the Federal Government. They utilized their excess reserves to immediately acquire a piece of the national debt, or other short-term creditor-ship obligations that were eligible for bank investment, whenever there was a paucity of credit worthy borrowers, pending a longer-term, and presumably more profitable disposition of their legal and economic lending capacity.
A brief “run down” will indicate just how costless, indeed how profitable – to the participants, was the creation of new money. If the Fed put through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits (clearing balances).
The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers protested that they didn’t earn any interest on their balances in the Federal Reserve Banks.
Given bankable opportunities (and the Federal Government is the largest creditworthy borrower providing zero risk-weighted assets), on the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit and money. And, through this money, they acquired a concomitant volume of additional earnings assets.
How much was this multiple expansion of money, credit, and bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about $206:1 (c. 2006), dollars in earning assets through credit creation.
https://www.realclearmarkets.com/articles/2023/04/08/ron_desantis_missed_a_golden_opportunity_to_critique_the_fed_for_the_right_reasons_892641.html
Intelligent commentary from John Tamny of RealClearMarkets. Notably, he mentions that Ron DeSantis has harsh things to say about the Fed. The Fed's foolishness is attracting attention and increasing political risk to its own credibility and operations. Things that once seemed unthinkable become more possible....
Well, I have given up having opinions on most topics, but I think Scott Grannis is right on this one.
The Fed needs a pause and then ponder lower rates.
Re OPEC cuts and inflation. Rising oil prices are not necessarily inflationary. If the Fed is pursuing a low-inflation policy correctly, higher oil prices will force other prices to decline, leaving inflation unchanged. If consumers have to pay more for oil, they will have to spend less on other things. So OPEC is not complicating the Fed's job. Higher oil prices and an inflation-neutral Fed can complicate the economy's ability to grow, however. Energy is essential for economic growth, so if energy becomes more expensive relative to other things, economic growth will decline.
I think I finally disagree with Scott Grannis on something.
I am not sure "higher oil prices will force other prices to decline."
If other non-oil prices are being set competitively, they are already about as low as they can go, where marginal costs equals marginal revenue. For example, margins at supermarkets are razor-thin.
Also, higher oil prices will feed into other costs.
Higher oil prices could also result in less transactions, that is less velocity.
Oil consumes more of outlays, and the rest of the economy shrinks, but prices do not decline.
George Selgin has addressed this topic.
But as I say, I have stopped having opinions on most topics.
I will say the XFL offers a second-rate product.
BTW, The Bank of Korea paused on rates today, as did the Reserve Bank of Australia recently. Maybe the Fed can take a cue.
The raise/not raise question will be resolved at the next meeting in early May. The market is saying one more 25 bps hike but likely accompanied by rhetoric that basically announces a pause.
But then it would seem that the spotlight will shift to our fiscal policy... and I don't see that as being a positive. W and Obama were grossly incompetent, imo, and the Trump years were otherworldly (but more than decent in terms of economic policy). But for pure ridiculousness I have never seen anything like this administration. Short of another easy money sugar high - which would likely bring its own set of problems - it's hard for me to be too positive.
I see a grinding, blender of a market for as far as the eye can see. It may surprise some to know that the Value Line index is flat over the last 2.5 years.
Grechster:
Ditto.
But at least now we can watch XFL games. I think there is a connection between the Biden years and XFL play quality, but I cannot prove that.
The distributed lag effect, the 2-year rate-of-change in money flows, the volume and velocity of our means-of-payment money, the proxy for inflation, has been sharply decelerating for some time. The U.S. should be down to normal inflation rates by the 4th quarter of this year.
As long-term money flows decelerate, short-term money flows decelerate faster. That's what produces a recession. It's just math.
The only interest rate inversion that didn't produce a recession was back in 1966. Then, the 1966 Interest Rate Adjustment Act lowered commercial bank deposit rates. This activated monetary savings, increasing velocity while decreasing money growth.
Whereas time deposits were 105 percent of demand deposits in July, by the end of the year, the proportion had fallen to 98 percent. These were all desirable developments.”M1 peaked @137.2 on 1/1/1966 and didn’t exceed that # until 9/1/1967. Deposit rates of banks, Reg. Q ceilings, decreased from a high range of 5 1/2 to a low range of 4 % (albeit not enough). A .75% interest rate differential was given to the nonbanks. And during this period, the unemployment rate and inflation rates fell. And real interest rates rose.
Waller, Williams, and Logan seem to agree. They “believe the Fed can keep unloading bonds even when officials cut interest rates at some future date.”
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