The Fed needs to cut rates soon

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

Chart #2 shows that the percentage of service sector businesses that report paying higher prices has plunged to its lowest level in almost three years. This is powerful evidence that inflation pressures in the all-important service sector peaked long ago (in December '21) and continue to decline. The inflation problem that the Fed is determined to fix is definitely on the mend; lowering rates today wouldn't stop this. Not cutting rates would only increase the downside risks to the economy. The time to ease is before the economy shows obvious signs of weakness, not after.

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.

More thoughts on the banking crisis

By calling into question the value of a significant portion of the country's bank deposits, the recent failure of one or more regional banks is equivalent to a sudden tightening of monetary policy, in which the supply of money is perceived to have contracted while the demand for the remaining portion has increased.

Background: The "ideal" money can be defined as a highly liquid, universally-accepted medium of exchange that holds its value over time and can—but not necessarily—also pay a floating rate of interest, e.g., currency, checking and demand deposits, and retail money market funds. M2 incorporates all of these and is thus an excellent way to track the supply of money.

Therefore, we might say that the current banking crisis is being caused by the perception that some portion of M2 (e.g., bank deposits in regional banks) may lose—or may have already lost—value in the event of a bank failure or expected bank failures. That perception automatically triggers an increased demand for the rest of M2. Together, this has the same effect as a sudden tightening of monetary policy; the supply of money has decreased at the same time the demand for money has increased.

If the Fed does not offset this effective tightening by reducing interest rates, things could get ugly. Reducing interest rates does two things: 1) it makes holding money less attractive on the margin, and 2) it makes borrowing money more attractive on the margin. This serves to reduce the demand for money while at the same time increasing the supply of money (because an increase in loans expands the supply of money). Together they amount to a relaxing of monetary policy, and that is the appropriate response to a sudden and unexpected tightening of monetary policy.

The Federal Open Market Committee (FOMC) meets on Wednesday, March 22, at which time they are expected to make what is now an extremely important decision: will they raise rates, hold rates steady, or cut rates? The market seems to expect they will most likely hold rates steady. I would argue they should cut rates, as my argument above suggests, and I hope they do.

Some helpful charts for background follow:

Chart #1

Chart #1 shows the inflation-adjusted value of the dollar relative to a trade-weighted measure of other currencies. By any measure the dollar is strong, and significantly stronger than it has been for most of the past half-century. Judging by this evidence, the dollar is still the world's premier currency. We could also infer that there is no excess supply of dollars relative to the world's demand for dollars. This further suggests that a sudden tightening of US monetary policy (as described above) could boost the dollar's value further, thus negatively impacting nearly every other currency on the planet. A strong currency is very important, as is a stable currency. A strong and appreciating currency is not necessarily a good thing.

Chart #2

Chart #2 compares the value of the dollar (using a popular but less robust measure of the dollar's value than that used in Chart #2) to the inflation-adjusted price of gold. (Note: I have inverted the dollar, so a falling blue line represents a stronger dollar.) If the dollar and gold were competing "safe ports in a monetary storm" then a stronger dollar might coincide with a lower gold price, and vice versa. That has been the case of many years, as the chart suggests. In recent years, however, the dollar has appreciated alongside a rising gold price. Is the dollar "too strong," or is gold "too strong?" I don't have a good answer to that, unfortunately.

Chart #3

Chart #3 shows the level of the Fed's balance sheet. Last week, the Fed's balance sheet jumped by about $300 billion, the result of the Fed extending credit to troubled banks in exchange for those banks posting notes and bonds as collateral for an emergency loan. Did the supply of money also increase? We won't know the answer to that question until the release of March M2 statistics on April 25th. I would also note that there has been no appreciable shrinkage in the Fed's balance sheet despite their professed intention to do so.

Chart #4

Chart #4 shows the level of bank reserves held on deposit with the Fed by the nation's banks. For decades prior to 2008, bank reserves were only a tiny fraction of what they are today. That's because bank reserves paid no interest prior to 2008, and banks were required to hold reserves in order to collateralize their deposits. Thus, banks held only the absolute minimum amount of reserves they were required to hold. After 2008, the Fed began paying interest on reserves, and so banks came to view reserves as a valuable asset: highest quality, risk-free, default-free, and paying a floating rate of interest. In short, reserves came to be viewed as functionally equivalent to T-bills, and banks were happy to load up on their holdings of reserves. 

By any measure, and from an historical perspective, there is an abundance of bank reserves today. The Fed is not significantly restricting the supply of this very important asset like they did prior to 2008, when the Fed intentionally restricted the supply of reserves in order to boost market interest rates (banks that wanted to expand their lending were forced to borrow reserves from other banks, and that boosted short-term interest rates). That is one good reason to think that the banking system and financial markets today are more resilient than in prior Fed tightenings.

Chart #5

Chart #5 shows the level of 2-yr swap spreads. (See my swap spread primer here.) This is an all-important measure of liquidity in the banking system (the lower the spread the greater the liquidity) as well as the financial health of the economy (the lower the better). Note that in the wake of the SVB crisis, swap spreads have fallen. This dovetails with Chart #5 in the sense that both suggest that there is abundant liquidity in the banking system, and that's a very good thing.

Chart #6

Chart #6 shows the level of Credit Default Swap spreads, which is a very liquid and generic indicator of the market's perception of the health of corporate profits, and by inference the health of the economy. These spreads have risen somewhat in the wake of the SVB crisis, but not significantly, and that's a good thing, since it means the economy is not likely on the cusp of recession.

Chart #7

Chart #7 shows the level of nominal and real 5-yr Treasury yields and the difference between the two, which is the market's expectation for what CPI inflation will average over the next 5 years. By this measure, the market is saying there is almost no problem with the outlook for inflation. Whatever the Fed has done to date has been sufficient to tame the inflation beast that awakened (unexpectedly, for those who have not followed this blog) over a year ago. 

Chart #8

Chart #8 shows the year over year and 6-mo. annualized rate of change in the Producer Price Final Demand index (i.e., inflation at the wholesale level). Both measures have dropped significantly from their peaks of last year. This is a good approximation of what we likely will see happening with the CPI over the course of this year. 

Swap and credit spreads say no recession

Today the market was rattled by news that Silicon Valley Bank (SIVB) was forced to sell most of its bond portfolio at a nearly $2 billion loss and will now have to raise additional capital to remain solvent. The question on everyone's mind: is this the first inning in a replay of 2008's financial crisis? Aggressive Fed tightening over the past year or so has devastated the value of bond portfolios because interest rates have risen by more and faster than during any prior bond bear market. To make matters worse, Chairman Powell two days ago declared that the Fed may well have to raise rates by even more than they expected, in large part because the economy is proving stronger than expected.

So what is it? Will the SIVB collapse mark the beginning of another financial crisis which in turn triggers the long-awaited recession? Or is the economy so healthy that the Fed will need to raise rates even more? Inquiring minds would like to know how these two fears can coexist.

I don't pretend to know the answer, but I do know that—outside of the now-famous inverted yield curve—it's difficult to find any signs that a recession is around the corner. A big disappointment in tomorrow's jobs number might persuade me to become less complacent, however.

I also know that, thanks to the decline in M2 and today's much higher interest rates, inflation pressures peaked some months ago and inflation is quite likely to decline over the course of this year as it returns to the Fed's 2% target. Following are some charts that round out the story:

Chart #1

Chart #1 shows the level of 2-yr swap spreads in the U.S. and Europe. These spreads have an uncanny ability to predict the onset and end of recessions (higher spreads predict bad news for the economy, and lower spreads predict better news). Eurozone swap spreads are still elevated, but they have come down significantly in recent months—thank goodness. U.S. swap spreads are only modestly elevated (a "normal" range would be roughly 15 to 35 bps) and they too have been declining of late. No signs of a recession here.

Chart #2

Chart #2 shows the level of corporate credit spreads. Like swap spreads, these too tend to predict the beginning and end of recessions. Current levels reflect substantially "normal" conditions. The bond market is signaling that the outlook for the economy is generally healthy, and liquidity conditions are good. No signs of a recession here.

Chart #3

Chart #3 is another way of looking at the spreads in Chart #2: the line represents the difference between high-yield and investment-grade spreads, otherwise known as the "junk spread." Here it becomes perhaps clearer that conditions today are pretty normal.

Chart #4

Chart #5

Charts #4 and #5 focus on Credit Default Swap Spreads, which are highly liquid and quite representative of generic credit risk. Here too its difficult to see signs of distress. 

Chart #6

Chart #6 shows the level of 30-yr fixed mortgage rates. Never before have they risen so much in so short a time. This has caused profound distress in the nation's real estate market. Real estate is the one area of the economy that is really suffering, but as the previous charts suggest, this suffering has not been contagious to the broader economy. One positive thing to note is that there is not a large overhang of new construction or a significant inventory of homes for sale (like we had in 2005-2006). The solution to the current real estate problem is not a collapse but a repricing: housing prices went up too far given the simultaneous surge in financing costs. The solution is simple, but it may take awhile to play out: prices need to fall and interest rates need to decline.

There is one good thing to note here: higher interest rates are having a big impact on asset markets, which in turn implies that Fed tightening is working. The Fed doesn't need to do much more, if anything.

Chart #7

Changing the subject, Chart #7 shows a very important macro statistic that is generally ignored by the financial press. Households' real net worth fell by about 9% last year, but it is not out of line with historical experience. As the green line suggests, this measure of our nation's well being has improved by about 3.6% per year for many decades, and the current level of real net worth is right in line with the long-term trend: $148 trillion.

Chart #8

Chart #8 is remarkable in that the jobs market is apparently more healthy today than it has been in a long time. Job openings are near record highs, and they exceed the number of people looking for work by a record margin. Some employers are shedding workers (e.g., the tech sector), but most others are having difficulty finding people willing and able to work. This is not the sort of situation that precedes recessions.