Daily Economics - Emergent Risk; What's Next for the Market?
Lede
This is a snippet of a CML Pro dossier that was sent to members earlier today.
Over the course of two weeks the United States has realized the reverberations of the the fastest Fed tightening cycle in the country’s history. Now we must discuss it.
Preface
On 3-15-2023 we wrote “We maintain our view from the update we sent that surrounded the Silicon Valley Bank failure, that this is a risk-off environment — which to us means that the upside potential could be smaller than the downside risk in the short-term” in the dossier Producer Inflation Stuns Lower; Retail Sales Fall, Yields Fall, Oil Falls, Another Bank Problem.
Just five-days prior to that we wrote, “We view the current time as extremely risky and are not immune from belief that this is a risk-off environment — a time where the risk part of the “risk-reward” analysis has risen high enough to offset the possible reward” in the dossier Payrolls Hot, But Wage Grows the Least in a Year; Credit Contagion Risk.
Today we reinforce that view, but with greater exposition — perfect for a Sunday read without the noise of the market.
The Story
During the weekend of March 12th, we learned that the Department of the Treasury, Federal Reserve, and FDIC collaborated to avert a contagion within the US banking system.
The entities guaranteed deposits at Silicon Valley Bank and Signature Bank of NY, ensuring they would be made whole without bailing out stockholders and bondholders: no taxpayer money was used.
Instead, a new short-term lending program called the “Bank Term Funding Program” (BTFP) will be employed.
The BTFP offers one-year loans to banks on more lenient terms and has a $25 billion allocation.
The underlying assets, primarily US treasuries and agencies, differ vastly from 2008’s toxic home loans.
A surge in bank borrowing from the Fed occurred, with approximately $12 billion from the BTFP, $140 billion for the two FDIC-backed banks, and an additional $150 billion to address liquidity risk.
Geographically, $233 billion originates from the San Francisco district and $55 billion from the New York district.
We agree with expert opinions (and disagree with FinTwit) that this activity is deflationary rather than inflationary and should not be considered quantitative easing (QE).
Banks are borrowing from the Fed to strengthen their balance sheets and prevent contagion, not to offer more loans, and will likely retain their cash.
QE involves the Fed purchasing bonds to raise their prices and lower long-term interest rates, exchanging bonds and other fixed-income assets for bank reserves. On the other hand, BTFP provides loans against collateral (bonds) for a specific duration.
While QE reduces collateral and duration, BTFP bolsters collateral.
This financial shock will alter money flows, directing funds toward safe collateral like treasuries and large banks.
In contrast, riskier entities like regional banks and consumer related loans could experience reduced money flows and lending.
Credit tightening is expected to occur rapidly, and although a quantitative framework for converting the new contagion risk into interest rate hikes is lacking, the suggested equivalence to a 150-basis point rate hike appears reasonable.
We see a shock to the system, exactly as we warned in the prior CML Pro webinars – a Hawkes process – and the tightening will be nearly immediate and long lasting.
On June 30th, we introduced the idea of a shock cluster, and we review it now, if only briefly, so we can move forward.
Interlude – Shock Clusters
This is, virtually, word for word what we wrote in June of 2022.
We acknowledge the doubt and criticism that ensued post publication, but we also acknowledge that we would have rather been wrong:
• We don’t usually think about it, but we should now…
…the characteristics of a random process matter and why one bad kind may be here.
• Jargon: A random process is formally called a “stochastic” process.
• A singularly stochastic process has just one underlying driver.
• These are the kind we are used to: coin flip, roll of dice.
Flip a coin once an hour for 100 days: we’ll call heads a success.
Every day you’ll get 24 results (one flip an hour) which on average will lead to 12 successes (heads).
Easy enough.
• It doesn’t matter what the last result was, the next one will always have a 50% chance of success.
• This is called path independence.
• The sum of these could formally be called a Poisson process. It’s singularly stochastic.
Easy breezy.
• But that’s not how all things in nature are best described (modeled).
• Take earthquakes, for example.
• On the one hand there is some underlying Poisson Process that drives it.
Let’s say there is a 1/100 chance an earthquake happens on any given day.
• But earthquakes cluster… 🤔 My prior research at Stanford dove into this phenomenon but it was first uncovered and beautifully examined by Japanese mathematicians as they find themselves on a wildly seismically active island.
Whatever the odds of an earthquake happening (say once every 100 days), those odds immediately rise following a prior earthquake.
• So, there must be a second stochastic process behind it, beyond the 1/100 days process.
• And if that’s true, then it’s not like a coin flip, because it’s path dependent.
• When an event itself occurring increases the odds that it happens again, we call it self-exciting.
• In this case, an earthquake increases the likelihood of another earthquake causing clusters.
This self-exciting doubly stochastic process is called a Hawkes process.
• But we’re not here to talk about earthquakes…
• When we got our health shock, COVID, we got a cluster of other shocks, each causing the next:
monetary shock, fiscal shock, asset shock (up), supply chain shock, food shock, inflation shock, asset shock (down)…
… we then got a geopolitical shock – Russia invading Ukraine.
• And now we are here and the greatest risk to the market and the world is not inflation, it’s a continuation of shocks.
That could be China invading Taiwan, but we don’t know.
• What we do know is that we don’t have any buffer or slack in the system to absorb anymore shocks.
• There is resiliency in this whole apparatus that connects us, but it can snap.
• And it’s the risk that this self-exciting doubly stochastic process excites yet another shock that is by far the largest risk to the market now.
• Inflation has peaked, normalcy is returning to the supply chain, COVID is controlled, all the right things but none of it will hold up under another shock.
• We need the shock cluster to end.
• The good news is that this doubly stochastic process, called a Hawkes process, does have an exponential decay characteristic.
• That means the elevated probability of an event occurring after one before it just occurred decays exponentially.
• So, what we really need, desperately need, is calm, because more calm time yields lower probabilities of more events.
• It was this shock cycle that strangled the U.S. in 1970s-80s (inflation, off gold standard, oil embargo, Iranian revolution, Vietnam, etc.).
• We need it to stop, and risk keeps rising that it won’t.
• So, what am I hoping for?… (This was back in June 2022.)
• Nothing else.
• If we get that, we’ll be fine.
• History tells us there is a risk we don’t get nothing else… but rather we get more.
• But history also tells us that eventually the self-exciting process chills out.
The importance of “when?” has rarely been as elevated.
• If the Fed continues to message hopelessness, the credit markets will oblige.
• We need calm, and calm does not come from a message of hopelessness.
• The Fed is getting dangerously close to handing itself its largest failure ever.
That was it from June 2022.
That sentence near the end rings true: “If the Fed continues to message hopelessness, the credit markets will oblige.”
We note today that Credit Suisse is nearing an emergency deal to be acquired by UBS as another bank shock strikes the western world.
OK, that’s the end of that interlude, and we turn back to the subject at hand.
End Interlude
So, what will the Fed do?
If the Fed does not raise rates next week, the market could get spooked; and it should. It could be a signal that there is a deeper systemic risk which the Fed is privy to with private data and communications.
If the Fed raises by 25 basis points (0.25%) but communicates a likely pause, that may soothe the market the most.
In either case, we believe the Fed’s march higher on rates is possibly over after this week.
The recent disruption in the banking system may not be the final shock, but regardless, we expect the recent shocks to have a significant disinflationary impact.
Just over a week ago, Chairman Powell was guiding the market to anticipate a 50-basis point (0.50%) increase.
However, it now appears that the Fed will likely follow the market’s pricing.
Assuming financial markets and the banking system stabilize in the coming week, a 25-basis point increase may be more likely.
The US economy is heavily reliant on credit, and given that banks are likely to prioritize strengthening their balance sheets over extending loans to the private sector, we have the makings of a possible recession.
Further, while commercial real estate (CRE) has been a topic of much discussion, we will only briefly mention it as another factor contributing to tightening and potential risk.
It is also essential to recognize that this is not a repeat of the 2008 crisis; a portion of what has happened recently is quite the opposite.
The largest money centers are now perceived as strongholds and flows of funds are moving to them.
The primary concern is duration risk for regional banks, which measures the extent to which bond prices may change in response to interest rate fluctuations.
Despite banks facing a mismatch in duration on their balance sheets, the underlying assets consist of government treasuries or agency debt, all backed by the full faith and credit of the United States.
This is a significant improvement compared to the toxic mortgage debt, credit default swaps (CDS), and other financial instruments that contributed to the Great Recession.
No one questions the trust worthiness of the debt, there is simply a question about how balance sheets have been marked-to-market.
But there is a reason that every recession in the last 50 years has followed a yield inversion (where short-term interest rates are higher than long-term interest rates): an unexpected incident or failure occurs; a shock.
Ultimately, the shock could be beneficial in the long-term: the futures market currently suggests a single rate hike followed by a decline.
So, in a very real sense, breaking the system a little could bring down the risk of breaking the system a lot, while also acting as a rather fast quantitative tightening shock.
As we have previously opined on prior CML Pro webinars, if the Fed was going to carry through on its rate hike trajectory it forecast last November, we saw a very high probability of a bad recession.
It appears that these realities are now acknowledged and rates may very well not get to the forecast of 5.1% – 5.4%.
That removes an underlying irritant to the shocks as long as inflation cools. If inflation does not cool, it’s a greater irritant and a worse outcome.
What Now?
We repeat our fundamental assessment of risk:
We maintain our view from the update we sent that surrounded the Silicon Valley Bank failure, that this is a risk-off environment — which to us means that the upside potential could be smaller than the downside risk in the short-term.
We see the possibility of a short-term rally on the Fed’s language and actions in the next FOMC meeting, but we do foresee a recession coming in the next couple of quarters and at least a stock market bobble.
Should that recession be met with surprising disinflation, the market could do slightly better than the economy and when it’s all said and done, we could look back and point to these series of shocks as the end to the inflationary regime and Fed tightening.
If inflation does not come down quickly, we could see a substantial sell-off in nearly all equity indices.
We will be adding a new Top Pick soon, in the energy sector, and will continue to look for opportunity in a possible swoon.
We will prioritize long-term growth over short-term gains, regardless of the economic cycle and continue to identify companies that continue to innovate, expand, and create value for shareholders.
Every stock has a story, and the best investors know how to read between the lines, unravel narratives, and identify the true value in the market.
Conclusion
An upside rally and the end to inflation may be on the horizon due to recent shocks, and a bullish biased but still reasonable analysis can reach that conclusion.
However, a reasonable analysis can also conclude that a recession is imminent, that earnings will drop, and the market will make new lows in the intermediate term.
That’s always the push and pull of the market – the reward and risk – but we see the latter as having higher likelihood than the former for the intermediate-term.
We will discuss these issues at greater length in the soon to be dated CML Pro webinar.
While we see higher risk than reward as a possibility in the intermediate-term, we feel quite bullish on the idea that these bank shocks will, in fact, bring inflation down much faster than the trajectory it was on prior.
We believe that the disinflationary pressure from the credit crunch and credit risk aversion that's about to come is going to coincide with huge base effects from oil (which was $120 last March) and rent (which makes up 43% of core CPI and will soon rollover) and we may see CPI with a 3-handle by August.
The inflation time bomb may have been set to disarm. That's our view. Now we wait.
But that's the optimistic view. The pessimistic view is… worse.
Every stock has a story, and the best investors know how to read between the lines, unravel narratives, and identify the true value in the market. We do the research. We watch the businesses. We interview CEOs and share word-for-word transcriptions.
You can learn more about CML Pro here:
Thanks for reading, friends.
Legal
The information contained on this site is provided for general informational purposes, as a convenience to the readers. The materials are not a substitute for obtaining professional advice from a qualified person, firm or corporation. Consult the appropriate professional advisor for more complete and current information. Capital Market Laboratories (“The Company”) does not engage in rendering any legal or professional services by placing these general informational materials on this website.
The Company specifically disclaims any liability, whether based in contract, tort, strict liability or otherwise, for any direct, indirect, incidental, consequential, or special damages arising out of or in any way connected with access to or use of the site, even if we have been advised of the possibility of such damages, including liability in connection with mistakes or omissions in, or delays in transmission of, information to or from the user, interruptions in telecommunications connections to the site or viruses.
The Company make no representations or warranties about the accuracy or completeness of the information contained on this website. Any links provided to other server sites are offered as a matter of convenience and in no way are meant to imply that The Company endorses, sponsors, promotes or is affiliated with the owners of or participants in those sites, or endorse any information contained on those sites, unless expressly stated.