Economist Milton Friedman once stated that monetary policy acts with such a long and variable lag that any attempt to use it actively may aggravate, rather than ameliorate, economic fluctuations. While Friedman's theory may be a bit simplistic, and require some nuance in today's world. The fact is that it would be incredibly foolish to believe that a decade of ZIRP/NIRP followed by the sharpest tightening cycle since the early '80s would result in a seamless soft landing transition.
In recent days, we have learned that a soft landing is less likely than ever before.
Let's assess some of the things that we can all probably agree are facts, and then I will offer some analysis/opinions:
- The Fed has hiked rates aggressively since early 2022 while embarking on QT (balance sheet reduction).
- This rate hiking cycle comes on the heels of ZIRP/NIRP pandemic policies and one of the fastest increases in M2 Money Supply in history
- Inflation exploded higher in 2021/2022, and has been steadily moderating for the last 6+ months. Albeit, not at the rate of moderation that the Fed would like to see.
- Suffice to say, too high inflation has been the market's #1 worry for the last year. Nobody has been worried about too low inflation or deflation.
- As recently as last Wednesday a majority of market participants were expecting a 50bps rate hike by the Fed at its next meeting on March 22nd.
- Even the biggest hawks have stated repeatedly that "the Fed is going to hike until something big breaks".
- On Friday, Silicon Valley Bank was taken into receivership by the FDIC. On Sunday, Signature Bank was taken into receivership by the New York Department of Financial Services.
- In total, these banks had $300 billion in total assets. This makes these bank failures roughly the same size as the largest single bank failure in US History, Washington Mutual.
- Something big has broken.
- Last Wednesday, markets were pricing in a probability of a 50bps hike by the Fed on March 22nd. This morning, markets are pricing in a probability of a PAUSE by the Fed at its next meeting on March 22nd (and the possibility of a 25bps rate cut).
A softer than expected CPI report on Tuesday morning could seal the deal for a pause by the Fed. After all, we are seeing the long and variable lags that Friedman was referring to so many years ago. It turns out that SIVB had taken on far too much duration risk in its "Hold To Maturity" (HTM) portfolio - this was done under a flawed assumption that deposits would continue to grow and depositors would not ask for their money back in any meaningful size.
To be clear, no bank can withstand an all-out run on the bank. While most banks are solvent, they are not prepared to pay out 90% of customer deposits in a 48 hour period. Bank runs create liquidity problems.
In fact, as an experiment, if you ever have too much time and money on your hands, stop into your local bank branch and ask to withdraw $100,000 in cash. See how difficult it is and how long it takes for the bank to meet your request (you can always just redeposit $99,000 of it after they have satisfied your withdrawal request).
The ferocity of the bank runs at SIVB, Signature, and First Republic forced the Fed to create a new Bank Term Funding Program (BTFP), offering loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. The Fed is valuing these assets at par, even though the market price is likely to be significantly lower than par (100 cents on the dollar). The BTFP saves banks from selling these underwater assets at a loss, and offers a critical source of liquidity during times of stress.
The $25 billion number is included in the press release, however, at this point we can assume that number will eventually become much larger. The Fed isn't going to start the BTFP and then back down, this will essentially be as large as it needs to be to support the banking system and re-instill confidence.
Something big has broken, and with the rapid spread of information in March 2023 literally everyone is aware of it. The lagging optimism of the last year is likely to give way to a greater focus on capital preservation, and increased risk aversion. To be clear, I disagree with commentators who say that the Fed now needs to start cutting rates. Remember, we are still dealing with inflation levels that are too high.
While I don't believe inflation is actually still a major problem, the Fed cannot begin lowering rates until the downtrend in CPI/PPI is more pronounced. Even then I expect the Fed to be behind the curve when it begins rate cuts (just like it was behind the curve when it began raising rates). To wit, when the rate cuts begin the economy will be solidly entrenched in recession.
The good news is that the market is always way ahead of the Fed, and this morning the Treasury market has slashed yields across the curve; the 2-year yield is down to 4.05% after peaking above 5.00% last week!
To be clear, this move in bond yields is an ominous sign for most risk assets like equities - we have had a deeply inverted yield-curve for much of the last year and now financial stocks are acting like a recession has arrived. All of this is occurring against a backdrop of a Fed that is still handcuffed by stubbornly high inflation. While I expect the inflation issue to resolve itself this year (recessions are inherently disinflationary), there are still nine months left in the year and that leaves a lot of room for stocks to tumble.
Where to hide?
Gold really stands out in this environment. Not only are we in an increasingly bifurcated world with the BRICS+ committed to de-dollarization, but we have reached a breaking point in Fed monetary policy tightening. The Fed can't tighten much more without the entire house of cards falling to pieces. The market knows this, and the market is always looking 6-9 months ahead.
Gold is the timeless store of value with no counterparty risk, and a track record of exhibiting low/no correlation during times of economic/systemic stress.
We are in the sweet spot for gold.
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