Category: Monetary Policy (Page 1 of 3)

This is Not That

One of the (very few) benefits of being in the business of capital markets and investing across more than three decades is the ability to quickly recognize the similarity of an event to something in the past. Or, in the case of this past week, the lack of similarity. The rapid unraveling of Silicon Valley Bank and the apparent encore of Signature Bank has people talking of 2008 and the Financial Crisis. It is actually hard for us to believe it has been around 15 years since the Crisis. It seems much more recently that we were standing with our colleagues watching Bloomberg screens of credit default swaps wondering who would fall next and what the likelihood was it would be our own employer. The whole system was unraveling. This is not that.

Superficially, there is enough in common to suggest history may not be repeating itself but at least it is rhyming. High-flying bank gets too far over its skis, customers and markets lose confidence, run on the bank, regulators step in and shut it down and look for a buyer. Looking another layer deep there is still some commonality – the bank failed at its most basic function, providing safekeeping of and access to customer money.

So, reasonably, people are concerned about contagion and a more widespread run on banks. But, unless some startling levels of as-yet unknown malfeasance or malpractice emerge to change the narrative, there is an important difference between what took down SVB and what took down Lehman Brothers, Bear Stearns, WaMu and others. In the depths of the Financial Crisis, the main problem was that nobody knew what bank balance sheets were actually worth. Complex securitized loan pools were valued based on assumptions and risk models that proved to be fragile or entirely wrong all at once. It wasn’t possible to look at these holdings and get even the slightest idea of what they were worth, which meant there was no way to understand how much capital the banks actually held against their depository and other obligations. The banks’ use of leverage also multiplied these unknowns making the consequences even more far reaching.

SVB on the other hand appears to be a good old fashioned case of staggering incompetence. Don’t get us wrong – that is no excuse. But in this case, it does not appear that the balance sheet of SVB cannot be valued. It is simply that they entirely blew the most basic and central internal role they needed to perform, which was to properly match assets and liabilities. They ended up with too many long-dated assets and short-dated liabilities and simply did not have the liquidity to satisfy customer demands that then blossomed into a run on the bank. By all accounts everybody knows what is on the balance sheet and what it is worth – and the answer is… not enough in the current market environment. Not zero, but not enough.

It also doesn’t appear that there is a quality issue like what plagued banks in 2008 where the securities on the books turned out to be far junkier than their ratings would suggest. They simply held too much high quality but long-dated Treasury and other obligations that got hit hard with the spike up in rates this past year. After the Crisis, the rules did change on what types of holdings counted and to what degree when assessing an institution’s capital adequacy. Treasuries are right at the top of the chart of holdings that satisfy those ratios. The bonds are still there, and there is no reason to think they wouldn’t pay out 100 cents on the dollar if held to maturity. But, SVB couldn’t sell them today to satisfy withdrawals for what they will be worth a decade from now. Again, basic asset-liability management seems to have eluded them.

Bank management may have assumed since cash was coming in hard and fast over the last couple years that liquidity was never going to be an issue, so they could step further out on duration to squeeze extra basis points of yield out of the balance sheet. A little stress testing would have shown that a meaningful rise in rates would hit the value of those long bonds, which meant everything rested on either the cash continuing to come in or at the very minimum their customers not looking for withdrawals in size. SVB, because of their business strategy, is unusually concentrated in its client exposure to the Tech and tech-adjacent sectors. It wasn’t a mystery that the whole Tech space was undergoing market stress, investors were tightening purse strings, and companies and their funders would be looking to tap their cash reserves to keep things going. They got caught in a simple squeeze – their principal clients needed to access liquidity at a time the bank couldn’t satisfy it without taking a hit on those assets.

As of late this weekend the regulators have stepped in and assured liquidity for all depositors, insured and uninsured. They do have a facility paid into by the banks that was set up precisely for this kind of situation. SVB (and Signature) is essentially defunct, and likely will be bought whole or in parts by one or more big, solvent institutions at a very attractive price and without having to assume the kind of risks banks faced buying the failed banks in 2008. In a bank run psychology does become reality, and even though the problems are not systemic in the way they were in the Financial Crisis, it is right and reasonable to be concerned about contagion. Customers could manufacture a crisis where one didn’t exist just out of fear. Regulators are doing the politically unpalatable and interceding in a way that will benefit a lot of unsympathetic parties in order to keep a very specific problem with a very specific group of institutions from blossoming into something much more damaging.

Dodd-Frank has never been popular, seen as too odious and heavy-handed and in the way of free enterprise in the view of industry stakeholders, and with the benefit of more than a decade in use it could definitely be improved. However, this past week serves as a graphic example of why it is necessary, and why regulation and supervision are essential to the orderly functioning of our financial systems. In the all-too-apropos words of the comedian Ron White, there’s no cure for stupid.

WCM Chart for July 22, 2022

The growth in the US money supply is decelerating rapidly, which is problematic for the economy and capital markets. To be absolutely clear, the money supply itself is not shrinking – the rate of growth is. It is no secret that the US Federal Reserve is reining in liquidity by raising policy rates and decreasing the size of its $8.9 trillion balance sheet. Pre-pandemic, the Fed’s balance sheet was $4.2 trillion, less than half the current level. The reason why this is important is the Fed has largely been responsible for the explosive growth in the money supply over the past two years, which peaked at an annual pace of 26.9% in February 2021. To place that in context, the 30-year average annual growth rate of M2 is 6.4% while the current pace as of May 31st is 6.5%. But, examine the included chart. Barring the extraordinary, the current trace will crash right through the long term trend and keep going.

The 30-year average nominal US GDP growth is 4.6% according to the US Bureau of Economic Analysis. Over the long-term, M2 grows faster than nominal GDP in order to bolster economic activity, and when it slows, so does the economy. The level of M2 peaked at the end of March at $21,809 trillion, and has only grown 1.26% year-to-date. Given the receding liquidity in the US economy, it is no wonder why Q1 2022 was an anemic -1.6% (and revised down). What is critically important to us is that the Fed has been the most dominant force in money supply growth in this cycle. In more normal times, banks create money from their deposit bases, but this has been overwhelmed by the Fed’s quantitative easing programs. And so, navigating the path back to normal involves the Fed stepping back to its more traditional role.

It is difficult to envision a scenario wherein the Fed engineers a “soft landing” while simultaneously reining in 40-year high levels of inflation and supporting economy and employment. GDP growth for the first half of 2022 will be reported on July 31st and we would not be surprised if another weak reading confirms that we are in a recession. Even so, the Fed has little choice but to maintain a less-than-dovish monetary stance given current inflationary trends here and abroad. [chart courtesy Bloomberg LP (c) 2022]

From the Board of Governors of the Federal Reserve System:

  1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (3) other liquid deposits, consisting of other checkable deposits (or OCDs, which comprise negotiable order of withdrawal, or NOW, and automatic transfer service, or ATS, accounts at depository institutions, share draft accounts at credit unions, and demand deposits at thrift institutions) and savings deposits (including money market deposit accounts). Seasonally adjusted M1 is constructed by summing currency, demand deposits, and other liquid deposits, each seasonally adjusted separately.
  2. M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less individual retirement account (IRA) and Keogh balances at depository institutions; and (2) balances in retail money market funds (MMFs) less IRA and Keogh balances at MMFs. Seasonally adjusted M2 is constructed by summing small-denomination time deposits and retail MMFs, each seasonally adjusted separately, and adding the result to seasonally adjusted M1.

WCM Chart of the Week for February 14, 2022

The February 10th inflation report for January was higher than expected. Key stock market gauges declined and were particularly weak toward the day’s close. Notably, all major inflation segments continue to rise — Services, Goods, and Food  — with the exception of Energy, but oil and gas prices are up so far in February.

The benchmark 10Y UST yield rose above 2.0%, which has been an adverse trigger level for stocks in the recent past. The real yield on US Treasuries is more than -5%, a historic anomaly. Meanwhile, the US Federal Reserve will begin reducing its balance sheet in March. It currently stands at $8.9T, increasing over $5T since the pre-pandemic low of $3.75T, about a 134% increase since the Fall of 2019.  Furthermore, the Fed is set to increase policy rates several times this year, perhaps as many as six times.

It is difficult to envision the Fed backing away from its intent to restrain monetary liquidity, especially considering that inflation trends appear to be gaining momentum. Consumer prices initially began to accelerate in March of last year, rising from 2% to about 4.5%, and had another upswing last Fall through the latest report. Headline inflation, now stands at 7.5%, a 40-year high level that very few, if any, at the Fed have had to deal with in a professional capacity.

Policy conditions are visibly changing, yet the equity market over the past couple of weeks attempted a rally from late January’s bottoms. The recent bid on US stocks could be value seekers, although the market is still fully valued if not overvalued considering a higher rate environment. It could be a response to more and more US states announcing a wind-down of COVID-era policies, or simply that capital needs a place to land and US stocks are more attractive than international equity markets or global bonds.

Absent a meaningful catalyst (we are still looking) we do not anticipate a sustained rally and expect the general trend of US equity prices to be range bound to downward. Investors must come to grips with a tighter monetary policy environment, higher interest rates and inflation. We note that other major central banks, notably the BOE, have increased policy rates, and the ECB is publicly debating the need to address inflationary trends on the European continent.  And, many emerging market CBs have already embarked on a tightening cycle. [chart data from US BLS © 2022]

WCM Chart of the Week for February 8, 2022

The market, in our view, is trying to come to grips with a less accommodative yet still supportive monetary and fiscal policy environment. Federal Reserve policy is dominant at this moment, since it appears fiscal policy progress has stalled until the mid-term elections and perhaps beyond. The Fed is unlikely to turn away from its recent pivot towards being less “dovish”, which in light of recent inflationary trends is still is a far cry from an aggressively “hawkish” stance.

It seems probable the market will re-test the lows of January 24th over the coming days or weeks, and from there we will ultimately see from which way the equity market breaks. The recent intra-day volatility was reminiscent of some of the price action during the financial crisis, particularly around the 2008 election. When it appeared that President Obama would easily win, the S&P 500 rallied over 18% from October 27th to election day November 4th. With deep uncertainty about who would fill the new President’s cabinet and what steps they would take to address the worsening crisis, the S&P 500 subsequently fell nearly 33%. The market ultimately bottomed when Timothy Geithner, Obama’s most important new cabinet appointee at that moment (Sec. Treas.), announced the deployment of the TARP funds. There are certainly differences between 2008-2009 and now, most notably the health of the financial sector. However, the market fears uncertainty and that is a common thread between now and then. Another more tenuous thread, but one worth watching, is the speculative bubble in digital assets that has already partially ruptured, and the run-up in residential real estate in part fueled by loose lending practices. Today’s uncertainty is primarily around what the future holds in a less accommodative monetary and fiscal environment. Economic activity, while still growing, appears to be slowing and high inflation persists, prompting concerns about the potential for stagflation. [chart: Wilde Capital Management © 2022, data from Standard & Poor’s 500 Index]

WCM Charting the Way to 2022

Since March 2020 the US federal government has injected an enormous amount of stimulus into the economy. There have been seven stimulus and reliefpackages ranging from the original Coronavirus Preparedness and Response Supplemental Appropriations Act to The Families First Act to the CARES Act to The Consolidated Appropriations Act and the most recent American Rescue Plan. Even without Build Back Better, this fiscal expenditure legislation amounts to nearly $15 trillion over the life of the legislation with more on the way with the new infrastructure plan. The Federal Reserve has also injected a tremendous amount of liquidity in the system by expanding its balance sheet by $4.5 trillion since March 2020 while maintaining a benign interest rate and regulatory environment. The combined government stimulus over the past twenty months amounts to over 83% of current US GDP (as of end Q3 2021). Compared to the recessionary bottom in 2020, the same stimulus is nearly 100%. By contrast, the 2009 TARP expenditure amounted to about 5% of US GDP at the time. We do not have to look far to see from where upward pressure on asset prices and inflation comes.

WCM Chart of the Week for November 29, 2021

Consumer prices in the US are observably on the rise across a broad array of products and services. The Federal Reserve’s preferred inflation gauge, the PCE, last week registered a 4.1% annual increase, well above the Fed’s target. The causes of higher prices are well known, ranging from supply chain bottlenecks to raw material scarcity to higher energy costs to a shortage of transportation personnel. Adding to the inflationary mix is strength in the US dollar which has recovered over 6% according to the Bloomberg US Dollar index, comprised of a basket of major currencies. The dollar has recovered to pre-pandemic levels and could strengthen further as the Fed begins to reign in liquidity towards the end of 2022 if not earlier. Continued dollar strength could provide some inflationary relief in the form of lower import prices and could be justified given strong US economic growth and the interest rate differential between the US bonds and the rest of the world. As this week’s chart illustrates though, currency movements are notoriously difficult to predict. [chart courtesy Bloomberg LP © 2021]

A WCM Seasonal Chart for October 15, 2021

The total return of the S&P 500 tends to be positive in the final quarter of the year, averaging nearly 5.2% since Q4 of 1989. The worst final quarters of the year occurred during the technology bubble, the financial crisis and most recently 2018. Let’s look at today’s headwinds. Inflation, which is near universal across the economy, works like a broad tax on everyone. Price increases in many segments of the economy are outpacing wage growth, and that is impacting consumption which makes up about 70% of GDP. Supply chain issues will likely persist into next year and perhaps beyond, continuing to pressure prices. Next, the Fed. Their actions or inactions will be scrutinized and probably criticized for years. Tapering will start soon, but liquidity and monetary support will still be positive, just less so. It is doubtful, even with so many Fed seats open, that President Biden will appoint hawks in this environment, so we expect that will keep the Fed accommodative for longer and rate hikes pushed out further. In the Fall of 2018, our last “bad” Q4, the Fed was in balance sheet reduction mode and in the midst of raising policy rates when Powell remarked that they were “not near interest rate neutrality” causing a rout in equities worldwide. Three years and a more seasoned Powell later means we do not expect the same rhetorical mistake will be repeated. We also need to watch the ECB. Inflation could be here for longer and that would fuel ongoing volatility. Bad for bonds but not necessarily stocks. For us, even with additional volatility, equities remain the default asset class at least over the next few quarters. [chart WCM © 2021, data from Bloomberg LP]

WCM Chart of the Week for October 8, 2021

The US Federal Reserve balance sheet currently stands at $8.51 trillion, doubling in size since the pandemic began. The Fed has recently suggested that it may begin to taper the current $120 billion monthly purchases of Treasuries and mortgages as soon as the November 2nd-3rd meeting. Progress in employment is a potential trigger cited by Chairman Powell for tapering, even considering September’s lackluster jobs report. It is important to note that the Fed will likely continue to expand the balance sheet. What they are talking about is lowering the amounts of new monthly purchases over time, so expanding less fast. Still, a reduction in monetary liquidity. Of bigger concern are the inflationary trends that may force the Fed to introduce less accommodative or even restrictive monetary policy. Prices seem to be increasing nearly everywhere, from energy to food to wages, and the Fed’s preferred inflation gauge, the PCE Deflator, is up 4.3% year-over-year as of August. A combination of higher policy rates and lower liquidity would pose a serious challenge for capital markets. [chart courtesy Bloomberg LP © 2021]

WCM Chart of the Week — Summer-End 2021

This will be our last chart before Labor Day. The US Federal Reserve’s preferred measure of inflation, the YoY rate of change in the Personal Consumption Expenditure Index (PCE), has been exceeding its 2% target rate since April making investors concerned that we may be approaching a monetary tightening cycle. That fear was escalated by this week’s release of the Fed’s July 28-29th meeting minutes that indicated they may begin to wind down the current $120 billion monthly asset purchases by the end of this year or the beginning of 2022. The Fed has expressed its view that current inflation trends are transitory and are likely due to temporary factors such as supply chain bottlenecks and a strong rebound in demand from last year’s lull in consumption. As of June 30th, the current annual rate of the PCE was 3.54%, well above the Fed’s target, but in June 2020 the reading was 1.13%. Since the Fall of 2008 during the Financial Crisis, the PCE has been stubbornly below 2%, averaging 1.59%. Over that period of nearly 13 years, the PCE has been over 2% only in Q1 2012 and for most of 2018.  Inflation has been undershooting for a long period leaving aggregate price levels far below the Fed’s ideal. This suggests to us that the Fed will likely tolerate inflation until the PCE normalizes.

WCM Chart of the Week for August 9, 2021

Investment Grade and High Yield bond spreads have been edging higher since reaching their tightest levels ever at the end of last quarter. Admittedly, the spread widening may have more to do with the decline in Treasury yields since June 30th than an indication of any deterioration in the credit markets. What is interesting to us is that this has been occurring while broad stock market indices in the US and Europe are hitting all-time highs. Equity market valuations are full, particularly in the US, but according to Bloomberg consensus earnings are expected to grow by 11.8% over the next 12 months, putting the forward PE ratio of the S&P 500 at 20.3x, lofty yet not extreme. Our sense is that, barring a major surprise or a misstep by the US Fed, the positive tone in equities in the Western world will continue. The outcome of the Fed’s September meeting will be highly scrutinized but the likelihood that they will surprise markets is low. [chart courtesy Bloomberg LP © 2021]

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