THE US Fed has discovered that when you push harder and faster than ever before, it’s likely something will break.
It’s taken time, but the market has found the weakest link in the form of shortfalls in bank asset-liability matching.
Bank asset-liability matching is when a bank ensures it has enough money to cover its obligations by balancing its assets and liabilities.
The likelihood of a full-blown banking crisis is relatively low, given better capitalisation of the US banks and relatively low loan-to-value ratios of US mortgages.
A “Goldilocks” scenario is also possible, where growth slows due to credit tightening as a result of pressure on banks – meaning rates don’t need to go to 6%.
But the full implications of this issue are yet to be seen, and the market last week was looking for guidance from treasury secretary Janet Yellen.
Her mixed messaging prompted some sharp market reactions.
The Fed raised rates by 25bps, largely in line with expectations (which ranged from 50bps to no hike at all).
Fed chair Jay Powell signalled that peak rates were close, but he maintained the mantra of “higher for longer”. The market says otherwise, with rate cuts baked into implied pricing for the back end of 2023.
Overall equity markets have performed reasonably well over the past couple of weeks, given what has been thrown at them. The bears would certainly be feeling quite short-changed.
The S&P/ASX 300 was off 0.58% last week and is down 3.36% for the month to date. The S&P 500 gained 1.41% for the week and is up 0.16% for the month.
Notwithstanding all the postulating over the course of the week, we have three open questions on the US banking issue:
After delivering a 25bp hike in rates, Powell acknowledged that “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”
As a result, it was too soon to determine the effects and how monetary policy should respond.
He noted that the rate-setting Federal Open Market Committee (FOMC) had considered a pause. But the hike was supported by a “strong consensus” with a change in guidance around additional hikes.
The “dot plots” graph which outlines future expectations continues to suggest higher for longer.
When quizzed on the market’s implied 125bps of rate cuts due to the banking issues, Powell said the Fed didn’t see rate cuts this year. (Though this was based on how the Fed now sees the economy evolving).
There was greater focus on Secretary Yellen’s comments.
On Monday she said US regulators might act to protect bank depositors if smaller lenders were threatened.
The government was ” resolutely committed” to mitigating financial stability risks where necessary. But she did not address the issue of whether Federal Deposit Insurance Corporation (FDIC) coverage could be expanded to cover all deposits.
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On Wednesday, Yellen said she had “not considered or discussed anything having to do with blanket insurance or guarantees of all deposits” in response to a question on whether Treasury would circumvent Congress and insure all deposits.
The market took exception to this and on Thursday Yellen walked this back, saying:
“We have used important tools to act quickly to prevent contagion. And they are tools we could use again. The strong actions we have taken ensure that Americans’ deposits are safe. Certainly, we would be prepared to take additional actions if warranted.”
Meanwhile the Fed’s balance sheet continued expanding (though at a slower rate than the previous week), as banks move to shore up funding.
The total balance sheet grew US$94 billion, on top of US$300 billion the previous week. This included (among other items):
Breaking down growth by the 12 Federal Reserve banks is instructive.
Growth in Fed assets is concentrated in the New York and San Francisco regions, which are up US$35 billion and US$24 billion for the week, respectively. There were modest increases across most other banks. But the continued concentration in just two districts gives the market some comfort around the risk of wider contagion.
There is still a clear and significant shift in deposits from smaller to bigger banks.
There is also a reduction of about US$100 billion in net deposits, which is feeding into some US$120 billion of flows last week into money market funds, on top of a similarly strong week before.
The FOMC statement and press conference suggest the Fed now sees risks to the economic outlook as more balanced than earlier in the month.
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Banking sector stress adds downside risks to growth, employment and inflation.
But despite already tightening conditions, recent data shows inflation has not yet cooled sufficiently to be consistent with Fed targets.
The real interest rate (nominal rates minus inflation) is now near 0.9%, which is nearing the 1% that Powell previously indicated was “restrictive territory”.
The Fed is navigating a fine line by raising rates 25bps (versus the 50bps some were expecting prior to Silicon Valley Bank’s collapse) and keeping the terminal rate consistent at 5.1%.
It recognises that inflation remains too high, but also accepts the economic outcome from the current banking crisis has a long way to unfold, with obvious risks to the downside.
Prior to the Fed’s meeting, markets were pricing an 82% chance of a 25bps hike – with cuts starting in November.
During Powell’s post-announcement press conference, the probability of a June cut increased from 55% to 80%.
Existing US home sales surged 14.5% in February, the most since mid-2020.
The median selling price of a pre-owned home fell 0.2% from a year earlier.
The jump in February sales follows 12 straight months of decline, but still leaves monthly sales 27.8% below the peak in January 2022.
The rate on a new 30-year conventional mortgage was 6.18% at the start of February – nearly 100bp lower than the recent peak in October. But it’s since risen sharply to 6.71% last week.
Mortgage payments for a new purchaser of a median-priced existing single-family home was equal to 51% of disposable income in February.
That’s down from the recent peak of 55% in October, but significantly above the 30% to 35% before Covid.
Rates are likely to remain elevated for some time, so a meaningful improvement in affordability will need to come via a decline in home prices.
Layoffs continue to grow without any reflection in unemployment claims. This probably reflects generous severance packages and ease of regaining alternate employment.
Growth in advertised rents in Australia has significantly outstripped growth in the CPI measure of rents for all rental housing since the onset of the pandemic in 2020.
So, unlike in the US where leading indicators are improving, there seems to be no relief coming domestically in the rent component of CPI.
The Bank of England pushed ahead with another rate hike, increasing by 25 bps to 4.25% – the highest since 2008.
The central bank believes UK living standards will remain flat this year and left the door open to further increases.
Further details were hammered out for the Swiss government’s solution to the Credit Suisse issue.
European Central Bank president Christine Lagarde ensured there was no ambiguity in her message regarding impact from the Credit Suisse crisis on policy.
“In such an environment, our ultimate goal is clear. We must – and we will – bring down inflation to our medium-term target in a timely manner,” she said.
In this regard, she has been helped by the fact that EU gas prices continue to fall and are down 45% this year.
Bonds yields fell in the aftermath of the Fed meeting.
The two-year and 10-year curve has steepened, with short-term yields falling more than long. But the cash rate/10-year curve has become even more inverted.
In US equities, large-cap technology and defensives have outperformed, while leveraged exposures like banks and property trusts have underperformed.
The US dollar has weakened. Commodity sector performance has been rather mixed.
The S&P/ASX 300 saw reasonable performance over the week. There was an expected weakness in REITs and financials while gold companies performed well.
There was limited company news.
Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.
Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share Fund here.
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