Essentially Broken – March 24, 2023

Essentially Broken – March 24, 2023
Morgan Lewis Posted on March 25, 2023

Essentially Broken

This week, the regional banking crisis in the US took a back seat to emerging troubles at major European banks. Adding to the existing regional bank concerns, UBS Group’s state-backed takeover of Credit Suisse fanned concerns about the health of the global banking sector. UBS agreed to buy the troubled rival bank on Sunday for $3.23 billion and assume up to $5.4 billion in losses. It was a shotgun merger engineered by Swiss authorities in an aim to rescue its banking system. The fresh banking jitters helped set the stage for Wednesday’s Federal reserve FOMC meeting, policy decision, and Powell press conference. 

Unlike previous meetings where the inflation fight was the sole focus, this time financial instability and fragility would compete for the Fed’s attention as the inflation fight had finally claimed casualties. Fed policy tightening in response to inflation had been partially credited with the demise of at least three small US banks, sparking a historic wave of bank deposit runs, and potentially damaging US regional bank lending. The question was, would the wreckage be enough to cause the Fed to abandon further policy tightening or even ease policy despite the fact that inflation remains significantly above target?

Ultimately, the answer—for now—is no. Powell and the Fed voted unanimously to raise the fed funds rate by 25 bps to a target range between 4.75%–5%. That said, the policy statement language was softened somewhat, and it now appears that the Fed is done hiking—or very nearly so.

Fed Chair Powell addressed the dueling issues of financial instability and inflation by first asserting that America’s banking system remains “sound and resilient,” but also by acknowledging that “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” In short, he recruited the recent banking blowup fallout as a factor that will tighten financial conditions independently and potentially alleviate the need for the Fed to implement significant additional rate hikes. The Fed will remain data dependent, though, and is prepared to act if needed. Powell’s press conference was relatively uneventful. The Chairman handled the delicate situation as well as can be expected, but he was clearly and awkwardly trapped between the two major conflicting issues of fighting inflation and alleviating financial instability.

Let’s pull back the lens and widen the frame to examine the impact of the bank crisis on the economy, markets, and Federal Reserve System. We can accurately say that before the banking crisis became a factor, trending economic growth was persistently decelerating. The manufacturing sector was in full recession, housing was in trouble, and the broader economy was in a pre-recessionary state. 

The economy relies on its primary sectors as an airplane relies on its engines. Before the banking crisis, two main engines—housing and manufacturing—were in trouble. The economy was decelerating and losing altitude. Now, with a full-blown manufacturing recession currently underway, we’ve effectively lost one primary engine. At the same time, with record housing market unaffordability amid 23 straight months of negative “real” (inflation adjusted) wages and a historically low savings rate, the housing engine has continued to lose power. 

Failure of one or more economic engines starts a vicious cycle that, unless offset elsewhere, begins to choke off growth powering the remaining engines. This is all the more significant given that, as past HAIs have chronicled, the leading economic indicators are recessionary and continue to slide to the downside. In fact, the latest Conference Board Leading Economic Index just notched the 11th straight monthly decline (its longest monthly decline streak since the great financial crisis) from already low levels that perfectly correlate with imminent recession in data stretching back to the 1950s.

The easy availability of money and credit is the straw that stirs the economic drink. The most recent Senior Loan Officer Opinion Survey confirms that the percentage of banks tightening lending standards had already reached recessionary levels before the regional bank crisis hit. In the wake of banking turmoil, the tightening grip on lending is likely to worsen. That’s because customers are pulling deposits from regional banks at an alarming rate. Deposit growth in the banking system was already contracting at a 5% annualized rate as higher yields in money market funds and Treasurys offered more attractive rates on cash. Now with the eruption of the bank crisis, the rate of deposit flight should significantly accelerate. That’s exactly what we’ve seen in the last two weeks. In consequence, banks will have to raise the rate they pay on deposits to compete for and retain as many deposits as possible. As deposits contract, credit to the private economy also contracts. In addition, as the payout rate on deposits increases, lending also becomes less profitable and that further disincentivizes bank lending.

In short, when deposits are falling and loan profitability is a struggle within the context of a deteriorating economic environment, banks get conservative, aim to protect their balance sheets, and go broadly risk-off. Given the dynamics at work, the availability of money and credit is very likely to significantly tighten further. With two of the most powerful cyclical economic engines already down, and the tightening throughout the banking sector picking up stream, additional stress is en route to the remaining economic engines.

This week, Morgan Stanley chief investment officer Mike Wilson said point blank that, as a result of the regional bank blowup, he expects “falling credit availability to squeeze growth out of the economy.”  For Wilson, the bank crisis is an unforeseen catalyst, obvious in hindsight, that’s likely to force market participants to acknowledge the bearish reality right in front of them.  He cautioned that this stage of a bear market “can be vicious…prices fall sharply.”  In other words, in our analogy of the economy as an airplane with engine trouble, efforts to maintain flight now face another flashing warning light—critically low fuel—as dwindling credit availability threatens a broad economic contractionary dive.

This week, Nomura Managing Director of Cross Asset Strategy and HAI favorite Charlie McElligott added further color on the recent regional bank failures. According to McElligott, “all of those fails are idiosyncratic symptoms of this larger bank profitability crisis becoming a solvency crisis… These are long-term structural dynamics for banks whose profitability models were built for an era of 0% interest rates, an era of large-scale [Fed] asset purchases, and an era of slowflation. And now we’re seeing that the emperor has no clothes pretty clearly here.”

As to the overall ramifications of the regional bank crisis? As McElligott sees it, “The implications…from the big picture is that this profitability and solvency crisis becomes a massive financial conditions tightener. Ultimately, in a fractional reserve banking system, where this is the transmission mechanism for US economic growth, the global economy is going to get toasted. It’s a really big story. It’s a really significant story… It’s where this cycle really takes a turn.”

With inflation back breathing fire again since the pandemic, and the Fed having to abandon easy money policies in response, these smaller regional banks have business models that just don’t work anymore. Crucially, as McElligott points out, “the problem is that they’re incredibly important from a lending perspective.”

The percentage of large commercial banks tightening lending standards has already reached recessionary levels. But add tightening of lending at smaller banks, and we have the potential makings of a credit freeze. The Federal Reserve has a category for smaller banks that it defines as those outside of the top 25 U.S. lenders. According to the Fed’s data, such banks’ share of all outstanding loans in the US is an extremely substantial 38%. These banks service 28% of all commercial and industrial loans, 37% of all residential real estate loans, 27% of credit cards, 50% of auto loans, and 48% of other consumer loans. Alarmingly, they also service a whopping 68% of all commercial real estate loans. Commercial real estate, already in deep trouble, is therefore widely expected to be the source of the next crisis. As McElligott concluded, with these smaller banks “touching this much of the lending and the money flow and the credit flow in the United States economy, you know we just accelerated into a pretty substantial hard landing.”

HAI wholeheartedly agrees. With magic disinflation theory debunked and the path to a soft-landing so narrow as to require a miracle, our current flight trajectory very likely ends in the crunch of a very hard landing—one in which the Fed as firefighter waits at the crash site, ready to administer crisis response easing. The Fed could prematurely pivot to try and avert such an outcome, but a full pivot would turbocharge already hot inflation and only delay the inevitable.

At present, most attention is fixed on banks. Ominously, however, all downstream sectors that primarily functioned on zero interest rates and endless liquidity stand to take an outsized hit as long as Fed policy and bank lending remain tight. Private equity, venture capital, profitless tech, autos, and, as mentioned, commercial real estate are all headed for significant further difficulties. As McElligott put it, “when you don’t have access to perpetual funding at zero, these models don’t work. And that’s where we are.”

That said, given that it could take time before the bearish ramifications of worsening lending standards fully play out, recent interventions from policymakers could inspire a short-term risk-on bounce. The S&P 500 certainly could trade back to well over 4,000, but if such a bounce develops, it will likely be short lived and quickly followed by a vicious sell-off. Financial assets are at greatest risk, but economically sensitive commodities also warrant caution if lending freezes and growth tanks. Select supply-constrained commodities are poised to lead markets once the next Fed easing cycle begins in earnest, but in the meantime, HAI suggests keeping position size relatively light with room to build on weakness.

This week included some notable additional soft content worth comment. On Wednesday’s post-FOMC coverage, Bloomberg host Romaine Bostic, presumably referring to Powell appearing caught between a rock (mounting financial instability, banking dysfunction, incoming recessionary hard landing) and a hard place (a mandate to curb consumer-crushing inflation that is tied to irreparable Fed credibility implications) offered a comment to Bloomberg guest and HAI favorite Jim Grant. Bostic said that after watching the post-FOMC Powell press conference, “I’m wondering whether the Federal Reserve System as we’ve known it isn’t essentially broken.”

Mark the day, March 22, 2023. That question—one that gold bugs have asked and answered in the affirmative for years—was floated during prime-time coverage on the world’s most reputable financial network immediately following the FOMC presser. The Fed is trapped in a quagmire, and Powell’s pickle is generating mainstream attention. Questions are beginning to be asked as to whether Powell and the Fed are up to the present challenge. Can they really save the system and fight inflation? Is the Federal Reserve System as we’ve known it essentially broken? In response to Bostic, Jim Grant replied, “I think the PhD [Fed] standard is demonstrably broken.”

Two days later, reality pierced the veil again, making another two-minute appearance on a mainstream financial network. This time it was CNBC. On Friday, network staple Rick Santelli fumed, “Many are seeing recession. I don’t see a way to avoid it… Is this really a banking crisis? It’s a Fed crisis. It’s a rate hiking crisis. It’s a crisis built on a crisis we never solved.” 

Quite right. We never solved the structural problems that triggered the bomb at the center of the great financial crisis. We threw trillions of dollars and near-zero interest rate policy at the problem, and were content to build an unsustainable house of cards a mile high into the sky. A crisis response of implementing history’s loosest monetary policy was not a “solution,” but a cynical can kick destined to increase the size of the problem and sow the seeds of the next crisis. That crisis is here.

Last week, HAI highlighted a working paper in which the San Francisco Fed observed that “A loose [policy] stance over an extended period of time leads to increased financial fragility several years down the line.” That financial fragility, the SF Fed concluded, is “a harbinger of financial turmoil.”

This is the Fed’s trap. “A loose [policy] stance over an extended period of time” has rendered widespread “financial fragility.” It’s exactly the point Charlie McElligott stressed in discussing banks and myriad other sectors whose business models are fully acclimated to and dependent upon easy money policy. They no longer function outside of an ultra-loose zero-interest rate financial universe. But the ultra-loose policy is inherently inflationary. Once inflation is out of the bag and out of hand, huge swaths of the “loose policy economy” won’t survive the new financial physics of interest rate gravity that the Fed must implement in order to vanquish the inflation outbreak.

So again, this is the trap in which the Fed is now fully ensnared. Effectively fight inflation and you crush the financial system, the economy, and eventually employment. Feed the financial system the loose policy sugar needed to avoid collapsing the weakened “loose policy economy” and you feed inflation and turbocharge the price problem. The Fed is cornered like never before. It walked too far out on its loose monetary policy plank, the damage is done, and it might no longer be able to effectively serve its dual mandates of maximum employment and price stability without unacceptable trade-offs in either direction. We appear to be on the verge of demonstrable evidence confirming that suspicion, and we will soon learn which mandate it defends and which it sacrifices. Markets will be watching closely.

Gold is many things, but not least among them is that, after we abandoned the gold standard, the yellow metal became insurance against monetary policy malpractice and Fed-sponsored financial dysfunction under the Fed-standard era. There may never be a better time to own gold than at the moment of confirmation and universal recognition that the financial system formerly governed by the gold standard and subsequently converted to the Fed standard has finally transitioned to being governed by no standard. Just like the price of flood insurance amid a deluge, HAI expects golden financial insurance to dramatically increase in price as it becomes increasingly clear that, when it comes to past norms of traditional market orthodoxy under the Fed standard, we’re not in Kansas anymore, and that the Fed standard is indeed “essentially broken.”

Weekly performance: The S&P 500 was up 1.39%. Gold was up 0.52%, silver gained 3.92%, platinum was up 0.54%, and palladium added 2.04%. The HUI gold miners index was up 2.53%. The IFRA iShares US Infrastructure ETF lost 0.44%. Energy commodities were volatile and higher on the week. WTI crude oil gained 3.48%, while natural gas gained 0.98%. The CRB Commodity Index was up 1.50%, while copper was gained 4.76%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.56% on the week. The dollar was down 0.58% to close at 102.76. The yield on the 10-yr Treasury lost 1 bp to end the week at 3.38%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

Stay Ahead of the Market
Receive posts right to your in box.
In the Foothills of Its Everest – April 19, 2024
Under Pressure – April 12, 2024
A New Set of Rules – April 5, 2024
Happy Easter! March 29, 24
Punch-Bowl Powell & Rational Exuberance – March 22, 2024
Nowhere to Go but Gold – March 15, 2024
Tying the Knot – March 8, 2024
Goldilocks – Between a Rock and a Hard Place – March 1, 2024
Double your ounces without investing another dollar!