Precious Truth
Our modern-market circus kicked off this week with the second largest bank failure in US history as First Republic Bank went bust. The seismic event sent tremors and aftershocks throughout the banking sector specifically, and to a lesser degree markets more broadly. Volatility was the name of the game. To flesh out that volatility theme, consider PacWest Bankcorp’s stock this week. Despite Friday’s breathtaking stock price rocket-launch higher by over 81%, PacWest stock still closed the week with a monumental loss of more than 43%. Now, that’s an impressive degree of price instability that would make even the hardiest of volatility cowboys and dedicated “meme” stock enthusiasts weak in the knees.
On the week, stocks dropped along with the dollar, energy, and most commodity metals, while gold, silver, and precious metals miners popped. Market moves this week revolved around regional bank sector instability, recessionary demand destruction concerns in commodity markets, the Federal reserve’s FOMC policy meeting, and Friday’s stronger than expected non-farm payrolls print.
The crisis in small and medium sized regional banks is ongoing. As former Atlanta Federal Reserve Bank chief Dennis Lockhart put it this week, referring to regional bank dynamics, “the vulnerable deer in the herd are being picked off.” What he didn’t say is that as long as the structural disconnect between the high rates individuals can earn on cash in money market funds relative to the low rates banks pay on deposits exists, a deposit drain is left wide open in the bottom of the regional bank liquidity tub. As long as the situation persists, the number of “vulnerable deer in the herd” will continue to grow. If the Fed keeps interest rates high for longer to fight inflation, an increasing number of banks are likely to get caught in the undertow. Rather than a fear-driven bank run, what we have in its place is an incentive-driven bank walk. Regardless, whether a speedy run or a slower walk, the ultimate outcome is the same. Dangerous deposit outflows are likely to continue.
As HAI has pointed out previously, as deposit outflows continue, regional bank lending will continue to tighten. Regional banks disproportionately serve the small- and medium-size business community, and it’s this segment of smaller businesses with less than 500 employees that drives employment growth in the U.S. As a result, if we have a broad-based credit slowdown among the small and regional banks, we’ll also have a broad-based slowdown in the small business economy. Since small companies are the engine of job growth in the U.S., the risk is that significant job losses ensue and that we get a big recessionary spike in the unemployment rate. As macro analyst Jim Bianco said this week, if small and regional banks continue to struggle, it’s “going to have a profound impact on the economy.”
The obvious Fed medicine to ease the crisis in regional banks is to cut interest rates and ease monetary policy. The Fed could certainly try to rescue the situation by once again suspending the financial physics of interest rate gravity and reinstituting zero-G, but inflation remains the sticky pair of shackles binding the hands of policy makers. Again, the lose/lose options for policy makers are to live with a recessionary crash or live with inflation and central bank credibility suicide. The latter brings the risk of an unhinged crack-up boom market and economy.
Is there a third path to a magically disinflationary goldilocks soft-landing? Unfortunately, HAI shares the view expressed this week by PDIT’s Amy Xie Patrick, who observed that the “soft-landing strip was narrow before, and it’s probably a dot now.”
On Wednesday, stepping up to the microphone and into this minefield at the FOMC press conference was Fed Chairman Powell. Powell and the FOMC raised the fed funds rate another 25 basis points to a range of 5.0%–5.25%. This rate hiking cycle has been a blitzkrieg in which Powell has raised the fed funds rate by 500 basis points (bps) in just 14 months. (For perspective, the rate hike cycle that preceded the great financial crisis was 400 bps over 23 months.) The Fed now appears poised to pause further rate hikes and assess the lagging impact of what’s already been done.
Powell says it’s more likely than not that the economy will avoid recession. Still, he doesn’t rule out recession, saying, “It’s possible that we will have what I hope would be a mild recession.” The problem is that, caught squarely between inflation and recession, Powell may be pausing rates, but the market is suggesting rate cuts are necessary to avoid an imminent blowup. At 3.92%, the yield on the 2-year Treasury is deeply inverted compared to the fed funds rate now over 5%. That’s a very strong warning that the Fed has gone too far to land the economy safely.
Sending the same message, the futures curves are pricing in significant second-half 2023 rate cuts despite Powell’s claim that he can maintain rates at these levels for the remainder of the year, bring inflation down to the 2% target, and avoid recession. Arguably the most important part of the presser came when Powell was asked about whether he would cut rates as the markets are indicating he needs to do to avoid further exacerbating the severity of recessionary crisis. Powell responded by saying that if the Fed’s forecast is broadly right, it won’t be “appropriate to cut rates, and we won’t cut rates.” Markets did not like Powell’s answer, and sold off hard from solid gains into negative territory in response. The market is strongly indicating that the Fed’s forecast is indeed wrong, and that Powell will cut rates. If Powell doesn’t, the market sees the writing on the wall, and it spells “big trouble.”
At this point, HAI’s baseline assumption remains as follows: policy makers will choose to pause rate hikes; they will keep policy restraint in place with rates as they are; crisis and recession will result and temporarily knock inflation lower. At that point, taking advantage of the consequent political cover, the Fed can more easily pivot to inflationary emergency response measures. In short, a hard landing will likely be required before the market gets the rate cuts it expects.
The Fed is in a tough spot. While watching the Chairman attempt to navigate the minefield on Wednesday, HAI was reminded of Winston Churchill’s remark that, “In wartime, truth is so precious that she should always be attended by a bodyguard of lies.” Despite what monetary policy makers might think, when the going gets tough they may opt to shape reality into as agreeable a form as possible. As Churchill’s words attest, the fog of war is thick. We must endeavor to pierce its veil.
Amid that fog of war, gold and silver are speaking a “precious” truth with a booming voice. Amid Powell’s soft-landing talk, Goldman Sachs partner Tony Pasquariello mused, “can you even imagine if we exit 13 years of interest rates pinned at zero, plus roll off billions in bond holdings, and the penalty is a mere 15% equity pullback from all-time highs at an 18x multiple? It would be the most elegant dismount of all time.” It certainly would be a stunning and miraculous dismount.
HAI’s opinion, however, is that if such a benign soft-landing-scenario had a credible chance of coming about, there’s next to no chance gold would currently be over $2,000/oz, repeatedly testing all-time highs, and patiently preparing for a major breakout into new record territory. In HAI’s view, gold is precious truth. Its testimony is that the process of crisis has been definitively unleashed. Whether via the route of inflation or recession, a little sooner or a bit later, as the fruits of Fed policy error fully ripen, gold will continue to react and the price of gold as crisis insurance can be expected to rise.
Weekly performance: The S&P 500 was down 0.80%. Gold gained 1.29%, silver was up 2.77%, platinum was down 2.00%, and palladium dropped 1.53%. The HUI gold miners index gained 6.94%. The IFRA iShares US Infrastructure ETF was up 0.49%. Energy commodities were volatile and lower on the week. WTI crude oil lost 7.09%, while natural gas was down 11.33%. The CRB Commodity Index lost 2.45%, while copper dropped by 0.26%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.55% on the week, while the Vanguard Utilities ETF was nearly flat, up 0.3%. The dollar was off 0.39% to close at 101. The yield on the 10-yr Treasury was unchanged, ending the week at 3.44%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
