The Ides of March
In Shakespeare’s Julius Caesar, the seer warned, “beware the ides of March.” Well, it may not be Shakespeare, and it certainly isn’t soothsaying, but in a research paper released earlier this month, the San Francisco Fed (of all outfits) warned policymakers that they were treading on ground that could erode beneath their feet. The warning—one that HAI wholeheartedly agrees with—concerns the record easy and accommodative policy path central bankers have walked for well over a decade. At this juncture, says the Fed, accommodation may be less a sturdy road paved toward a bold and prosperous future than a plank that ends abruptly and in ruins. In their words, “A loose [policy] stance over an extended period of time leads to increased financial fragility several years down the line.” That financial fragility is, “a harbinger of financial turmoil.”
Quite right, and now, many more than several years down this plank, financial turmoil is upon us. The SF Fed continued with an astute observation that may have been a little more helpful and relevant a decade ago: “Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences.”
After more than a decade of the loosest, easiest, most accommodative global monetary policy in history, it’s clear that policymakers consistently chose the “short-run gains of loose monetary policy” and made one massive consensus bet – a bet that, despite adopting monetary inflation as policy, consumer price inflation would prove an extinct remnant of history. The policymakers were wrong. The inflation dragon still lives and breathes fire. After denying that fact in 2021, officials must now curb the worst bout of global consumer price inflation in 40 years.
But “a loose [policy] stance over an extended period of time” has already borne the financial fragility that is the “harbinger of financial turmoil.” We have a structurally fragile economy that’s drowning in record debt and dependent on near-zero interest rates along with endless rivers of liquidity and credit expansion. So to fight the inflation that’s not dead after all, the Fed has been forced to seriously tighten monetary policy. It’s a particularly powerful poison for the structurally fragile economy and financial system the Fed itself created.
We’re now at the one-year anniversary of the first 25-basis-point rate hike last March that marked the start of the tightening cycle. The Fed has since engaged in quantitative tightening (liquidity withdrawal) and a rate-hike blitzkrieg that’s sent the fed funds rate from 0–0.25% to the 4.50–4.75% range at present. The bank crisis of the last two weeks involving Signature Bank, Silicon Valley Bank, First Republic Bank, Credit Suisse, and likely others yet to be revealed is the latest evidence that Fed tightening is certainly beginning to bite hard, and that things are starting to break.
That said, Fed policy works with “long and variable lags.” Most estimates gauge the lag at around 8–9 months, while some estimates are longer. If we use an 8–9-month lag as a rough guide, then 225 basis points of tightening have filtered through the economy to date. Keep in mind, things are already breaking now. Based on the lag, we still have another 225 bps (250 if the Fed hikes another 25 bps next week) of further tightening already in the pipeline, queued up to hit between now and November. All else equal, if substantial financial turmoil is hitting now, it’s likely just the appetizer to a main course yet to come.
In response to the sudden eruption of financial upheaval, and in the context of a hard-hitting punch of cumulative and lagged rate hike impacts still on the way, JPMorgan asset management CIO Bob Michele said this week, “I think this is the tip of the iceberg… I think there’s a lot more pain to come.” No argument here.
So take a moment to appreciate the irony. The underlying structural financial instability created by years of loose monetary policy is now descending into financial turmoil caused by a Fed tightening cycle aimed at fighting inflation. In other words, the Fed is both the original arsonist and the firefighter of last resort.
On Sunday evening, the Fed as firefighter, along with other agencies, threw a big wet blanket over the flames engulfing the banking sector. After Silicon Valley Bank failed when losses on its hold-to-maturity Treasury book triggered a bank run, the Fed implemented a new program—the Bank Term Funding Program (BTFP)—aimed at easing the liquidity problem and guaranteeing deposits. The crisis, resulting response, and likelihood of further turmoil and financial system breakage if the Fed doesn’t ease policy prompt a far-reaching question: What does it all mean for the Fed policy outlook, inflation, the economy, and markets?
In short, it’s complicated and we don’t exactly know yet, but let’s explore. As BofA Chief Investment Strategist Michael Hartnett has said, Fed tightening cycles “end with a recession or an event that causes the Fed to reverse policy.” To be sure, significant financial turmoil is now competing with inflation for the Fed’s attention, but we don’t yet know if the last two weeks amount to an “event” sufficient to cause the Fed to reverse policy. This week, Nomura speculated that the answer was yes. The bank anticipates a 25-basis point rate cut at next Wednesday’s FOMC meeting. Goldman Sachs assumes the Fed will now pause on further rate hikes. Other banks (and HAI) expect another 25-basis-point hike.
At this point, it’s all conjecture. What we do know is that fragile and significant financial structures are beginning to break, and that they are breaking well before inflation has been slain. At the same time, the other potential catalyst for a policy pivot—the looming recession needed to tame prices (for a while at least)—is incoming but has yet to hit or is just getting started.
Again, it’s complicated. If the Fed sees recent turmoil as a reason to downshift the inflation fight or outright pivot despite high inflation, it may loosen market-based financial conditions again, delay recession, and further entrench and perpetuate inflation. This course risks a prolonged stagflationary crisis (a consumer-crushing combo of mild recession along with still elevated inflation) potentially far more devastating than the one the US went through in the 1970s.
This stagflationary path also comes with an outsized upside risk to inflation. This week, University of Michigan Surveys of Consumers Director Joanne Hsu mentioned that, “With ongoing turbulence in the financial sector and uncertainty over the Fed’s possible policy response, inflation expectations are likely to be volatile in the months ahead.” In HAI’s opinion, Director Hsu’s emphasis on expecting heightened inflation expectation volatility is spot on and reveals a crucial insight. While consumer inflation expectations are (in Fed parlance) relatively “well anchored,” a related measure, inflation expectation uncertainty, is sky high. In other words, consumers are assuming policymakers will tame inflation, but their conviction is paper-thin.
If the Fed, now staring financial instability in the face, wavers on the inflation fight, if it starts looking desperate for a fast track to a pause as prelude to a pivot while inflation is still unquestionably running hot, the war on inflation will likely be lost. The extremely high levels of consumer inflation uncertainty will suddenly turn to universal certainty concerning an incendiary inflation outlook. At that point, both corporate and consumer inflation psychology (a circular and self-fulfilling inflationary process that feeds on itself) will kick in fast. We have yet to see inflation psychology rear its ugly head as an ingredient in our current inflationary cocktail. If the Fed confirms it is not up to the inflation fighting challenge, inflation psychology could quickly set in and supercharge the price problem.
On the other hand, if Powell and the Fed try to maintain the tighter policy course until a sufficiently forceful cleansing recession arrives while aiming to contain the fires their policy starts along the way, they’ll be outright crashing markets and the economy to get inflation to target.
Overall, in assessing the specific impacts the bank crisis and subsequent policy response are likely to have on inflation and the recession outlook, two critical takeaways are apparent. First, the bank bailouts are inflationary. As JPMorgan and Citi concluded this week, the BTFP facility effectively amounts to stealth quantitative easing (QE) because, as JPM put it, “the BTFP would inject liquidity, i.e. reserves, into the banking system at a time when there are signs that reserves are becoming scarcer.” In other words, depending on the degree of BTFP usage, stealth QE will have an offsetting impact on QT.
The second takeaway, and perhaps the more significant one, is that barring a more comprehensive and imminent offsetting policy pivot from the Fed, the bank crisis seems likely to nearly seal the deal on recessionary hard landing odds. Morgan Stanley analysts see the crisis leading to a meaningful increase in bank funding costs, which will lead to tighter lending standards, wider loan spreads, and slower loan growth. Schwab Chief Fixed Income Strategist Kathy Jones agrees. She points out that financial turmoil “is inherently deflationary/disinflationary because it causes banks to pull back on lending, which tightens financial conditions in turn.” As a result, “Consumer confidence tends to fall, leading to lower consumption…, and asset prices fall, leading businesses to pull back on investment.”
It’s all a vicious recessionary cycle, but the key is that when lending freezes, the economy freezes. The prospect of an accelerated slowdown in loan growth/credit expansion as a result of this week’s dynamics is made all the more powerful given that the percentage of banks tightening lending standards had already reached recessionary levels prior to the latest bank crisis.
The essential role played by credit in our saga is underscored by Ludwig Von Mises. The legendary Austrian economist observed that, “governments can reduce the rate of interest in the short run… They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse soon or late and to bring about a depression.” Again, all else equal, if the increased cost of funding and a general risk-off sentiment at banks deepens in response to the crisis, credit growth drops off a cliff and the economy gets toasted as the Wile E. Coyote moment arrives suddenly. The artificial boom described by Mises may indeed be “bound to collapse.”
This week, JPMorgan’s Ron Adler noted that, “Whenever the Fed hits the brakes, someone goes through the windshield.” Right now it’s the banking sector that isn’t wearing a seatbelt. Going forward, however, HAI anticipates that, in either the stagflation or hard recession scenario, financial assets more broadly may be caught unbuckled and sporting outsized bruises on the wrong side of the windshield. As legendary first ballot hall of fame investor Stanley Druckenmiller recently observed, “When I look back at the bull market that we’ve had in financial assets…all the factors that created that not only have stopped, they’ve reversed.” During the era of a “loose [policy] stance over an extended period of time,” financial assets were the leaders in the resulting artificial boom. In the new regime-change era of real economy dominance, structurally elevated inflation, higher interest rates, resource nationalism, and commodity scarcity, however, HAI believes hard assets are poised to be the new regime leaders.
The Ides of March revealed that the new financial physics of interest rate gravity wrought by the Fed’s tightening cycle are finally starting to break fragile market structures. All eyes will be on Powell and the FOMC next Wednesday for the latest insights on the Fed policy response and forward policy path. Volatility awaits.
Weekly performance: The S&P 500 was up 1.42%. Gold was up 5.69%, silver jumped 9.51%, platinum was up 1.70%, and palladium was up 1.75%. The HUI gold miners index surged 13.21%. The IFRA iShares US Infrastructure ETF lost 2.26%. Energy commodities were volatile and lower on the week. WTI crude oil was crushed by 12.72%, and natural gas lost 3.79%. The CRB Commodity Index was off 3.90%. Copper was down 3.47%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.93% on the week, while the Vanguard Utilities ETF (VPU) was up 3.47%. The dollar was down 0.76% to close at 103.36. The yield on the 10-yr Treasury tumbled 31 bps to end the week at 3.39%.
Investment Strategist & Co-Portfolio Manager