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Wednesday, April 5, 2023

2023-04-05

*** denotes well-worth reading in full at source (even if excerpted extensively here)


Economic and Market Fare:

Let’s step back from today’s banking financial crisis and look at the bigger picture. That will help us to understand the system dynamics, and estimate how long the crisis might last, and how destructive it might be.
As a preliminary matter, let’s distinguish between a recession (even a bad one) and a financial crisis. They’re different.
A recession is a part of the business cycle. It involves some combination of tighter monetary conditions, higher unemployment, business failures, inventory dumping, declines in industrial output and declining GDP.
In recent decades, we’ve had recessions in 1973, 1980, 1981, 1990, 2000, 2007 and 2020. That’s a tempo of one recession about every seven years, although the recessions of 1980 and 1981 show that back-to-back recessions are possible.
Of those, the 2007 recession lasted the longest (one year and six months). The 2020 recession produced the most severe decline in GDP (down 19.2%).
The U.S. is likely in another recession right now, but we won’t have confirmation of that until more first-half data is revealed.
Over the same 50-year period, we’ve had a succession of financial crises.
These included the Latin American debt crisis (1982–1987), the Savings & Loan Crisis (1986–1989), the Black Monday crash (Oct. 19, 1987), the Nikkei collapse (1990), the Mexican Tequila Crisis  (1994), The Asia-Russia-LTCM crisis (1997–1998), the dot-com crash (2000) and the subprime mortgage crisis (2007–2008).
That’s eight crises in 50 years or a tempo of one crisis about every six years.
So much for the “Black Swan” theory, and the idea of 5-sigma events that occur once every 14,000 years. That’s junk science. These things happen all the time. .......


Since the failure of Silicon Valley Bank almost a month ago, interest rates have fallen dramatically. 2-yr Treasury yields are down 130 bps, 5-yr Treasury yields are down 100 bps, and 10-yr Treasury yields are down 70 bps. This amounts to a pronounced steepening of the yield curve, and that in turn is the market's way of telling the Fed that they are going to have to cut short rates soon, and by a lot. In effect, the bond market has priced in a strong likelihood of significant monetary ease. The only question seems to be the timing: will it come at the May 3rd FOMC meeting, or will it be at the June 14th meeting? I wouldn't be at all surprised if it happened before May 3rd. If I were Fed Chair, I would announce a cut in the funds rate of at least 50 bps way before May 3rd. ...

........ Unfortunately, the Fed is notorious for being behind the curve as rates rise, and behind the curve when rates fall. This serves to fuel inflation as it rises, and to crush the economy as rates fall. Today we apparently are watching another re-run of the same, unless the Fed soon wakes up. .........


Models matter -- and the Fed is ignoring the obvious signals that policy is too restrictive already.

................. So we have evidence of a chase in equity markets. What about credit? Credit is showing signs of deterioration. Lower quality high yield, Caa and below, is seeing spreads versus Baa inline with the 2008 Bear Stearns takeover:


This is particularly concerning when we consider the relative tightness of the energy sector. As always, problems emerge in sectors considered “safe” before this cycle.


... Our primary takeaways are as follows:
  • Nominal activity has decelerated, with real growth contracting and inflation decelerating. These moves aligned with our expectations and reflected the slowing of the labor impulse to broader activity.
  • Alongside this contraction in real activity, we saw significant stress in the banking system as the cumulative impact of tightening policy liquidity flowed through to financial intermediaries. We are now moving into the part of the cycle where public and private sector liquidity are likely to contract in unison. This path bodes ill for future nominal activity.
  • Our systems have now confirmed recessionary conditions. We see equity markets as particularly exposed to this risk, which our cycle strategies will look to exploit.







We examine three market-based signals for timing of rate cuts: the money market curve, the 2s10s UST curve, and swaption skew. We find that risks of more imminent Fed action are accumulating.
  • The explosion of volatility in the short-end implies a much broader distribution of outcomes for rates at year-end than only a month or two ago.
  • This translates to a wide band of risks around our modal forecast, which sees the hiking cycle ending at 5.25% in May, recession in H2 2023 and rate cuts beginning in Q1 2024.
  • Such high implied volatility suggests ‘fat tails’ in either direction relative to the year-end forward curve, but the bigger risk is to lower yields, we think



Summary: While some parts of the service sector demonstrate resilience to the fastest rate hikes in a generation, the message from today's ISM manufacturing index is that the factory sector is reeling. The headline measure fell to its lowest since 2020, and every sub-component is below 50. ...






MPC member Silvana Tenreyro .... “I expect that the high current level of Bank rate will require an earlier and faster reversal, to avoid a significant inflation undershoot.”



Quotes of the Week:

Alf: True, the market is pricing more Fed cuts in the next 12 months (~150 bps) than it has ever done in recent history. Even more cuts priced in than Dec 2000 or 2007. But as a reminder, in 2001 and 2008 the Fed DID end up cutting rates by over 400 (!) bps.



Charts:
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(not just) for the ESG crowd:

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