FRC - A Hot February CPI Could Put The Fed In A Terrible Pickle

2023-03-14 00:42:02 ET

Summary

• What happens when accelerating inflation meets fears of systemic banking risk? There isn't a lot of precedent.
• In 2008, summer fears over inflation rapidly gave way to banking system fears and rapid deflation after the sudden failure of Lehman Brothers and the September 2008 market rout.
• This time, trading action in gold, Bitcoin, and the dollar is so far signaling more fear of money printing than of a banking crisis.
• But will the Fed really pivot if inflation is roaring back? Probably not, but we'll soon find out.

One week ago, all eyes were on the "known" risks of the Fed and inflation. Then, out of nowhere, Silicon Valley ( SIVB ) bank fails, followed by Signature Bank ( SBNY ) and the rescue of First Republic ( FRC ). In a flash, 3 of the 30 largest banks in America found themselves on the brink of collapse. This led to immediate comparisons to 2008, another year when inflation was hot until giving way to a sudden and severe recession. The surprise weekend bank crisis relegated this week's CPI report and next week's Fed meeting to a mere subplot. But the inflation drama won't be going away. CPI is set to be released Tuesday at 8:30 am Eastern. If the numbers come in hot, the Fed may find itself trapped between rapid inflation on one hand and a troubled banking system on the other.

The immediate parallels to 2008 are spooky, but there are key differences that we'll get into in a second. In September 2007, the S&P 500 ( SPY ) was down roughly the same amount off of the all-time highs as it is today. After Lehman failed, a 20% bear market in stocks rapidly collapsed to -50% by early 2009.

Inflation was fairly hot in 2008. The August 2008 CPI showed a rate of 5.4% year over year, released around the same time Lehman failed. However, the core inflation numbers were fairly benign throughout the year, coming in at only 2.5%. Oil drove price increases that year, topping out near $150 per barrel. Of course, oil subsequently had an epic crash.

Bitcoin ( BTC-USD ) didn't exist back then, but gold ( GLD ) did. Gold initially surged during the crisis, but sold back off and then yo-yoed for a few months before starting a big bull run in 2009.

Now, here we are in 2023, for stocks–

Oil-

And gold.

So what should we make of the similarities and differences between 2008 and 2023? There are some key differences.

1. Core inflation was much more benign in 2008, while unemployment was much higher – over 6% by August 2008. One reason this is important is that it allowed the Fed to help the equity markets as much as they could, cutting interest rates to near 0% by December 2008. Starting equity valuations are much higher now than they were in 2008, unemployment is much lower, and inflation is much higher. These all mean that the Fed is likely unable to provide the kind of market overt market support it has in the past unless unemployment rises substantially. We saw traders buying high multiple Nasdaq ( QQQ ) stocks today in hopes of a Fed pivot. But the pivot isn't happening unless inflation rapidly comes under control via a huge recession, in which case they may want to be careful what they wish for.
2. One interesting thing about 2008 is that when the crisis started, the dollar was immediately seen as a safe haven. A lot of the drama last time around focused on European banks, while this time the issues have been almost exclusively in the US. Now, traders are actually selling the dollar and buying into other currencies. This strikes me as rather suspect, as if American banks were the only out-of-control risk-takers in the world of zero interest rates, while those in Europe and Asia-Pacific are immune! To this point, Bitcoin surged 20% after the bank rescues. Bitcoin is still likely a good long-term investment, but people panic buying it might get stung if/when the next shoes drop. International stocks likely are a better long-term value than the US here, but the idea that the only shoes to drop in the global financial system are in the United States is a dangerous fantasy right now.

Where Will February CPI Come In?

Both core and overall inflation are expected to rise 0.4% for the month– 5.5% and 6.0% year, respectively. These expectations are already bad, and if the numbers come in above expectations, the Fed will be in a serious pickle. On one hand, they'd have a banking system that is increasingly seen as fragile, while on the other, they have a public that largely believes "cash is trash" and that inflation will continue to accelerate. To make matters worse, econometric models suggest that the Fed probably fell behind the curve on inflation again. Building on last month, we've just seen inflation rocket higher in Spain , Germany , and Japan for February. Used car prices are shooting in the US again, flashing another early warning sign. I'd take the over here on February CPI.

The Cleveland Fed nowcast has inflation coming in at 0.45% for the core and 0.54% overall. With inflation over 5% annualized, interest rates clearly need to be at 6% to start bringing prices down. The problem is that the banking system is already showing stress. Overall, interest rate sensitivities are high for banks and the housing market and low for consumers who have FOMO and/or want to YOLO. These differing sensitivities to rate changes for different parts of the economy don't give me great hope that a "soft landing" can be achieved.

What we saw in 2008 was that banking crises can be a powerful deflationary force. If banks suddenly stop lending, then inflation won't be able to continue. However, we don't know how powerful the deflationary force will be this time around. If we avoid a broader crisis–the fact that depositors are taking no losses, falling rates, and a weaker dollar may make this inflationary in the end. After all, stocks are still slightly higher for the year, and money is fleeing the dollar and pouring into Bitcoin, gold, and any other perceived safe haven. This is already starting to work to put upward pressure on inflation, potentially leading to a dreaded bout of " stagflation ".

Bottom Line

Overall, the February core CPI numbers are likely to be hot. And absent a full-scale bank crisis, the March numbers will be hot as well, possibly showing a continued acceleration of inflation. With the Fed very possibly behind the curve on inflation, it's possible that the Fed will have to make some sort of arrangement with banks to keep the system functioning while continuing to jack up rates to tackle inflation. In any case, a red-hot CPI number after a couple of bank failures over the weekend would be a nightmare for stock bulls, with S&P 500 valuations trading dangerously close to bubble highs and nearly 50% more above where they were in September 2008. For the real economy, things are (hopefully) likely to be much kinder and gentler in 2023 than in 2008. However, stock bulls hoping for a pivot and return to all-time highs may not be as lucky.

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