TYO - Bonds Likely Offsides As Powell Dances Around A Pause

2023-05-04 07:05:00 ET

Summary

• The Federal Reserve's latest meeting occurred on Wednesday and, as expected, the Fed raised the benchmark Fed funds rate by 25 bps.
• Given the recent banking stress, many had speculated the Fed would explicitly signal a pause, but it instead shrewdly teased one.
• Powell came out with an air of confidence on the recent banking dislocations and focused on a key language change.
• He mentioned he sees positive developments, but that there's still a lot of work to do to bring inflation down.
• Overall, higher for longer seems the more likely outcome, which means the bond market is likely offsides.

Jay Powell conducted what many hoped would be the final press conference of America's second-most aggressive tightening cycle in history. The implications for the S&P 500 ( SPY ) are significant, as bonds will likely remain at levels that make them attractive relative to stocks until the market gets a better idea of when it can expect cuts.

It may have been the last hike, or it might not have been. Now you see Powell, and now you don't. He danced around a pause at the press conference yesterday, which is appropriate given the apprehension around recent events in the banking cycle.

Many may not realize that the origins of our great American tradition of understanding financial crises through the lens of blame occurred in the shadow of one of the highest-profile events in history, but also one which might surprise you.

The American perennial is older even than the two major modern political parties. But it's likely exacerbated by the digital age. Content about banking doesn't exactly sing in our overstimulated digital world, so inserting blame might make it less accurate. But certainly less boring.

Still, as investors, we must seek truth to profit consistently. As someone who worked very thoroughly on financial stability issues in the wake of the Global Financial Crisis, I'd say financial stability is much stronger than the consensus believes.

It's easy to get confused, though. You see, the early financial history of the Republic was marked by economic expansion and stability. The constant state of war between Revolutionary and then Napoleonic France and England was devastating in terms of human life and resulted in tectonic political shifts across the European continent. It was also highly auspicious for the young United States, which profited handsomely from the militarization of the global economy.

Of course, when the banking failures that followed the termination of this dynamic in global and economic affairs economically crippled the new Republic, vicious recriminations ensued between political parties. It started a debate about the federal government's role and centralization in banking policy that still rages to this day. It also unleashed a customary process of blaming your adversary for the banking crisis of the day, regardless of fact.

In retrospect, though, it's clear that despite the colorful political rhetoric and salacious explanations for the economic turmoil, the ultimate culprit was Emperor Bonaparte. His disastrous defeat at Waterloo was surely the ultimate root of America's first banking crisis. Certainly more so than many blame-laden political narratives advanced at the time, even if they contained elements of truth.

I use this allegory only to highlight that the high emotional tenor that always surrounds banking collapses can obscure the truth to the detriment of ascertaining the effect it will have on markets. While many may present cynical narratives about recent events around First Republic Bank ( FRC ), I think Powell, Dimon, and many who know the banking system well are correct and genuine when they say the worst of the banking crisis is behind us.

Despite indicators like yield curve inversions that are flashing imminent recession, and the fear spreading from bank failures, net charge-offs at banks and the credit condition of US households and corporations do not suggest the type of rolling waves of bank failures caused after the financial crisis.

Hundreds of bank failures occurred after the financial crisis, and the system was dramatically undercapitalized. That is very different than three banks with specialized business models which are amongst the most dependent on uninsured deposits failing because of pernicious Twitter sewing circles.

This is a liabilities problem, not really an asset one at this point. Loans are still performing, even though credit standards are tightening in the wake of the banking anxiety.

An important thing to remember is that when Regulation Q was still in place before Greenspan's wave of de-regulation, the Fed would purposely try to induce credit crunches, similar to what is occurring and will likely follow, by raising the Fed funds rate above the deposit rate ceiling.

Of course, with Reg Q ceilings in place, this made policy more draconian but also more controlled, and the effects tended to be abbreviated.

So, in the past, they would cause the very type of deposit flight to higher-yielding instruments like MMFs on purpose, like a controlled burn. Coincidentally, the fact that MMFs are even seen as a haven is also a check in favor of intact financial stability. The problems we face today are certainly better than MMFs breaking the buck.

Seen in this light, the current banking crisis is not as acute as hyperbolic coverage would indicate. This is another opportunity at the idea of rhetorical arbitrage that I discussed in my recent piece on Exxon Mobil ( XOM ). Powell's bold bet that he has a better handle on financial stability than the market is seemingly backed up by the data and a suite of shiny new tools.

Remember, the stock price weakness in regionals is likely more about the uncertainty around their future profitability rather than predicting imminent waves of failure. Analyst Jim Bianco calls this process a "bank walk," which is a good term for it. He has great analytics on Twitter pertaining to the subject.

The critical variable is CRE, and given that this industry recently was looking down the barrel of a .44 as COVID caused unprecedented demand uncertainty, the risk management here could be more robust than the consensus believes. Even if acute weakness does occur, it will likely be regionally concentrated.

So the competitive consequences of the trade-offs made in Dodd-Frank and interstate branching reform are coming to fruition rather quickly, which is unfortunate. But remember, the biggest guys have separate resolution regimes from all other banks for a reason. Regulators can handle failures of banks that aren't systemically important. And despite the uproar, they've proven that three times in a row.

But rolling bank failures and economic panic that forces the Fed into cuts before the year-end seems quite unlikely unless another Black Swan emerges that would tank markets. Say, maybe a US default or a close call.

However, that's precisely what bond markets are suggesting. So, for this reason, even though there could be a pop on the pause baiting Powell did, the bias is to the downside, since the likeliest outcome - in my estimation - is for rates to stay elevated for the remainder the year.

While you might have thought the banking crisis is a card that helps the bond market's hand in the divergence of rate expectations, I think it actually makes the Fed's rate projections more likely to materialize than those implied by the market.

Powell's Poker Prowess is Reconfirmed

Markets, of course, wanted more than the continued ambiguity. Of course, a rally and congratulations on a job well-done for vanquishing inflation would have been friendly and merry. However, Powell also ominously mentioned he's still expecting a protracted process to wrestle inflation down to the 2% target. The press tried to nail him down on a definitive statement about the prospects for a June hike.

He danced around the issue, teasing them about as much as he could before walking it back and saying the FOMC would have to look at the data. He specifically mentioned a significant change as something participants should pay attention to. He did say the Fed may be done.

CNBC's Steve Liesman referred to the approach taken by the Fed today as a "halfway house" to a pause. I think this is a good description. It was wise of the Fed to give itself some additional flexibility before definitively proclaiming the end of such a vital cycle.

Psychologically, this made a lot of sense for the Fed to do. It also showed confidence to a traumatized market that today's banking crisis does not present the same risk to the economy and capital markets stability as in the wake of Washington Mutual's failure.

Powell's lack of a definitive stance on whether this was the last hike gives the FOMC additional flexibility to navigate a world obscured by the after-fog of COVID, which has upended data and broken down reliable correlations all over the universe of important relationships. Powell is metaphorically blinded from the anomalous data situation, but so is the bond market in many respects.

Where Does The Market Go From Here?

While there's always acerbic Monday morning quarter banking on Powell's performance, particularly from the fixed-income crowd, I'd say Chairman Powell handled this particularly tough presser adeptly. As I mentioned a few months ago, I was already starting to gain more confidence in his poker-playing prowess .

I think the market could bounce around in the range it's been in based on daily banking developments and since another reprieve occurred in expected earnings write-downs. However, given the prospect of further hikes remains on the table, I view a violation of the recent range to the downside as more likely than a breakout upward. Violation of October lows isn't much likelier than new highs before the pause formally begins.

The pause hasn't begun yet, though, despite the insinuations of Powell. Once it does, I will re-evaluate my bearish position on the S&P 500's most widely used ETF. Until a pause begins, I think markets will remain choppy and range-bound with a bias to the downside and low probabilities of upside breakouts.

This is mainly because the market is pricing forced cuts by the Fed, and I think such an event is unlikely given the robust government actions to stem the bleeding in banks on the asset side. If such an event occurs, it will mean a significant downside swoon in markets before the Fed provides relief. In such situations of the past, relief stops bleeding - it doesn't propel the market to new highs in short order.

This helps me have confidence in being biased to the downside in the medium term despite the historical market performance following FOMC meetings in this tightening cycle. A short-term pop could occur, but I would guess it is not sustainable.

Risks and Where I Could Be Wrong

I know the banking crisis is nothing to be sneezed at. There is also a gang of potentially vicious Black Swans stalking the market; the banking crisis is at the fore right now, but more threats to markets are waiting in the wings. Apple ( AAPL ) earnings are coming up and could launch the market upward if they come in significantly above consensus.

I am making a bearish call on the S&P 500, even though the historical tendency in this cycle is for a post-conference rally. Of course, outcomes diverge widely from the composite. This is risky, and I could very well be wrong. My former colleagues put together the handy chart below:

But the even-scarier debt ceiling crisis is just about to take its place. While earnings haven't collapsed, I don't find it likely that they'll support valuations by accelerating either, particularly with the damper on credit conditions. But the flock of Black Swans could prove the bond market correct, to be sure.

• Escalation in Ukraine or Taiwan
• Fed policy error
• Widespread corporate defaults
• Banking crisis worsens
• Return of inflation
• CRE meltdown
• Write-downs of private assets

The most significant risk to my thesis is that the market fixates on the prospect of a pause, not a hike. A rally could gain momentum that's hard to stop and get us to higher levels. Still, I think we're going to move toward the lows before the post-tightening cycle relief rally can begin, fueled by multiple expansions.

The market could focus on the banking crisis not being systemic, but I think recency bias and trauma from the crisis preclude that from happening. If it does, though, markets could rally big time. As someone with extensive experience with banking supervision and regulation, it's difficult for me to anticipate how "the crowd" will interpret the banking events.

In a Keynesian Beauty Contest sense, the crowd appears to be interpreting events around the banking failures very differently than experts, so this is a risk. Ultimately, price is the ultimate decider. The range of markets reflects the uncertainty and ambiguous data.

I think Powell's adept bobbing and weaving at the press conference has ensured that neither the bulls nor bears have a decisive advantage over the other yet. The waiting game continues. Stay frosty around crucial data releases.

Conclusion

I believe that the comparable properties between stocks and bonds are significant drivers of flows and prices, and I think the data speaks for itself on this assertion. The market is a forward discounting mechanism, and it certainly looks ahead, but Powell did not give the "all-clear" that could have resulted in the sea-change in sentiment necessary for a bullish breakout.

Volatility, which has the property of being very mean reverting , has hit recent lows. Despite a spike in regional bank woes, I suspect it will move more toward its long-term averages than to lower bull market levels. I think the low was likely made for the VIX, and we'll experience elevated volatility until the next Fed meeting, potentially after a short rally.

It will be hard for stocks to break out sustainably and hold new levels without some help from the Fed, and they weren't ready to give it today. Given other downside risks, and even if the bond market ends up being right, it will likely be against a backdrop of a free-falling market. If the bond market is not right, which is my base case, and the Fed is then higher for longer, it will continue keeping a lid on the heights the market can achieve.

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