QQEW - Recession Risk Rises As Powell And Yellen Slam Bullish Hopes

2023-03-23 06:00:58 ET

Summary

• Powell's remarks were generally hawkish. In particular, he pushed back against expectations of a pivot later in 2023.
• Yellen's remarks threw cold water on hopes for a quick and decisive extension of insurance guarantees for all US deposits.
• The combined effect of Powell's and Yellen's remarks was to increase the concerns of market participants about the risk of a US recession later in 2023.

On Wednesday, March 22, 2023, any market participants were hoping for indications that the Fed was ready to “pause” interest rate hikes and then “pivot” towards interest rate cuts later this year. Fed Chair Jerome Powell strongly pushed back against those expectations.

Furthermore, many market participants were hoping that Janet Yellen would announce a blanket extension of FDIC insurance to all deposits in the US banking system. US Treasury Secretary Janet Yellen strongly pushed back against these hopes.

Today’s clarification of Fed and Treasury policies by Powell and Yellen have sparked renewed fears of recession later this year. Both equity and bond markets reacted in a way that reflected increased assessments of recession probabilities.

Powell Remained Hawkish on Inflation

Regarding the future path of US monetary policy, Fed Chair Jerome Powell’s remarks were generally quite hawkish. He started by stating that inflation was far too high, and that there was a long way to go before the Fed could feel comfortable regarding the trajectory of inflation. Powell said that the last two CPI reports has been disappointing and that the overall economy and labor market were stronger than expected. As a result, Powell said that, prior to the banking sector crisis, the Fed was inclined to raise rates significantly above the level that was indicated by the last SEP.

In this context, Powell, acknowledged that the ongoing banking crisis could change the course of monetary policy -- but only to the extent that it provoked a tightening of credit conditions that was (more or less) equivalent to that which would normally be expected after several rate increase.

Although the current banking sector crisis might reduce the degree to which the Fed will have to tighten its monetary policy, Powell indicated that the Fed believes that further overall tightening of financial conditions -- from whatever source -- will be necessary to bring inflation below the Fed's target of 2.0%.

Perhaps the most significant thing that Powell said on Wednesday is that, notwithstanding the recent banking sector crisis, lowering rates before the end of 2023 was not something that the Fed was actively considering. Many market participants have been predicting (and/or hoping) that the Fed would pivot toward lower rates later in 2023.

Powell's remarks dashed those hopes and expectations.

Yellen Dashes Hopes That US Will Guarantee All Deposits

For the past week, there have been many prominent voices calling for the US government to provide a blanket guarantee for all deposits in the US banking system (including deposits of above $250,000). Representatives of numerous US banks have called for such a blanket guarantee of all deposits. Certain prominent US business figures such as Bill Ackman and Elon Musk have also been advocating for a dramatic and decisive change of policy along these lines.

However, in testimony before a Senate Committee hearing, Yellen threw cold water on this idea, stating that, “I have not considered or discussed anything having to do with blanket insurance or guarantees of deposits.” Furthermore, the context of her remarks implied that she believed that such blanket insurance coverage would likely require Congressional approval.

Passing new legislation that would provide a US government guarantee for all deposits would be extremely difficult to achieve. Aside from the political difficulties involved with passing such legislation, as I pointed out in a recent article , a universal deposit insurance scheme regime would be very problematic from the perspective of long-term US economic growth.

Yellen’s afore-mentioned remarks came near the highs of the day, sparking a 60 point rapid decline in the S&P 500.

Yellen’s remarks have renewed fears of further bank runs. For example, after the market closed, Bill Ackman stated on Twitter that, “I would be surprised if deposit outflows don’t accelerate effective immediately.” In a separate Tweet, he later added, “I fear we are headed for another train wreck.”

Regardless of whether one thinks that Ackman's policy proposals are correct or not, it cannot be questioned that many investors share his fears about the consequences of not instituting a blanket guarantee of deposits.

Investment Implications

The combination of Powell’s and Yellen’s remarks has increased concerns about course of the US economy.

Powell has made it clear that the Fed is prepared to continue raising rates to combat inflation, even if this means triggering a recession.

Yellen made it clear that there will be no easy or immediate solution to the bank runs that are currently plaguing the US banking sector.

As a result of the combined effects of Powell's and Yellen's remarks, US equities fell approximately 2.5% from their intra-day peak. US Treasury bond yields declined dramatically across various maturities.

Both types of market action were clear signs that financial market participants, at the margin, have increased their estimated risk of recession.

At Successful Portfolio Strategy , our strategic asset allocation changes significantly as our assessment of recession risk is modified. In this regard, our own macroeconomic assessment of recession risk did, indeed, increase marginally on Wednesday as a result of Powell’s and Yellen’s remarks. More generally, we believe that recession risks will increase very substantially if bank runs are not completely halted and bank funding pressures are not substantially relieved within the next couple of weeks.

From a short-term perspective, unless there is some sort of reversal of today’s remarks, particularly those by Janet Yellen, I would be surprised if the US equity market does not re-test recent short-term lows around 3808 on the S&P 500 and recent lows in US Treasury yields across the curve.

In terms of our intermediate-term outlook, we think that it almost entirely hinges on the evolving prospects for a recession later in 2023. The response of US authorities toward any further bank runs, and or bank funding pressures, will be critical in this regard.

As stated in recently published article , a confirmed violation of 3764 on the S&P 500 would constitute a strong signal that the marginal equity investor in the US market has shifted their base case assessment from that of a “soft landing” to that of a recession later in 2023. Independent of our own macroeconomic assessment, careful observation of the market action, can provide strong indications regarding whether, and to what extent, the recession risk assessments of market participants are changing at the margin.

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