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home / news releases / VABS - The Fed Needs To Cut Rates Soon


VABS - The Fed Needs To Cut Rates Soon

2023-04-06 03:53:00 ET

Summary

  • For months, I have been pointing to clear signs that monetary policy has become tight enough to make a difference in people's behavior.
  • A pronounced steepening of the yield curve is the market's way of telling the Fed that they are going to have to cut short rates soon, and by a lot.
  • 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?

Since the failure of Silicon Valley Bank ( SIVBQ ) 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.

While it's very encouraging to note that swap and credit spreads are largely unchanged in the wake of the SVB failure (i.e., there are still no signs of an imminent recession, and liquidity in general remains abundant), there has been some significant capital flight out of smaller banks and into larger banks, and out of deposits and into money market funds and government securities. Since the end of February through March 22nd, commercial bank deposits have plunged by about $400 billion, according to the Fed. At this rate, it's reasonable to think that by now, deposits have plunged by at least another $200-300 billion, or almost $1 trillion since the end of last year. Depositors are voting with their feet, and they are almost running for the exits. Bank stocks have been hit hard, especially the regional banks. There's a strong whiff of crisis in the air.

As Chart #1 shows, the last time the bond market experienced something similar was in late 2007, just before the Great Recession. That's an uncomfortable parallel to say the least.

Chart #1

The top part of Chart #1 shows the Fed funds target rate (white line) and 2-yr Treasury yields (orange line), and the bottom portion shows the difference between the two. Leading up to the end of 2007, short-term interest rates had been rising as the Fed tightened, but then they began to fall precipitously. Notably, the Fed was very slow to follow suit, though eventually they did. By the end of 2008, the funds rate had fallen from 5.25% to 0.25% and financial panic had spread throughout the world. More recently, over the past year the Fed has been very slow to raise rates, always following the market instead of leading the market, since for way too long they thought that the big rise in inflation was just "transitory." Looking ahead, they will likely have to catch up to the reality of declining inflation and a slowing economy by lowering rates.

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.

For months, I have been pointing to clear signs that monetary policy has become tight enough to make a difference in people's behavior. Higher rates increase the appeal of holding cash and bank deposits, and they discourage people from borrowing to buy, say, homes. The housing market has been hit hard: since early last year, applications for new mortgages have plunged by 50%, refinancing activity is down by more than 90%, and the supply of new homes for sale has more than doubled. Nationwide, home prices have fallen since hitting a peak about a year ago. Existing home sales are down 30%.

The nascent banking crisis only serves to tighten monetary conditions, thus adding to already-existing downward pressure on inflation. Whenever a crisis starts, the public's demand for money (and safety) spikes. If that is not offset by a relaxation of monetary policy (i.e., lower interest rates), then deflationary pressures are the result.

Chart #2

Chart #2 shows that the percentage of service sector businesses that report paying higher prices has plunged to its lowest level in almost three years. This is powerful evidence that inflation pressures in the all-important service sector peaked long ago (in December '21) and continue to decline. The inflation problem that the Fed is determined to fix is definitely on the mend; lowering rates today wouldn't stop this. Not cutting rates would only increase the downside risks to the economy. The time to ease is before the economy shows obvious signs of weakness, not after.

Quick update on mortgage rates:

Chart #3

Chart #3 shows the relationship between 30-yr fixed mortgage rates and the yield on 10-yr Treasuries. In normal circumstances, 30-yr fixed mortgage rates tend to be about a point and a half (150 bps) above the yield on 10-yr Treasuries. (Think of 10-yr Treasuries as the North Star of the world bond market: the standard against which all other interest rates trade.) If the current spread were 150 bps instead of today's 344 bps, 30-yr fixed mortgage rates would be 4.8% instead of today's 6.7%. Mortgage rates today are hugely inflated relative to where they should be, and that has a powerful and negative impact on the housing market. They will trade lower only as the market loses its fear of inflation and its fear of an unexpected tightening of monetary policy.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

For further details see:

The Fed Needs To Cut Rates Soon
Stock Information

Company Name: Virtus Newfleet ABS/MBS ETF
Stock Symbol: VABS
Market: NYSE

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