Fed pauses - now what?
The Fed hiked 25 bp last night and signaled a pause by removing the phrase “some additional policy firming may be appropriate” from its statement. The market is assuming that this is the last hike in the Fed’s tightening cycle and is now looking for signs of when the first cut will happen.
What made the last two days more eventful than the Fed was the sharp drop in US regional banks. The US regional bank ETF KRE dropped 8%, with small banks such as PacWest, Western Alliance, and First Horizon dropping 30-60% over the last two days.
Concerns over the banking sector pushed 5 and 10 yr Treasury yields back to the year’s lows, while gold (my favorite long) tested resistance at 2070.
I previously touched upon the problems in the banking sector and the knock-on effects they would have on commercial real estate lending. Those problems will not go away just because the Fed paused. There are three places people can park their cash and earn a safe yield right now - T-bills, the reverse repo facility (via money market funds), and bank deposits. Bank deposits are the least competitive in both yield and counterparty risk, which is why deposits continue to leak out of the banking system and flowing into T-bills and money market funds, subjecting the most vulnerable banks to runs.
This week’s panic should be contained, as the three hardest hit banks today (PACW, WAL, FHN) have a combined deposit base of $137b, slightly more than First Republic’s $104b. If we see a run on a super-regional bank such as US Bancorp or PNC, or a large European bank such as Deutsche or Socgen, that would elevate this crisis to another level. For now, I think this will play out more like a slow-motion train wreck as tightening credit slows down the economy and several banks get snuffed out every few weeks or so.
With each flareup, Treasuries will surge higher to price in cuts over coming quarters, which in turn pushes USD lower. In the near term I expect these rallies to fail, as the Fed will not cave easily to market pricing, as core inflation is still sticky at 5-6% annualized. Policy is restrictive but not that restrictive, barely sitting above nominal GDP growth of 5%. The road to the Fed’s 2% inflation target will be a long one and it’s even questionable whether we will get there.
The end result is that bank failures are dealt with by the Fed pumping liquidity back into the financial system rather than cutting rates. Perhaps this is why gold has been so sensitive to selloffs in KRE, even more so than Treasuries. Net liquidity surged after the Fed created the BTFP facility for banks struggling with losses on their held-to-maturity portfolios, while the discount lending window helped banks survive deposit flight. The current environment is akin to Jerome Powell holding one foot on the brake pedal (keeping rates high) while hitting the gas with his other foot (pumping liquidity) to rescue failed banks.
The FDIC is doing the heavy lifting when it comes to making depositors of failed banks whole, as well as backstopping losses on the portfolios of failed banks. Take a look at the terms of the sale of First Republic to JPM. The FDIC is covering 80% of all losses on First Republic’s loans and providing a new $50b 5-yr fixed rate financing.
There have also been calls by policy makers to expand the $250k FDIC insurance threshold, which would require an act of Congress to push through. If it reaches Congress and passes, this would significantly increase the amount of capital the FDIC would need to put up when banks fail. For now, the FDIC Insurance Fund only has $128b in it, collectively funded by all the commercial banks in the US. If continued bank failures exhaust the capacity of the FDIC Insurance Fund, additional funds would have to first come from healthy banks (who are struggling already), then the Treasury, and ultimately the Fed.
How does a global macro trader navigate through this environment? If failed banks = more USD liquidity, then gold should be supported on dips. Eventually the pressure will be strong enough to break through all-time highs at 2070 in spot and start a new bull market. If the view is that rates stay high for longer than the market expects, then rallies in near-term SOFR futures offer great selling opportunities. The combination of these two strategies could allow for profits to be made as the market whips between risk-on and risk-off.
In the meantime, the US economy will slow-dance into recession. If inflation falls faster than growth, then the Fed will be able to support the economy and banking system with rate cuts and perhaps engineer a mild recession. If growth falls faster than inflation, that support from the Fed will be less forthcoming, raising the risk of a hard landing.
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