The Federal Reserve Monetary Policy Committee is meeting this week. After that meeting on Wednesday, they will comment on the state of the economy and banking industry. They will also announce a change (or not) in their target Fed Funds Rate.
The Fed Funds Rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It is the primary tool used by the Federal Reserve to influence interest rates and credit availability in the U.S. economy. The Fed charges a similar rate at their Fed Window when banks need to borrow from the Federal Reserve to deal with liquidity issues. Since the Fed does not want banks to rely on them for funding, they typically charge something higher.
Borrowing money from the Fed is an act of desperation. They are the lender of last resort. So they lend to banks when nobody else will. Since borrowing from the Fed is a last-ditch effort to keep a bank liquid, the names of banks that borrow from the Fed are kept secret for two years. By this time, the bank will have got its act together, and releasing such information would not impact people’s perception of the bank.
The Fed has put itself between a rock and a hard place. As we discussed in our post titled bailouts and sinking ships, the Fed smashed the health of banks by purchasing over $5 trillion in U.S. Treasury and Mortgage Backed Securities. In the process, over $5 trillion in new cash landed on the banks’ balance sheets. Since companies did not need to borrow that money, they bought massively issued overvalued debt securities the U.S. government was issuing. It was only a matter of time before the rate rose again, sending the price of Treasury security down sharply. So now, many banks are insolvent.
About three weeks ago. JPo gave testimony to Congress, and the Target Fed Funds rates sat at 4.50 to 4.75%. In that testimony, he said that inflation is still hot and expected it to be sticky. Going into that meeting, the consensus was that the Fed would increase the target Fed Funds rate by 0.25% and another 0.25% after the meeting in May. The probability of further rate increases was more of a coin toss. After that meeting, the consensus shifted to a 0.50% rate increase this Wednesday, with a series of rate increases of 0.25% or more afterward.
The collapse of Silvergate Bank, Silicon Valley Bank, and Signature Bank over the past week, along with UBS’s rescue of Credit Suisse, has changed everything. The world just realized that regional banks are in trouble, and the Fed needs to act fast and fire up the bailout machine. The Fed quickly lent $200 billion from their discount window, and we suspect more is taking place. The consensus view of a rate increase has changed.
The Fed Funds Futures suggest an 83% chance that the Fed will increase the rate by 0.25% and a 17% chance they will leave the rate unchanged. This is all fine and dandy, but we think it will be the wrong thing to do no matter what the Fed does. They are in the classic position of being between a rock and a hard place with nowhere out. If they are the rate by 0.25%, they increase the cost of funding for banks. Since they are stuck with bonds yielding 0.5% or less at purchase, the loss of carrying those securities will grow. More banks are likely to go under. In our experience, the Fed does what the Fed Funds Futures expect. So we expect them to raise the rate and announce that there is not likely to be any more rate increases until the banking problem is cleaned up. People will rightly conclude that the Fed is putting the banking problem first and that addressing inflation must take a back seat. It is possible that long-term bond prices could fall on this news. Higher inflation makes bonds worth less as people lose purchasing power. So they demand higher rates to mitigate the loss in purchasing power. Higher long-term rates will hurt share prices as well. So we are looking for stock prices to fall after the announcement.
So what should the Fed do? Raising the rate by 0.50% is out of the question as it would smash the banks by increasing their cost of funding. This will lead to a calamity that none of us need. We do not think they should do that, nor do we believe they will. The chance of that in our mind is zero.
If the Fed was only concerned with the banking industry, we think they should stand pat. But here is the problem. Everyone is expecting a 0.25% rate increase. If the Fed does not go through with it, people will ask, “what do they know that we do not?” This will cause a rush to sell stocks and potentially buy bonds in a flight to safety. Such a move in the bond market would cut banks’ losses in the “held to maturity” portfolios. Such a mover in stock prices would smash everyone else.
As a result, we see a scenario where bond prices could rally or one where they could fall. However, we do not see a good scenario for stock prices. It is possible that stock prices could rally if JPo can convince the investment world that the trouble in the banking industry will kill the inflation genie and rate increases are no longer necessary, essentially arguing the market will do the Fed’s job for them. Hard to see how JPo threads this needle successfully, but who knows? Asset prices can do anything it wants.
We are not going to suggest any trades today or Wednesday. We want to wait to see what the Fed says and how people react. We have presented some hedging structures using SPY and IWM as the underlying instrument. For nearly a year now, we have suggested that traders and investors take less risk than usual. Bear markets are vicious in b both directions. Prices seem to fall out of bed for no reason. These sharp drops are followed by short squeezes that take the price back up, but not up to the point where the selloff began. This process frustrated both the bulls and the bears. When it is all over, share prices are much lower, creating opportunities for those with the patience to wait for the right time to buy. Remember, “to have money at the bottom, you have to have money at the top.”
Our working thesis is that a significant bear market started at the beginning of 2022. It took prices down in a choppy fashion that constantly “kept hope alive.” Throughout the past year, we explained that the bear market would confuse people because the economy would be strong, and so will employment. Those two economic features are still true today. It would not be a recession-induced selloff but one caused by rising interest rates. The math here is simple. The value of assets falls when interest rates rise and vice versa. A nice counter-trend rally started in October 2022, and we think it ended in February 2023. This rally was long and powerful enough to erase the memory of the pain the market dished out in the first leg of the bear market.
We think the second leg of the selloff will accompany a drop in profits and pain associated with higher debt levels in all sectors of the economy. Banks will tighten credit standards as they shore up their balance sheets. They will be a better seller of bonds as they work out of the held-to-maturity positions. Interest rates may fall slightly, but the process is close to the end. The next thing investors will focus on is Government interest payments.
According to The Office of Management and Budget expects, the deficit for the fiscal year 2023 to be $1.3 trillion. It was over $2 trillion per year in the past few years as the government dropped money from helicopters on people and companies during the C19 lockdown. This estimate will surely be exceeded as the government bails out the banking industry again. It is clear they have no intention of balancing the budget, much less paying down the debt. Interest expenditure is running at a rate of $850 billion per year. Notice that number on the chart above is going straight up, and we expect that trend to continue. The government will be hit with a double whammy. More debt and higher interest rates are already leading to an explosion in interest payments.
As a point of reverence, the OMB expects the government to collect $2.4 trillion in personal income taxes and $0.5 trillion in corporate income taxes. We estimate the average interest rate paid on government debt is currently 2.6%. We expect that rate to rise to 4% at least as the government rolls over its debt as it comes due. So we think interest payments are on their way to $1.3 trillion within the next few years. It will not be long before interest payments consume half the personal income tax. The government will take the easy way out and borrow. It does not matter what political party is in charge; the deficit will get bigger as the government spending commitments are etched in past legislation. This is why we do not see interest rates falling significantly from here. Interest rates are in a doom loop. The secular drop in rates since the 1980s is over.
But what about the super short term? How do the charts suggest stocks will trade in the short term? Our reading of the short-term price chart is shown below.
The charts indicate that the past of least resistance is down. If the JPo’s p presser does not go well, stock prices will fall immediately. If he can thread the needle, stock prices may bounce slightly but will ultimately be met with selling. We do not see a bullish scenario. That does not mean it does not exist. It means we do not see it. Stay on your toes. We just might see a spectacular fireworks display in the weeks and months ahead.
Photo by Martin Petras: https://www.pexels.com/photo/white-and-red-firework-burst-287487/
