Published on April 13, 2023
2023 has already been an eventful year, featuring a banking crisis and more Fed rate hikes. In our view, this is not a “set it and forget it” type of market – investors need to stay vigilant.
And We Thought 2022 Was a Crazy Year
Wow! What a start to the year this has been. We began with a full-blown risk-on rally, with lower quality and longer duration assets leading the charge. With no Federal Open Market Committee (FOMC) meeting scheduled in January, there was no rein on the exuberance. Pundits predicted a lower terminal fed funds rate and quick 2023 pivot to an easier monetary stance by the Fed, but we were skeptical. Sure enough, on February 1st, the FOMC spoiled the rally by raising the federal funds rate and announcing that “ongoing increases would be appropriate.” The soft-landing sentiment quickly hardened, leading to a risk selloff. Instead of arguing for a pivot and lower rates, as had been the case previously, investors reversed course and began calling for much higher rates – recency bias hard at work. To be fair, the sudden change of heart makes some sense, as the economic data have truly been a mixed bag so far this year. Weekly releases show either hot economic growth or slowing inflation, giving investors agita as they try to decipher which way the economy is going and what the Fed’s next move will be. Additionally, seasonal adjustments in January were much larger than usual, adding to the uncertainty. More on that later.
There have been no shortage of strategists, commentators, and armchair economists that have been saying that the FOMC was going to raise rates until they broke something. As is typically the case in tightening cycles, they finally did. For varied reasons, we saw the collapse of three banks (Silicon Valley Bank “SVB," Silvergate Bank, and Signature Bank), the forced takeover of a fourth (Credit Suisse), and two more that the market has soured on (First Republic and Deutsche Bank). Many wonder if this is 2008 all over again (hint: we don’t think so).
Perhaps a review of fractional banking would help explain why banks seem to falter with regularity. In fractional banking, banks take your deposit for safekeeping and hold only a fraction of it in readily accessible liquid reserves. They then lend out the rest in the form of mortgages, real estate, and personal/home equity loans. If there are not enough opportunities to make loans, they can lend to the government by buying Treasury securities. The difference in what the bank pays depositors and what they charge on their loans is the net interest margin, which is how the bank makes money. Think of those reserves as a cushion against losses on loans due to delinquencies, etc. If a bank keeps 10% of deposits, they have a 10% cushion.
Prior to 2008, banks enhanced their returns by holding less in reserve relative to what they lent out; this was a form of leverage, which at times exceeded 30 times their reserves, meaning that their margin for error was close to 3%. This did not end well. Post the Great Financial Crisis, regulators made banks keep more in reserves, called Tier 1 capital, and leverage was brought down. In spite of their grumbling, it forced the larger banks to be better capitalized, which helped them weather a very low interest rate environment, rather than seeking yield in riskier loans. But when the Fed started raising rates in 2022, and the yield curve inverted, this created significant stress for the banks, who typically fund themselves in the short-term market (what they pay for deposits) and lend in the long-term market (mortgages or in many cases, longer-dated Treasuries).
There were a few noted exceptions to the staid banking model we have just discussed, and they went into a severe downward spiral in March. Silvergate Bank, for example, was a darling of the crypto world with significant deposits tied to cryptocurrencies and links to the FTX collapse. SVB was an entirely different story. The bank was heavily reliant on the venture capital (VC) community, almost tripling its balance sheet over the last several years as VC firms invested in every type of tech startup they could find. These firms would then encourage the recipients of their capital to deposit their excess cash at SVB. As we discussed above, fractional banking works as long as you have enough in liquid reserves to meet withdrawals and you have enough assets that can be sold without a loss if there is a run on the bank. Unfortunately, given that many banks own longer-dated Treasuries, they now sit on unrealized losses in those securities (because rates have steadily climbed). In the case of SVB, as venture capital availability tightened, cash-burning startups needed funds to run their companies. Deposits began shrinking and the bank attempted to raise cash by selling part of its Treasury positions at a large loss.
The hope was that they would fill that hole with fresh equity, but alas, the equity markets said, “No thank you.” This is when things began to unravel quickly, as is often the case. In the age of cellphones and electronic banking, access to funds is instantaneous – no more long lines around the block to withdraw money. SVB experienced $42 billion in redemptions in one day, before the Fed stepped in. With memories of 2008 still strong and social media rapidly spreading the news, fear spread as other banks were singled out, especially First Republic Bank (FRC) and PacWest Bank. Depositors and the media did not ask if the fear was rational or whether FRC was similar to SVB. Sadly, a run is a run. Fractional banking has been in a boom-bust cycle since the Medicis introduced the concept centuries ago. Not wanting to repeat a “Lehman Moment” of 2008, the major banks, led by JP Morgan, deposited $30 billion at First Republic Bank to help meet withdrawals and calm depositors. The Fed also set up a facility where banks can exchange eligible assets for Federal deposits at face value, meaning that Treasuries trading at deep discounts can be swapped for a par amount of fed funds. So far, this has quelled some of the run, giving the bank time to raise additional capital and hopefully end this bank contagion. Stay tuned.
During the era of extremely low interest rates, depositors became inured to not receiving payment for their cash at the bank. For people old enough to remember what banking was like pre-2008, one shopped around for the best deposit rate (and the best prizes). Not so when everyone was essentially paying zero. Bring back the toasters! The alternatives, money market funds, were also not offering any yield and were soon forgotten by people who started banking in the era of zero rates. Jim Bianco of Bianco Research reports that in February 2022, we began to see a real divergence in the interest rate paid on money market mutual funds versus bank deposit rates. And by March 17, 2023, the former was almost 4% higher. In the same time period, approximately half a trillion dollars of new money was invested in money market mutual funds. It had to come from somewhere – most likely from savings accounts. No one has ever accused banks of being eager to pay for deposits, but since the outflows have become too big to ignore, we are seeing a movement to pay for deposits (anyone remember brokered deposits?). While this will stem some defections, it will also eat into profitability for banks until they can raise the rates earned on their loan portfolios. This will take time as very few customers will want to give up their low-rate mortgages. We see more headwinds than tailwinds in this sector for a while.
As we mentioned at the beginning of our outlook, seasonal adjustments during and post Covid are making the data more confusing. Add to that, economic surveys are becoming less dependable due to low response rates. The FOMC is having a challenging time deciding what the correct balance should be in fighting inflation with rate increases versus letting the economy just run its course. The Bureau of Labor Statistics (BLS) surveys by phone and electronically about 131,000 businesses and government offices or about 670,000 worksites. Typically, the BLS will conduct a first inquiry right after a specific period and then follow up two more times as businesses finalize their accounting. The response rate from those first surveys has been falling since 2016 from around 80% to about 65%. Thankfully, the response rate for the follow-up surveys has stayed relatively steady at around 90%. These follow-up surveys can be weeks later than the first survey. The problem is that with such a big disparity in response rates, the Fed and other economists are making decisions based on the first answer and then revising the data later, potentially significantly.
Since the beginning of Covid, these revisions have been getting larger, which makes relying on them to make decisions more problematic. This is also the case with the seasonal adjustments. For example, during their quarterly earnings calls, retailers generally report when weather has a significant impact on customer traffic. Investors often adjust their estimates to smooth out the impact of weather. The same goes for economic releases. Seasonal adjustments normalize the seasonality so data from different economic periods are comparable and forecasts for the future can be made. Usually, this is relatively straightforward and works over time to make comparisons relevant. However, during the pandemic we saw large swings in economic activity, from a severe shutdown with massive unemployment to a rapid rebound featuring strong pent-up demand and very low unemployment.
The dilemma is that these spikes in activity are more extreme than normal, which makes seasonal adjustments very imprecise – though they are still important. Paul Donovan at UBS points out that over the course of a year, seasonal adjustments should net to zero. The jobs report for January 2023 shows this economic conundrum clearly. The BLS reported January payrolls as a seasonally adjusted gain of 517,000 jobs compared to the average monthly gain of 401,000 in 2022. Looks like a strong data point, but the BLS also recently made a major adjustment to their estimates of the household population along with other revisions. As reported by the Wall Street Journal, the unadjusted, or raw January payroll number was a loss of more than 2.5 million jobs, or a seasonal adjustment swing of over three million jobs! If seasonal adjustments need to net to zero on an annual basis, we should see this three million gain reverse to an even bigger reported seasonally adjusted loss before the end of the year. It will be an important factor to keep in mind for the Fed so that they are not misled by headlines. Steve Blitz at TS Lombard noted that the seasonal adjusted retail sales gain in January was actually an unadjusted decline for the month. It is clear why investors are having a hard time forecasting, given the size of adjustments during and post Covid being so extreme. We hope that as the effects of Covid wear off, we get back to more tempered swings in economic reports.
We can also see this in the 2023 Consumer Price Index (CPI) comparison to 2022. To quote Jim Bianco again, “Between January 2022 and June 2022…the month-over-month change in CPI was much higher than in the 2020 period. This means the current monthly numbers will have a much higher bar to surpass if inflation is going to remain elevated.” So, any declines in the growth of CPI against a tough 2022 comparable will imply inflation is ebbing and the Fed can take their foot off the rate accelerator. However, Jim also points out that the comps flip in the back half of 2022, so the CPI results later in 2023 could look like they are rising again. This simply adds to the Fed’s dilemma.
As a final example, let us take a quick look at the U.S. job openings data (which goes back to 2000), also known as JOLTS and published by the BLS. This is a point-in-time snapshot of the total number of job openings that are reported by domestic employers, and it happened to peak in 2018 at 7.5 million job openings. Post 2018, the JOLTS dropped by over 1.6 million jobs to under 5.8 million openings during Covid. The current JOLTS reported number is over 10.8 million as of February 2023. Coupled with an unemployment rate of 3.6%, this would imply that the economy is extremely hot, and the Fed needs to keep raising rates to slow the economy down. However, according to reporting by the Wall Street Journal, those job openings may not really be actual job openings. As reported, according to a survey of 1,000 hiring managers, “close to half said they kept the ads up to give the impression the company was growing” and “one-third of the managers who said they advertised jobs they weren’t trying to fill said they kept the listings up to placate overworked employees.” These are sometimes referred to as ghost jobs, and there is no good way to isolate them from real job openings. So, the question then is: How much of this data is the Fed relying on to make its decisions? Setting economic policy and interest rates with murky data is difficult at best, risky at worst.
With all the adjustments and volatile year-over-year comparisons, we wonder if the economic releases now could be hiding that we are in a recession while the Fed is raising rates and perhaps later, as economic releases look more negative, do they need to cut rates even though we may already be in a recovery? Only time will tell.
This is not a set-it-and-forget-it market. Investors and/or their investment managers need to be active in assessing the data and managing portfolios. This goes for both economic data and corporate financial releases. Being a passive bystander in a market as challenging as this does not make sense. We continue to follow our disciplined investment process as we wade through the releases with a focus on finding the least risky way to generate strong risk-adjusted returns. With an inverted yield curve, we are getting paid on our cash and commercial paper as we hunt for longer term bargains. This is a confusing market with lots of headline noise, and it should benefit those employing common sense in a calm and deliberate manner.
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Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income
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The Job Openings and Labor Turnover Survey (JOLTS) program produces data on job openings, hires, and separations.
Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.
A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.
Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.
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