Confidence Men (Committee)

More Confidence

To call Wednesday an eventful day is an understatement. Treasury responded to concerns that their above their advisory committee suggested bill issuance they initiated in November to stabilize the bear steepening Treasury market selloff was draining excessive liquidity, potentially causing an earlier than planned end to the Fed’s balance sheet contraction (QT). Increased coupon issuance and net negative issuance of bills in 2Q, all things equal, should steepen the curve primarily through higher maturity longer maturity yields. Of course, all things were definitely not equal on Wednesday; Chair Powell faced a stream of less than interesting questions until he was finally asked specifically when they were likely to start cutting rates, and he dunked on all the March forecasts. Finally, near the end of the presser, he was asked about the balance sheet by the Axios reporter, and he responded that a detailed discussion was likely in March and there was no fixed threshold for RRP, currently $513 billion, down from a peak of $2.375 trillion, that would trigger a QT taper.

If nothing else had occurred, the Treasury market likely would have bear steepened, but something else did. NY Community Bank and Aozora Bank results and share price reactions (-30+%) are a manifestation of the risks emanating from the deepest yield curve inversion since Volcker’s impact on real estate and the misguided capital increase proposal from NEC Director Brainard, Fed Vice Chair for Supervision Barr, FDIC Chair Gruenberg and acting Comptroller of the Currency Hsu. When the dust settled Wednesday evening with 2s -12bp, S&P’s -80 points, the S&P Regional Bank ETF (KRE) -5.85% and the market still pricing a YE24 policy rate below 4%, the market concluded the Fed was on track for a nonlinear tightening of financial conditions (breaking something). The regional bank equity carnage continued Thursday, falling an additional 6.3% in the morning before recovering somewhat later in the day, thereby extending the safety bid for USTs. The 5-day return for the S&P Regional Bank (KRE) ETF is -7.21%.

Our interpretation of the Chair’s responses to reporters that the Committee needed ‘more confidence’ that the 6 months of disinflation was not transitory, was that the base case, namely another quarter of 0.2% core personal consumption deflator reports without triggering the Sahm Rule (4% unemployment), would only result in three 25bp cuts in ‘24. This is ‘soft landing’ base case, the committee would ‘proceed cautiously’ by reducing policy rates in a measured fashion from ‘well into restrictive territory’. In this scenario, it seems unlikely the curve would disinvert enough to reopen the bank credit channel sufficiently wide, given the capital requirement proposal, for banks to play a role in financing the federal government, real estate or small business sector. When Chair Powell characterized the risks as balanced, what the markets heard skewed towards more aggressive cuts, and while he didn’t provide any color on their inflation outlook, Thursday’s ISM Manufacturing Prices Paid and New Orders highlights the risk of the outsized role of goods deflation in the 2H23 cooler than expected core inflation. In other words, resilient output and employment growth, combined with a recovery in core goods prices due to either supply chain disruptions (Red Sea) or a recovery in global trade and manufacturing, from the current -2.5% 6-month annualized rate, absent a significant offset from housing services (much smaller weight in PCED than CPI), could result in an even later start in the coming cutting cycle. That said, the inverted yield curve, big increase in Treasury coupon net supply, delay in tapering QT and cooling demand for labor imply a greater risk of aggressive cuts than no cuts. In other words, we agree with Chair Powell: policy is well into restrictive territory. With big tech earnings pushing total S&P 500 earnings into positive territory, the dynamic sector is overcoming interventionist policy, but the Treasury market is way over its skis and due for a drubbing.

Figure 1: Contractions in commercial & industrial loans are typical during recessions, but contractions in bank credit are not. Only during the ‘94 and ‘23-’24 hiking cycles did securities holdings turn negative. We don’t understand why the deep curve inversion and contraction in bank credit doesn’t appear to be an issue for the FOMC.