Bad Moon Rising
Last week’s events surrounding Silicon Valley Bank & Signature Bank, just to name a couple, served as a painful reminder of how quickly things can change, particularly when fear ripples across markets. I’ve often used the analogy of a boulder rolling down a mountain. It begins slowly and takes a lot of effort to push, but once it picks up speed it’s nearly impossible to stop.
Despite a government backstop of deposits over the weekend, new headlines today surrounding European bank fears have shaken market confidence again. As such, a flight to safety and swift move in fed rate expectations sent U.S. yields tumbling. In just one week’s time, the 2-year Treasury yield fell 118 basis points (bps) and the 10-year fell 53 bps.
Moves of this magnitude do not find themselves on a list of “stable market conditions.”
That said, the interesting part about these moves in yields is that the increase in Treasury bond prices (which move in the opposite direction of yields) has actually helped reduce the unrealized losses on bank balance sheets. But I said reduce, not eliminate.
Earthquakes and Lightnin’
If you are a newer investor, or under the age of 35, the only crisis you’ve likely lived through as a market participant is the pandemic. But even for those of us who are less youthful, it’s been 14 years since we saw stress in the system that was caused by financial market forces.
None of us want to relive what happened in 2008-2009, and I don’t think we will. I’ll stop short of saying this time is different, because I’m of the opinion that financial market crises tend to resemble one another on a number of different levels. The catalyst to bring us into them is usually what’s different.
If a serious drawdown occurs this time, the catalyst is likely to have been an extremely fast tightening cycle that appears to now be working its way into the system. That’s different from the layers of counterparty risk and bad loans that caused the Global Financial Crisis, thus the compounding risk is not as high right now, in my view.
However, it’s been my stance that despite the “soft landing” possibility and optimism, I couldn’t imagine a world in which we raised policy rates by nearly 500 bps in 12 months and trotted off merrily into a new bull market.
The Volatility Index (VIX) was unnaturally low considering the environment, which coincided with stocks being unjustifiably high, in my opinion. The last few days have moved both, and the massive drop in Treasury yields has also moved the bond volatility index (MOVE Index).
I recognize that this feels scary at the moment, and seeing a chart of volatility spikes can become a self-fulfilling prophecy where fear begets fear. I’m showing this to point out how nearly impossible it is to get ahead of a spike in vol once it starts. And how dangerous it can be to get greedy when valuations are high.
The good news about spikes in vol is that they don’t tend to last very long, but when tensions are high the minutes feel longer. And that’s when investor emotion gets stronger. The best thing investors can do right now is try not to let temporary emotions turn into permanent decisions. If you’ve put defensive positions in your portfolio, let them do their job. On big down days, most things go down, even the “safe” stuff. That doesn’t mean they’re broken over the medium-term.
Who’ll Stop the Rain
It’s not fun to be bearish, it’s even less fun to be criticized for it by those who are optimistic. But my job isn’t to please everyone, it’s to provide my intellectually honest view of the macro and market conditions.
The title of my 2023 outlook was, “This Ends One Way or Another,” and at the time I thought we’d see the end sooner rather than later. It’s taking longer than I expected, but what I was calling for was an end to the purgatory. In other words, the constant wondering of whether or not something would break, whether inflation would die of natural causes or a head-on collision, whether we’ve already seen the market lows of this cycle, and whether corporations could withstand tightening with a minimal hit to earnings.
Not all of these questions are answered, but I still think they will be before the year is over, and likely much sooner. Before then, the bigger looming question is what happens on March 22nd when the Fed gives us their next rate announcement. Will they pause in reaction to recent market stress or keep hiking because of inflationary pressure?
At the time of this writing, the market is undecided and fed fund futures show a 50/50 probability of hike/no hike. If the odds stay close to 50/50, the market move on the announcement is likely to be big. There is no such thing as “in line with expectations” when expectations are a coin toss.
Jerome Powell doesn’t call me for my opinion and I don’t get a vote, so take this with a grain of salt. But even if the Fed doesn’t hike next week, it’s not a sure thing that they’re done. A pause in hikes is likely to be paired with commentary that inflation is still a concern and they are going to wait a bit to determine if more instability is on the horizon before possibly hiking again.
If inflation is left undefeated, it poses more long-term danger to the economy in the form of stagflation, semi-permanent higher costs of capital, and recession risk that’s simply pushed out further. I don’t think the market will like a pause or a hike. That’s the rub.
Whether correctly or not, the Fed believes they have the tools to “save” us from stress induced by prior hikes. As uncomfortable as this last week has been, I don’t think it’s enough to assume they’re going to pump liquidity back into markets. In fact, I think a so-called “Fed put” (i.e., the idea of a rate cut or more quantitative easing) carries more risk than letting the market feel some pain. But again, I don’t get a vote. I just get to watch what happens live and give my best guess on what the market reaction could be. For now, my best guess is to value safety over heroism in your portfolio.
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