Been hedging around the pivot? Don't stop now

Something must give

It can't carry on like this much longer. We now know that Corporate America is in much better shape than many had thought, largely because the American consumer is also far more robust than many believed. The labour market remains obdurately healthy. And yet the confidence with which bond markets are now betting that the Federal Reserve must "pivot" (start cutting rates) and do so imminently has never been greater. This divergence has been present and growing for a while, but some resolution must now be close.

That's because fed funds futures now price a likelihood that over the next six meetings of the Federal Open Market Committee, from now until January, we'll see the equivalent of five 25-basis-point cuts to the rate (and plenty of other, more liquid markets are making much the same implicit prediction). Last week's rate hike from the Fed, combined with a dip in expectations for next January, brought the gap to its widest in this cycle: 

Cometh the hour, cometh the pivot

Either the Fed starts cutting rates soon, or the market has this very wrong.

This is based on various assumptions, but the idea that inflation will come under control very swiftly is critical to them. The two-year inflation breakeven (derived from the difference between inflation-protected and fixed-income bonds) suggests that inflation will average almost exactly 2%, the Fed's official target, into the first half of 2025. It's worth remembering, though, that breakevens can be wrong, particularly in the bizarre conditions created by the pandemic, which have made fools of us all.  This chart shows the two-year breakeven and the actual consumer price inflation number with a two-year lag, so at each point it compares the bond market prediction with the actual outcome. The peak in inflation, above 9%, came almost exactly two years after breakevens had suggested that there would be outright deflation by that point: 

Warning: Inflation predictions can be wrong

Two years before 9% peak inflation, the bond market predicted deflation.

The almighty shock of Covid-19 has made it very easy to be wrongfooted, so there's no necessary embarrassment in this. But with the shockwaves still moving through the system, it seems odd to bet with quite such confidence that inflation will be back under control two years hence.

That grows that much harder to grasp after looking at the employment figures for April. Perhaps the most useful gauge is the following, which shows the proportion of people between the ages of 25 and 54 who are in work. It rose steadily in the first four decades after World War II as women moved into the workforce. That epic social shift was broadly completed by the early 1990s — and since then, the ratio has been higher than it is now for only a year or two, around the turn of the century. The times felt good then. They don't feel anything like so good now, but much the same proportion of the working-age population has a job.

Employment could scarcely be stronger

The proportion of working-age people in work is close to the all-time high.

The Fed has a mandate to maintain full employment, and conventional measures suggest we're there at present. It's hard to see much reason to expect rate cuts from this. Meanwhile, the labor market is impacting inflation through wage increases, which put pressure on  corporate costs while raising demand. Average hourly earnings rose by almost 0.5% month-on-month in April, which is right at the top of the normal range (the following chart excludes the two or three extreme months from the pandemic in 2020 for legibility). This isn't evidence of a terrifying "wage-price spiral"; but it certainly doesn't suggest the Fed will feel comfortable to relent on rates any time soon.

Wage growth: Strongest in 12 months

Average hourly earnings continued to grow at a healthy clip last month.

As for the very short term, there's very little anticipation of a significant decline for inflation when the April numbers are revealed Wednesday. Both the Cleveland Fed's "Nowcast" and the average respondent in Bloomberg's survey of economists expects core CPI to be virtually unchanged. A big drop would validate the current rate calls — a surprise in the other direction might be harder to deal with.

The big fall in inflation isn't expected this week

Expectations are for core CPI to stay comfortably above 5% for April.

Why, then, the confidence that rates must come down quickly? Remember that employment is a lagging indicator, as employers treat layoffs as a last resort as the recession approaches. As rehearsed many times in this newsletter,  a range of usually reliable market indicators suggest that an economic downturn will soon be upon us. The Treasury yield curve is deeply inverted (still); leading economic indicators are pointing directly downward; the ISM supply manager surveys have been signaling a recession for six months. Commodity prices are falling, particularly oil, suggesting a lack of global demand. It's eminently reasonable to brace for a recession before much longer.

The more important question is whether it will come with sufficient speed and severity to force the Fed to cut rates at least five times over its next six meetings. The judgment of the Fed itself matters more than that of the National Bureau of Economic Research, the body charged with officially defining when a recession has occurred. The NBER generally only declares a recession many months after it has started. But the University of Michigan economist Justin Wolfers shares this chart of the measures the NBER takes into account. While the jobs market and particularly the consumer remain this strong, it's very hard to see a recession coming soon.

The best word to explain why the economy is so infuriatingly difficult to read is "Covid." The shock has not finished working its way through the system and, in particular, the extra cash that landed in consumers' wallets via stimulus payments hasn't all been spent yet. Judging how the consumer will behave in unprecedented circumstances is nightmarishly difficult.

What, then, should investors do about it? The beauty of investment is that you can hedge your bets. If the more dire recession predictions come true, then you probably want to crowd into bonds and get out of the US stock market, which is looking badly overpriced again. If the strength indicated by the first-quarter earnings is a more reliable indicator, then stocks should beat bonds. And if you're not sure, something in between.

Looking at the last 12 months, it does look as though many are unsure. Both 10-year Treasuries and the S&P 500 have been trading in a wide range for more or less all of that time. People are hedging their bets.

The confidence in a Fed pivot is so strong at present that there is more danger of a breakout toward higher yields. But it's best to avoid extreme positioning in any direction.

A very modern bank run

If there's one big reason to bet on a Fed pivot, it's the crisis afflicting US regional banks. The question is just how much of a crisis is it? Lest this sound Pollyanna-ish, after a series of bank failures on a scale not seen since 2008, it's worth looking at exactly what's happened. Banks' share prices have tanked, and the shareholders of the failed institutions have been cleaned out. No depositor has lost a penny. There is no panic as it would normally be understood. The Fed has even hiked rates twice since the closure of SVB Financial Group sparked the turmoil. 

This is a crisis for bank shareholders, arguably; it's hard to view it as a generalized banking crisis, at least as it's normally understood. And to cite someone with a bit more experience, this was the line that Warren Buffett offered over the weekend in his annual question-and-answer session at Berkshire Hathaway Inc's shareholder meeting in Omaha, Nebraska:

"The messaging has been very poor. You shouldn't have so many people that misunderstand the fact... that the FDIC and the US government have no interest in having a bank fail and having deposits actually lost by people. I can't imagine anybody in the administration or Congress or Federal Reserve saying I'd like to be the one to go on television tomorrow and explain to the American public why we're only keeping $250,000 insured. It would start a run on every bank."

He's right about this. Allowing deposits to crash would be so calamitous that no politician is going to allow it to happen. But if Buffett saw little danger of banking disaster, he also showed little interest in investing in them. He's played the role of financial rescuer in the past, briefly taking over Salomon Brothers in 1991 after the scandal over its attempt to fix Treasury auctions, and lending money at very preferential terms (to Berkshire) to the likes of Goldman Sachs during the turmoil of 2008. He also considered but decided against buying insurance giant American International Group.

The reasons he's not interested in buying banks at present are, first, that bank holding company laws stop him from taking a commanding share of more than one, and, second, that banks' profits look challenged. To explain the problem, Gerard MacDonell of 22V Research LLC invoked the concept of a "Bank Walk": 

"You may have recently heard the expression bank walk, which is meant to contrast with bank run.  In my opinion, the expression is helpful because it invokes an image of depositors responding rationally and calmly to shifting incentives, rather than acting in a panic. If deposits are assumed to be money good, but if depositors are more aware of higher returns elsewhere, then money will tend – ex ante, at the old deposit rates — to leave banks.  This will raise returns for depositors via higher deposit rates and thereby cut into bank profits by reducing net interest margin. It probably leads to a more efficient financial system in the longer-term and through that channel slightly higher living standards. So, it is difficult to call it "bad." But in the short to medium term, the hit to profitability and the sense of unease among bankers generally can – I hear – lead to tighter lending standards, through higher borrowing rates and non-price rationing."

The logic of the situation will lead to more consolidation, as has already been seen with the sales of SVB Financial Group and First Republic Bank. The US has a far more fragmented banking system than any other developed economy, so there is room for many more mergers — although this would have a big effect on the way smaller businesses raise their funds. As share prices of regional banks tank, so they will find it harder to raise equity finance and to hold on to deposits, leaving a sale at a disappointing price as their best option. It's not a great situation for bank stock investors, and the risk of extra burdens on the public purse, eventually to be extracted from future bank profits, is real. To lower the cost of taking over failed institutions, the Federal Deposit Insurance Corp. is considering sharing losses with non-banks (such as private equity groups) that are prepared to take them over — not a move likely to be politically popular. Some form of explicit deposit guarantee seems close to unavoidable.

Does this add up to a crisis that will on its own force the Fed to cut rates again and again? Probably not. Although that doesn't mean that all is good. The Fed's quarterly Senior Lending Officers Survey is due within hours of receipt of this newsletter, which will give the first solid evidence on whether the bank failures have forced to lenders to make credit harder to come by. And nothing that shakes up the banks can ever be safely ignored. Peter Tchir of Academy Securities made this point forcefully with a comparison to the Global Financial Crisis of 2008. He pointed out that it was largely a myth that nobody saw the problems coming — many had been sounding the alarm from the moment house prices started to turn down in 2006.

The main takeaway, he says, is that the market treated things as "solved" multiple times during those years, only to find out that they really weren't, or that the issue had changed.  Excitement about regional banks' rebound Friday, therefore, may well be premature. The outlines of a narrative that involves serious difficulties for many financial institutions as interest rates rise have been clear for years. It hasn't played out as quickly as many (myself included) had expected. Economic logic takes a long time to work its way out in the real world.

That proved true in 2008, and it will prove so again this time. Regional banks' shares are the casualties of imbalances that took many years to develop. Resolving the situation may well take just as long.