Something Has Broken, What's Powell's Next Move? | Morning Express | 3/21/2023

Posted: March 21, 2023, 8:56 a.m.

E-mini S&P (June) / E-mini NQ (June)

S&P, yesterday’s close:

NQ, yesterday’s close:

Fundamentals: The Federal Reserve begins its two-day policy meeting today and concludes tomorrow at 1:00 pm CT with a rate decision. Will they raise interest rates in the face of recent bank turmoil? The CME’s FedWatch Tool says yes to a 25bps hike with an 83.4% probability, whereas only 16.6% points to no move at all. The Fed took interest rates from zero to 4.25% last year, including an unprecedented four consecutive hikes of 75bps, before tacking on another 25bps on February 1st. Additionally, its balance sheet fell by from $9 trillion to $8.3 trillion from April 2022 through the first week of March. The steadfast policy tightening inverted the U.S. Treasury curve, with the 2s10s spread hitting a record low of -1.08% on Wednesday, March 8th, the day before

SIVB began its two-day death spiral, setting off a banking crisis, and the day after Fed Chair Powell surprised markets. On that Tuesday, Fed Chair Powell flip-flopped from an unwarranted victory lap on disinflation a month earlier to injecting fear and channeling his Jackson Hole hawkishness. Ultimately, he shocked markets, extrapolating rate hikes, underpinning a rise in the 2-year above 5%, the highest since June 2007, and set forth this chain of events within the banking sector. The Fed and Powell have been intent on breaking something in order to tame inflation, and he broke something that day.SIVB’s demise did not happen overnight, it was poorly managed with misfocused values, and neither did this crisis. The move in rates and the curve created insurmountable stress on banks’ balance sheets due to ill-managed bond holdings that were now losing value due to the rise in rates. Furthermore, sophisticated depositors began moving balances into interest-yielding assets, something banks were not providing in the typical checking account. Also, the Fed’s tightening slowed the venture capital market. For SIVB and some regional banks with close ties to banking venture capital-backed companies, this meant a loss of corporate deposits, which were now needed to meet day-to-day business obligations. Although this mismanagement was within a niche type of banking, it cannot be ignored as a canary in the coal mine. Credit Suisse was the latest domino to fall, but the writing was its wall for years. If rates were to continue moving higher and the curve deeper into inversion, there is no telling how widespread the turmoil could reach.

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Over these last two weeks, the U.S. 2-year yield fell from 5.08% to 3.64%. The moves across rate markets now discount a 25bps rate cut from the current 4.50% by yearend. Lower rates mean higher bond prices, and this has eased pressures on banks’ balance sheets. Although the landscape seems to have stabilized a bit, that canary in a coal mine could be an object in motion that has been set in motion and one that will remain in motion until derailed. Fed Chair Powell lost some credibility with his February-March flip-flop, and we believe inflation is showing signs of slowing. Additionally, the banking stress is expected to weigh on the economy as credit conditions and lending tighten. By some considerations, the Federal Reserve finds itself in a more favorable spot now than feared two weeks ago. However, its next steps must be chosen wisely, and we see a 25bps rate hike as highly likely because the words they choose can also dictate policy, and we expect a very thoughtful (dovish) communication.

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