From Hawk to Dove

Last Sunday, when the BTFP facility was introduced to try to save the regional banks from bank runs, you had a big rally overnight which faded huge, with a 130 point swing from top to bottom before the cash open.  This time, you didn't get that big rally off the Credit Suisse bailout news, as you didn't have a "clean" bailout, as some bond holders ate giant losses in the process.  You had people on Twitter going on a tizzy over the lack of bailout for all bondholders as the equity still retained some value.  This will be forgotten about in 3 days but it got the bears excited for a moment.  The staying power of these headlines gets shorter and the effect gets weaker. 

When stocks struggle to go lower even as you continue to get bad news headlines about systematically important banks under stress, you know you are late in the selloff.  Its been over a month since the market topped out.  Most of the nervous stock holders have already sold at this point, and you will need to break technical levels at SPX 3800, and below to get stop loss selling and the fear necessary to get a swoon lower.  Given that the FOMC meeting is on Wednesday, the bears don't have much time left to drive this market down.  

In most cases, these scary news headlines are signs of a short term bad news bottom.  With the bond market rallying huge over the past week, you got some serious relief for the banks on the interest rate side, which cannot be ignored.  The regional banks will remain shaky until Powell cuts rates aggressively, mainly due to deposit flight for higher interest in money market funds.  But the money center banks should be fine in the short term, as they will be getting a lot of those deposits fleeing the smaller banks.  Beyond the next few weeks, without deep rate cuts, even the money center banks will be struggling.  They are too big to fail, so deposits are safe, but they also offer even lower rates than the regionals on savings, so they will also suffer deposit losses to higher yielding, risk-free instruments, especially as the public gets wiser on the huge interest rate differentials between bank savings and money markets.  

While the big bank headlines keep coming, the realized volatility has been dropping since the SIVB bomb first went.  This is typical price action when the market gets used to the daily negative news flow, and reacts less and less to each headline.  On a fundamental basis, I see more long term economic ramifications of these bank runs than systemic financial ones.  With the Fed and overseas governments willing and eager to backstop failing banks and to pump in liquidity without hesitation ($300B last week), you have taken away the short term systemic issues from panicked depositors/investors.  

The current issue worrying the market the most are the weakened bank balance sheets holding huge unrealized losses on their HTM portfolio, a problem that can be easily fixed with a hammer:  big rate cuts.  So its not going to be a long term problem.  Even deposits leaving the smaller banks can be covered by tapping the discount window or BTFP at market rates to avoid selling HTM bonds at a loss and the capital hit that comes with it.  The long term concern is the tighter credit and lending conditions that these bank runs have created.   They won't show up right away, so I am sure equity investors will forget about it over the next few weeks when the market calms down.  But these tighter conditions will be lasting, as the economic fundamentals are simultaneously deteriorating as excess savings are drawn down, and as housing slows even further.  Plus, you have the lagged effect of the 450 bps of rate hikes in the past 12 months, which the economy will feel more and more as the year goes on.  

I am optimistic in the short term as the market moves on from the banks to a potential end to rate hikes, which I expect soon.  As the stock market loves to do, it likes to front run future catalysts, and this time, it will be the much anticipated Fed pivot.  Paradoxically, the future economic weakness that these tightening bank lending and credit conditions create are what will allow the Fed to be more dovish and to end their rate hiking campaign sooner than most expected.  The stock market will have its usual Pavlovian response when the Fed is no longer hawkish and starts to signal a pause.  With the pivot in sight, the bond market will also add to the bullishness, as it won't be the weak link anymore which drags down equities.  I expect that bullish reflex response to push the SPX towards the YTD highs around 4150-4200, perhaps even a bit higher.  That's when things will get interesting.  That's when you can load up on a list of short names to ride down for the next wave down, which is usually the most brutal.  The one that comes after the Fed pivots towards future easing.  Below is an example in 2000-2001, showing price action after a Fed pause, signaling the end of a rate hiking cycle, and after the beginning of a cutting cycle.  

We are in a new phase of the bear market, the portion of the bear market when the economy notably slows down, but with that, comes lower bond yields which is initially embraced by the stock market as it looks forward to a Fed pivot.  These Fed pivot rallies are easier to short because they happen at the start of a recessionary environment of earnings declines and lower rates.  With all the angst over monster rate hikes and surging bond yields across the curve in 2022, it is only natural for the stock market to get excited about the end of this rate hiking cycle.  It is a trap.  There will be growing optimism in the coming weeks when the Fed heads are no longer talking 6% rates (Bullard, Kashkari, and other fair weather clowns), and instead have more balanced takes on future policy.  

I have low conviction on what Powell will do on Wednesday, but I am leaning towards 25 bps hike and dovish commentary that takes out talk of future rate hikes.  That will be taken positively by the Street, as a signal of a pause, and the end of this Fed rate hiking cycle.  Its possible Powell continues his hawk talk and leaves open the door for future rate hikes, which would NOT be taken well by the stock market, so I'm definitely not going to go into the meeting with bullish positions, but based on where we are in the monetary cycle, we are due for a Fed pivot rally very soon.  This should time up with seasonal equity strength from late March into late April, which is about as much of a rally as any bull should hope for.  At that point, it should be a free fire zone on the short side for stocks/ buying zone for bonds.  

One last note on the financials.  I expect financials underperformance on the next bear market rally.  Last week, you saw a lot of retail buying in the beaten up regional banks, a bad sign that speculators are playing for a bounce (chart of retail buying on the right).  They are the weakest hands and are guaranteed future sellers. 

Fundamentally, there are too many headwinds (mainly deposit flight to safer, higher yielding MMFs) and they are just not cheap enough to take on the possible go to zero risk.  They have become daytrader favorites, and they are exhibiting the classic daytrading intraday patterns.  Once the daytraders move on from the action, I expect these stocks to slowly drift lower over the next few months.