Same Old Fed

You thought the drug addict was clean after going to rehab, but its the same guy.  He's still going to chase that hit, always remembering the feeling of that first one.  Trying to relive those fun memories.  You thought it was a new Fed, no longer addicted to QE, focused on fighting inflation, thinking this was the 1970s.  Raising rates to sufficiently restrictive, and keeping them there, higher for longer.  No longer reaching for the money printer when things looked a bit shaky.  Sike.

Wall Street is a big psychological experiment in real-time.  You get to see how opinions and views evolve based on recent history and the current news flow.  Its hard-wired into most our reptilian brains over millions of years of evolution.  The extrapolation of recent history into the future.  Hearing the same thing over and over again from analysts and "experts" and eventually believing it.  

In early 2022, after repeated lies about transitory inflation and obnoxious forward guidance that stretched out to 3 years in the future (Fed hubris at its worst), you had knuckleheads in finance and banking that ate it up and extended duration to reach for yield in MBS and long bonds in a ZIRP environment.  SIVB was just another victim of believing in the Fed's forward guidance, thinking that they would keep rates at zero until 2024, while inflation was blooming in 2021.  

Powell was the drug dealer selling low rates, offering a 3 year guarantee, and reneging on that pledge after getting his nomination confirmed, just as heat from the public and politicians about inflation was boiling over.  Some of the B-team execs working at the regional banks took his word: hook, line, and sinker.  They didn't hedge duration risk, as that dampens profitability.  They didn't run a balanced book, running sky high duration assets against very short duration liabilities.  Thanks to the Fed from 2008 to 2021, who conditioned everyone that rates above zero were always temporary, and would be immediately brought back down to zero in a slowdown.  

Now you had a lot of traders and hedge funds that got blown out on the six sigma move in STIRs, as they bought into the higher for longer mantra, that Powell was going to hike to 6%, that inflation was sticky, jobs market was hot, and that the economy is strong.  All balderdash, but it was repeated over and over again, so people started believing.  They built up huge shorts in 2, 5, 10 year Treasuries.  Even though Fed forward guidance of higher for longer is about as believable as transitory inflation and zero rates until 2024 was 2 years ago, people bought into it.  When lies are repeated, eventually people believe it. 

People get used to zero interest rates.  For 13 years, its been zero, or near zero. That's why so many didn't even think about pulling out money from their banks' savings account earning next to nothing for higher yields in money markets and T-bills.  In the past, money markets and T-bills were offering zero as well.  But with this SIVB incident, the news has been plastered with stories about bank runs, making people actually think about what there money is doing in the bank.  Its earning next to nothing.  They are getting robbed of huge chunks of interest, while absorbing the risk of boneheaded risk managers at two-bit banks.  A raw deal. 

There are some out there screaming moral hazard about the bailouts, but they probably underestimate how much panic was brewing.   Judging by the outflows out of the regional banks into other banks and MMFs even with a bailout, it would have been an absolute deluge of money seeking safety, and it would probably have been the modern day version of the Panic of 1907.  That would kill inflation on the spot if they let Schumpeter's creative destruction take place, but you know they would never let that happen after the fallout they got from not bailing out Lehman in 2008.  

So after this heart attack among the regional banks, you have suddenly educated the masses about the dangers of having over $250K in a non money center bank.  Plus, to add insult to injury, some of them will finally realize that money markets are paying nearly 5% and its safer there than at these regionals.  And that they were just giving money away to these banks out of sheer ignorance for the past several months.  That is reason you had $121B flowing to the MMFs.  I expect those massive flows to continue out of bank deposits into money market funds and T-bills.  At this pace, it will make a serious dent into the deposit base of banks and force them to make up for it by either selling their AFS (available for sale) securities or hitting the discount window to pay out deposits and not have to dip into their HTM securities, which would force them to mark to market all of their HTM assets, crystallizing the loss on their book.  It will continue.  The seal has been broken.  Genie is out of the bottle.  

There is a chart going around showing the huge increase in the Fed balance sheet over the past week, an increase of $300B, about half of the QT done so far since 2022.  While its not QE, its not nothing either.  That is liquidity that the Fed has offered to banks instead of having that liquidity taken from the private sector.  It is one of the reasons that you had a strong rally this week in both stocks and bonds.  I expect that upward trend to continue unless Powell splashes cold water on the rally next Wednesday and hikes rates and signals more hikes by saying inflation is still too high, data dependent, and downplays what happened with the bank runs.  No strong lean on what he'll do next week, but I think he'll be more dovish than Lagarde yesterday, while still hiking 25 bps. 

Its a tricky environment, the economy is rapidly slowing but the lagging indicators which the Fed focuses on are still hot.  Credit will get tighter, but the Covid stimulus was so huge, that the US economy is hanging tough.  There are still a lot of excess savings.  And there is also the carrot of a Fed pivot coming sooner than people think, so its a dangerous time to short.  You will get that Fed pivot rally before the Fed cuts rates.  It will come when everyone realizes that the Fed is done hiking, and can now look forward to rate cuts, even if the Fed lies and says they are higher for longer after a pause.  That is the one whopper of a bull catalyst that could run the market up for several weeks.  But it would also be the easiest one to fade as the economy will be right at the starting line of a deep recession at that point.  

Currently holding some bonds, but mostly cash waiting for a good entry point to either add more bonds on a dip or short some of the retail names if they pop up on quasi QE delusions.  Stocks have been quite resilient this week, and it never reached levels where I was looking to buy dips.  Investors are still hardwired to buy stocks when they see the Fed and Treasury bailing out banks, thinking that the Fed is now on their side.  Its a hard habit to break.  It can only be broken with capitulation, and we're not even close.