May 8, 2023Scroll down
Quarter-point hike was the consensus outcome
Last Wednesday, the US Federal Reserve announced its 10th straight increase in the Fed Funds rate, raising its benchmark policy rate by another quarter of a point to a 5%-5.25% range. There was broad consensus that this would be the case, as futures put the likelihood of a 25 bps hike at nearly 92% in the day before the FOMC met. In his post-meeting statement, Fed chair Jerome Powell hinted at a pause as soon as the next meeting in June. Whether that comes to pass, of course, will depend on economic data released in the next few weeks. Bond traders are currently betting that the data will be conducive to a Fed pivot, predicting a reversal in course by July, as credit conditions continue to tighten and yields on the benchmark 10-year note ticked lower. Stocks fell on Wednesday, extending their losses the following day.
If the hike was in line, why did stocks fall?
We imagine part of the weakness in equities comes down to disappointment on the part of investors in the Fed’s delicate messaging as to where we go from here. In its March statement, the Fed said it ”anticipates that some additional policy firming may be appropriate.” In last week’s release, however, authors Powell et al. opted for modified wording, indicating that the central bank would “take into account” a range of factors “in determining the extent to which additional policy firming may be appropriate”—clearly a dovish edit to the statement, though we suspect the stock market expected a more explicit commitment to easing conditions. In its statement, the Fed also made clear that the magnitude of the banking crisis was uncertain and complicated the central bank’s assessment of when the policy rates have reached a sufficiently restrictive level. Even so, Fed Funds futures were pricing rate cuts by the second half of this year, reflecting continued expectation of a policy pivot in short order.
What’s the timeline for a pause, rate cuts?
We do believe that given various tightening tools running in the background and the ongoing credit crunch likely to further cool the economy, the Fed’s messaging here opens the door to a pause at the next Fed meeting—at present, we see it as the most likely outcome—though another quarter-point hike could very well come to pass if the job market remains tight and inflation appears to reaccelerate. Short of some serious calamity, in any case, it’s hard for us to imagine the Fed will begin easing as soon as this summer. Instead, we see Powell’s seemingly ambivalent stance as reflecting a central bank attempting to carefully cool an economy boosted by strong consumption using an indirect monetary tool. The chances have diminished, but we still see some slim hope for a soft landing: slower growth that gets inflation back down without an outright recession. Though it’s obviously far from assured, and we agree that Powell should avoid rushing to promise a pause while inflation remains so far above a comfortable level.
April jobs report reverses labor market cooling
Last Friday’s Bureau of Labor Statistics (BLS) report for April showed the US economy adding 253 thousand jobs for the month, on a seasonally adjusted basis, marking a sharp upturn after job gains slowed in both February and March. And while downward revisions in Q1 figures bring total jobs added in the first quarter to 222 thousand/month, significantly slower than the 400 thousand/month added in 2022, observing such labor market conditions in the face of continued rate hikes and more restrictive lending conditions amidst the US banking crisis must weigh on the Fed’s decision as to whether June should really begin a pause in this monetary tightening cycle. Meanwhile, recent data also show that US worker productivity declined more than forecasted last quarter, as job creation was offset by weaker GDP growth, resulting in a hit to efficiency metrics. The upshot, illustrated below, is that unit labor costs—i.e., the costs of hiring workers minus their productivity—continue to outpace price growth, putting corporate margins under even more pressure.
Growing wages, slowing growth point to stagflation risk
Looking at the chart above, we’re not convinced the Fed will be able to engineer a compression of margins that will bring down inflation without meaningfully slowing wage growth—which also popped 4.4% year-over-year in April, higher than the 4.2% economists expected. There are glimmers of hope that labor markets could be cooling. The prior two months’ slowing was a welcome development. Even in the lead-up to last week’s jobs report, data showed applications for US unemployment benefits rising by the most in six weeks (though continuing claims fell). Another issue worth noting is that labor market tightness doesn’t necessarily correspond to unconditional economic strength. Declining labor participation in recent years suggests that more people are opting out of the labor force and an elevated job openings to vacancy rate doesn’t perfectly map to new opportunities, but rather points to a demographics-related, pandemic-induced shortage of labor. If many of these opt-outs decide not to return to the labor force, a shortage of workers might keep costs high even as growth falters, increasing the odds of a painful period of stagflation.
Why couldn’t First Republic survive?
Last Monday, regulators seized First Republic Bank after the firm had been teetering on the brink of failure for weeks, marking the third large US bank to collapse in recent months and the second-largest bank failure in US history after Washington Mutual in 2008 (see below). Ultimately, First Republic succumbed to some of the same issues that led to the demise of Silicon Valley Bank (SVB) and Signature Bank before it: rising interest rates put immense pressure on the bank to offer higher rates to customers to keep deposits at the bank, while the high proportion of large clients in the bank’s deposit base—some 70% of accounts by mid-March were larger than the FDIC insurance limit—sent depositors on a run to withdraw as the bank’s fortunes dimmed. Indeed, First Republic’s uninsured accounts were the third largest behind SVB and Signature, compared with an industry median of 55% for mid-sized banks. On the other side of its balance sheet, First Republic was carrying a disproportionate heap of fixed loans with long terms and low rates, which were suffering heavy losses as Fed policy rates climbed. Eleven other banks injected $30 billion in March to keep First Republic afloat, but the flood of withdrawals, amounting to almost $100 billion, or around 40% of the bank’s deposits, proved too much. By comparison, Goldman Sachs estimates the average regional bank has only suffered a 5% drop in deposits, year to date.
Equity investors’ rebound hopes dashed
Investors had initially hoped that First Republic might hang on given its balance sheet, despite the problems mentioned above, was still far more diversified than SVB’s, which focused heavily on clients in the tech sector. Moreover, the $30 billion lifeline provided by peer institutions, along with a $70 billion line of credit extended by JPMorgan was aimed at giving First Republic some serious cushion against a bank run and calming public nerves over the institution’s viability. Plans to sell off underwater bonds at favorable terms and trim its workforce were proposed as means of shoring up the bank’s financial position. In the end, a devastating quarterly earnings report—not to mention management’s perplexing decision not to answer analysts’ questions—confirmed investors’ worst fears about the true depth of First Republic’s plight, and shareholders followed depositors in a rush for the exits. By the time regulators took over, First Republic shares had lost 97% of their value since the start of the year, wiping out more than $21 billion.
Despite averting systemic risk, the crisis isn’t over
In the days before seizing the bank’s assets, regulators sought bids for a takeover of First Republic. Ultimately, JPMorgan came out on top and will absorb First Republic: Jamie Dimon’s second fire-sale purchase of a massive lender, having also assumed control of WaMu, America’s biggest-ever failed bank, during the Global Financial Crisis. Upon agreeing to acquire First Republic, JPMorgan’s Dimon declared that “this part of the crisis is over”—but note his careful qualification that we’re only clear of “this part” of the financial sector’s woes.
Zooming out to examine the broader banking ecosystem, it’s hard to imagine the storm has passed. The current crisis reflects what we expect will be a long and painful hangover from zero interest-rate policy (ZIRP), as the Fed’s rapid tightening over the last year throws into disarray any investor, business, or industry that adapted to exploit the super-low-rate environment. Dimon’s deal for First Republic stabilizes the banking sector for now, but it could be detrimental to competition in the longer run, and with JPMorgan’s balance sheet already around $3.7 trillion, it definitely underscores the “too-big-to-fail” moral hazard in our financial system. On top of that, technology is proving a further challenge to financial stability, with digital banking allowing runs to happen in near-silence, while social media serves to sow confusion and amplify a panic. All of these developments, of course, raise the prospect of tighter regulation on banks, which certainly won’t be cheered by financial firms’ shareholders.
Thankfully, this time around it’s not that commercial banks are sitting on a massive pile of bad loans, though some borrowers will naturally struggle if we go into a recession. The problem is that banks haven’t been able to compete with the Treasury in terms of deposit rates, so they’re losing their funding source, which puts them in a liquidity crunch. As we’ve just seen with First Republic, the situation can be solved; it just requires someone liquid to take over those banks’ loans at a discount and wipe out the banks’ equity owners. Investors are advised to buckle up, as the exit from ZIRP promises to be a very bumpy ride.