March 2023

Following the Federal Reserve-induced banking crisis that gripped the capital markets last month, much debate has focused on the next course of action.  Clearly, the Fed’s sharp and relentless rise in interest rates, and negligence of its regulatory responsibility contributed to the demise of Silicon Valley Bank and Signature Bank.  From that, an argument can be made that they should pause from any additional rate hikes to evaluate their action to date.  If for no reason other than to let any banks that extended duration too soon generate some net interest income.  However, an equally persuasive argument is that the inflation mentality is starting to become entrenched.  From our perspective, there were three big hurdles to overcome to justify raising rates at the next meeting, and all of them have flashed a green light for the Fed.  The employment report, the consumer price index, and the producer price index all portrayed an economy that is slowing, but by no means is falling off a cliff.  That should be enough to give them room for at least another 25-basis point hike.

Several money center banks were the first to report quarterly earnings results.  J.P. Morgan, Citi, and Wells Fargo all reported better than expected earnings for the first quarter.  Investors were fearful that the three would miss expectations or report balance sheet deterioration.  Contrary to that concern, all three reported better than expected results.  That’s not to say that we’re out of the woods with the sector.  Bank of America, Morgan Stanley, Goldman Sachs, TD Bank, and US Bancorp are all set to report in the coming days, with smaller regionals reporting later this month.

Also released mid-month were the University of Michigan surveys.  We like the surveys because they present an unbiased portrayal of consumer sentiment in real time, as opposed to the BLS reports that are massaged and seasonally adjusted to smooth changes.  In reviewing the results, we were surprised that the current conditions index actually rose to 68.6 from 66.0 last month.  While that’s well off the high reached in 2020, given the noticeable deceleration in economic activity we were surprised that it didn’t fall.  The other surprise, and this one is certain to be noticed by the Fed, is the 1-year forward expectations for inflation rose to 4.6% from 3.7% last month.  While that’s well off the 5.4% expectation touched last year, that consumers expect inflation to rise further despite the rate hikes to date lead us to conclude that inflation concerns are starting to become ingrained.  Exactly what the Fed had hoped to avoid.

Given the backdrop of slowing economic output, but stubbornly low unemployment, the Fed is likely to continue with its data-dependent philosophy.  At least in the near future.  But the Fed Funds futures market is anticipating that Fed will begin to cut interest rate later this year and take the overnight rate to about 3.5% by the end of next year.  Moreover, the coupon curve indicates that traders think the dovish response in 2024 is likely as well.  The 2-year/30-year yield curve has flattened from an inverted spread of 117 basis-points to an inversion of 38 basis-points over the last month, which makes perfect sense.  If the Fed actually swings to monetary accommodation, long bond investors are going to demand compensation for the inflation risk of an easier Fed.  This is all happening despite inflation continuing to rise at an uncomfortable rate.  Hopefully the Fed will understand that they are the cause of this economic outcome and not overreact during the next downcycle.

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