Financial update from Brewin Dolphin - 5 May 2023

May 2023

The Weekly Round-up

Friday 5 May 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the latest Federal Reserve policy rate hike, the impact of the banking turmoil and the threat of the US federal debt ceiling.

Rate hikes

From earnings season to interest rate season, we are in the midst of a two-week period which will see some key monetary policy decisions. The Federal Reserve (Fed) hiked its policy rate by another 25 basis points yesterday to the 5-5.25% range. Interest rates have risen at a pretty dramaticpace – the cumulative five percentage points of rate rises this cycle is the most since the 1980 to 1981 tightening cycle, which was infamous for taming the runaway inflation of the 1970s and bearing short term the economic cost of doing so. In the statement that accompanied this week’s rate hike announcement, the Federal Open Market Committee (FOMC) removed the line that said the Committee anticipated some further policy firming may be necessary, which was universally taken as a strong signal the Fed is now on hold. Additional rate hikes down the line are possible but seem unlikely. The main debate has probably rightly turned to how soon and how aggressively the Fed will start cutting rates, with the market now expecting 80 basis points of cuts by the Fed’s meeting this December.

Fed chair Jay Powell, however, was dismissive of rate hikes, despite the fact that there are things to worry about from an economic perspective, such as turmoil in the banking sector and a looming political crisis over raising the debt ceiling. Although there is debate about the level at which interest rates become restrictive, we can be fairly confident that we have surpassed it now. The real Fed funds rate is now more above its own five year moving average than at any point since at least the late 1980s.

We therefore maintain the view that it is more likely than not that this rate hiking cycle will end in a recession. That said, it’s not obvious that the Fed will be forced to cut as aggressively as soon as the market anticipates. For one, even though rates have moved up substantially over a very short time horizon, it takes time for monetary policy to slow the economy. During previous hiking cycles, it’s taken a median of 43 months from the point the real Fed funds rate rises above its own five-year moving average before the economy goes into a recession. In this cycle, the real Fed funds rate only turned positive last July. The lag will probably be much shorter than the median this cycle, in large part due to how quickly and aggressively monetary policy has tightened. But the main point is that monetary policy usually acts with big lags.

Banking sector challenges

What is harder to assess is the impact of the banking turmoil. Powell put a resolute spin on recent events, saying that the “resolution and sale of First Republic” (which took place earlier this week) was “an important step in drawing a line under the crisis.”

So far it has not alleviated investors’ concerns. Three more regional banks have come under the spotlight: PacWest, Western Alliance and First Horizon. Despite mostly reassuring results reported just a fortnight ago, in which they could justifiably claim that deposit outflows have largely ended, the three suffered extraordinary share price declines this week. PacWest conceded that it was discussing strategic options with investors… and fell further. Western Alliance categorically denied that it was in any such discussions and fell too. With banking statistics bearing out the claim that deposits at smaller banks have indeed stabilised, the sell offs seem unwarranted.

This week’s increase in interest rates is seen as potentially reigniting outflows. Those higher interest rates will be immediately available to investors in money market funds but are unlikely to be passed on by banks, particularly those holding low-yielding high quality bond assets that are trading below their redemption values.

Another concern for bank investors, though, is that, far from drawing a line under the turmoil, the resolution of First Republic may have destabilised other, weaker banks.

First Republic, we wrote before, was the beneficiary of a rescue plan led by JP Morgan and syndicated amongst other banks, which all injected deposits into the bank. This act of altruism proved insufficient and when First Republic eventually failed, JP Morgan was able to acquire its choice of First Republic assets and extract some federal protection against losses in a way which would not be possible when buying an institution from a going concern. Shortly afterwardsweaker banks began to see their shares decline.

Federal debt ceiling

A growing source of concern for markets comes from the looming threat of the US federal debt ceiling. This limitation on the amount that the government is allowed to borrow must be raised by Congress if the government is to continue borrowing. The government itself is required to spend according to commitments it has been given by Congress. This puts government spending on a collision course with the debt ceiling and the first question is when they will meet. According to Treasury secretary Janet Yellen, that could happen as early as the beginning of June. We have begun to see dislocation in Treasury bill prices, with those assets maturing before the start of June being valued much higher than those thereafter. Unless a deal is reached between the White House and Congress sometime within the following weeks, the US will default on a bond coupon payment, an otherwise unthinkable event. Nobody quite knows the impact of a default on what has long been considered the ultimate risk-free asset.

We have been here before; ordinarily an eleventh-hour deal will be reached. During each successive crisis, the path to such a deal narrows a bit more. The obstacles are entirely political. The Republicans have a tiny majority, within their number are some debt ceiling zealots who have vowed never to compromise. A meeting between the White House and the Republican leadership is planned for next week, although both sides remain resolute in their determination not to compromise.

Europe

On the heels of the Fed meeting, the European Central Bank (ECB) met yesterday and hiked rates a quarter of a percent, taking the deposit rate up to 3.25%. In terms of the ECB’s balance sheet, it has been shrinking since last autumn and began to decline faster in March, when the ECB stopped fully reinvesting securities that matured within its asset purchase programme (APP) portfolio. The decline has been at a pace of about €15bn per month, and the ECB confirmed yesterday it would stick to that pace through June. It then plans to stop reinvesting maturing APP securities entirely in July. In the press conference, ECB president Christine Lagarde said that this would amount to roughly €25bn per month of securities not being re-invested. As concerns the separate pandemic emergency purchase programme (PEPP) security portfolio, the ECB confirmed that principal payments would be re-invested until at least the end of 2024.

In the press conference, like Powell the day before, Lagarde acknowledged the strains coming from tighter credit conditions. The ECB’s quarterly bank lending survey come out earlier this week, and it showed a sharp drop in business loan demand. Strikingly, the net change in loan demand last quarter hit the lowest level since the depths of the global financial crisis. But the message was a little mixed, with a decline in the net percentage of banks reporting tighter credit standards for house purchases and consumer credit.

Europe has benefitted from sharp declines in natural gas prices and reassuring resilience in its peripheral economies, most notably Italy. At the moment, economic momentum seems stronger in Italy and Spain than it does in Germany. Overall, the labour market in Europe is arguably even tighter than in the US, and as such, investors expect interest rates to continue to increase even as the US pauses, a fact that should be positive for the euro if it is not already reflected in somewhat extended investor positioning and sentiment.

The very latest data on economic momentum does slightly challenge the market’s expectations of declining interest rates in the US and rising ones in Europe. It shows that the US manufacturing sector is accelerating at a time when the eurozone’s (and for that matter the UK’s and China’s) is contracting. Turmoil in the banking sector has intensified recessionary fears and seen the oil price slide, but that will provide a further boost to US consumers, who according to today’s jobs report are benefitting from yet another month of strong jobs growth, with an acceleration of wage growth and an unemployment rate that has fallen back to its lowest since the 1950s!

A recession remains likely but far from certain.

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