When the Fed embarked on its rate-hike cycle in early 2022, many market observers were quick to point out that every time the Fed had hiked rates in the past, the hikes eventually led to a financial crisis of some sort.
Given the Fed was starting its current rate-hike cycle when the U.S. debt-to-GDP ratio was 130% (not to mention the significant debt held by households and businesses), it didn’t seem as though the Fed would have much room to raise rates higher before another crisis would materialize (as higher rates would make that mass of debt unmanageable).
Indeed, the Fed itself likely thought the same–first denying inflation was an issue (it never wanted to raise rates), then starting out with baby hikes of 25 bps when short-term rates were at 0% and inflation had exceeded 8%.
But somehow the Fed managed to raise rates up to 4.5% in less than 12 months and the Earth was still revolving around the sun–helped in large part by an equity market that, while well off its all-time highs, hadn’t truly cracked (yet).
(Notably, since June of 2022, institutional investors have been relatively bullish on the equity market, almost certainly this bullishness stemmed from a belief that the math was clear: The Fed couldn’t raise rates as high as their jawboning would have one believe.)
Last week, however, may have changed the course of this cycle, as it appears the Fed has finally broken something–the banking system–as evidenced by the collapse of both Silicon Valley Bank (SVB) and Signature Bank (the 16th, and 35th largest banks by assets, respectively, as of late 2022).
The volatility started on Tuesday when Fed Chairman, Jerome Powell, testified to Congress that the Fed could absolutely increase the pace of rate hikes if the economic data warranted such quickening.
Given the strong economic data of late, the market quickly went from forecasting a 25 basis point rate hike in March to forecasting a 50 basis point hike. This caused both bonds and equities to fall.
On Thursday, new jobless claims came in higher than expected and the market reacted favorably at the outset. But soon the weight of the SVB fiasco overwhelmed any bullish inclinations and the market fell 2% from its morning high to its afternoon low.
On Friday, the non-farm payrolls report also came in somewhat favorably–average hourly earnings were lower and the unemployment rate was higher, both suggestive of a slowing economy and thus (potentially) slowing inflation.
Again, the market responded favorably at first–rising half a percent shortly after the open. But the uncertainty surrounding SVB’s collapse (and its takeover by the FDIC) coupled with the fears of contagion eventually caused the market to sell off to its lowest level since early January.
The S&P 500 Regional Bank ETF (KRE) fell 20% on the week!
The question as always is “What’s next?” And in light of the current circumstances, that question generally means what will the Fed do next?
Will the Fed backstop depositors but continue its rate hikes? Will the Fed take note of the potential systemic risk in the banking system and pause hikes to observe the lag effects of previous hikes? Or is the banking system in such peril that the Fed will actually have to cut rates?
One would think the Fed–a private institution owned by the banks it oversees–would view an imperiled banking system as more of an existential threat than 4%-5% inflation (inflation the U.S. government ultimately needs in order not to default on its debt) and full employment. In which case, the Fed may slow down, pause, or reverse its rate hikes, rather than accelerate them.
Such action would likely lead to lower real interest rates and thus fan the flames of the inflationary secular market regime we are locked in. The assets most likely to benefit from a Fed pause or pivot are gold, commodities, energy stocks, and bitcoin, while the assets most likely to suffer are intermediate- and long-duration U.S. government bonds (as inflation outpaces their yields).
The Fed will likely take a lot of flak for the demise of SVB, a demise rooted in 13 years of quantitative easing and the Fed’s post-pandemic monetary policy response.
But ultimately the Fed is fighting a losing battle. 220 years of secular market history tells us we are in a secular bear market driven by high inflation that should last at least a decade. The Fed is essentially powerless against the inexorable forces of a sovereign bond bubble, de-dollarization, and de-globalization (not to mention the early stages of World War III).
Thus, what can the Fed do? It won’t nuke the U.S. economy for the sake of 2% inflation.
The Bull Case
Systemic risk may force the Fed and Treasury to step in and backstop depositors to stabilize the banking system (this has already happened). Banks, which sold off hard last week, could bounce on the news. Institutions are still relatively bullish equities and hedge funds have taken extreme short positions (at levels that led to interim market bottoms in 2022).
Thus, the market may be ripe for another short-squeeze. Notably, the Nasdaq has been strongly outperforming the S&P 500, something that typically happens only during bullish phases in the market (for example, while the S&P finished last week below its low from the previous week, the Nasdaq did not).
The Bear Case
The Fed and Treasury stabilize the banks but the CPI comes in hot on Tuesday, and the Fed feels the need to raise rates by 50 bps in March. Or the feds are unable to stabilize the banks and last week’s mini-panic grows. Or the Fed pauses and inflation comes roaring back, which leads to bond market dysfunction that spills over to equities. Valuations are not supportive of equities at current levels, so any of the above scenarios could lead to renewed selling.
We tend to subscribe to the view that markets top on good news and bottom on bad news. The news isn’t joyous at the moment, hedge funds have extreme short positions, and retail investors are unlikely to be buying given the negative news flow. That leaves institutional investors as the only ones likely to step up and buy equities. They are already more bullish than either retail or speculators and they tend to be right, especially when it matters. While we have no doubt that the systemic rot will eventually wear down equities (and bring valuations to more justifiable levels), we don’t believe that time is now.
Whether equities go up or down, the one asset that may stand to benefit, regardless, is gold. If the Fed pauses rate hikes and allows real rates to fall, gold should do well. Conversely, if the Fed continues hiking, something else is likely to break and gold would almost certainly see more safe haven flows.
At Allio, our portfolios are constructed with the secular market cycle in mind. Currently, we are in a secular bear market driven by high inflation and gold is one asset (among others) that is likely to perform well in such a regime. Consequently, all of our investment portfolios have exposure to gold, which rallied 3% on Thursday and Friday as SVB collapsed.