It’s amazing that the Federal Reserve (Fed) kicked-off this unprecedented tightening cycle with an initial 25bp rate hike only 12 months ago. Since then, they have meticulously pondered each turn of the screw against a plethora of slowing economic data. Then came the ghosts of the Great Financial Crisis (GFC). For the past 10 days, we have watched sudden bank runs, massive government backstops, and hasty rescue packages emerge from the 24/7 headlines around the globe. It culminated, at least for now, with this weekend’s announcement of the biggest bank rescue package since 2008– a $3.25bn forced marriage between UBS and Credit Suisse.
This can’t be what the Fed had envisioned as a capstone flourish to its tightening campaign, can it? Well, that is very well what we may have just witnessed. Sure, the Fed may carry through with one more 25bp hike on Wednesday, but the economic impact of this mess doesn’t look transitory to us. A crisis in U.S. bank confidence by both depositors and creditors will require major additional corrective actions by regulators and politicians to avoid the scary risks of deflationary contagion.
Figure 1 shows the real-time impact of the past 10-days on overall financial conditions. The collapse of Silicon Valley and Signature Banks along with the existential stress on Credit Suisse and First Republic has depressed overall financial conditions back to the level of peak Fed hawkishness in 2022, or just prior to the UK Pension and political crisis. Although that market crisis was smoothed over quickly, the pull-back on tightening by Central Banks around the world shortly thereafter was no coincidence. The Fed, the Bank of England, the European Central Bank, and the Bank of Japan place financial stability at the top of their multi-pronged mandates – above economic growth and price stability – especially when shadows of the 2008 crisis emerge.
While we wait for Powell to do his best linguistic juggling act in front of the popular media on Wednesday afternoon, the 2-year Treasury is flashing ominous warning signs. Its recent run of yield volatility, including 7+ days of 20+bp moves (not to mention a 100+bp rally from its high of 5.07% on March 8th) implies that the hard vs. soft landing debate will return to the forefront of investors’ psyches. Front-end yield curve volatility now exceeds that during the Covid Crisis and threatens to rival that found at the depths of GFC (Figure 2). Although today’s banking woes are nowhere near those in 2008, the economic ramifications of this situation has its own unique caveats. Topping that list is the notion that the Fed and Congress now have limited means to provide additional rescue stimulus given the political environment and inflationary consequences.
Perhaps the most notable signal emanating from the Treasury market is the correction in the level of the 2-year/10-year inversion. This recession indicator hit a low of -110bps on March 7th and has now steepened back to -50bps as of this writing. While that sounds like a vote of confidence in our economic future, it’s important to understand how inversions have historically corrected through the economic cycle. Typically, a 2-10’s inversion reverts via a powerful bull steepener (front-end of the yield curve falling faster than the long end) right before a recession hits. Figure 3 shows that to be the case in each of the last three recessions.
The recession chatter prior to the bout of strong January economic data was centered on the probability of a soft vs. hard landing in the second half of 2023. Now that the market-economic feedback loop is accelerating, it is pulling forward once distant outcomes into the realm of possibilities for the second quarter. If broad stress on bank credit and deposit conditions continues to plague the financial sector, contagion will quickly spread to corporate and main street America.
Tighter financial conditions are, in effect, the invisible hand of real economic activity. That hand is clenching a bit harder this morning. The risk premium embedded in mortgage and commercial real estate rates, the stipulations applied to business loans, and the fees/limits attached to credit card balances are all frictions which can rise as banks and regulators sort this out. If this does push us towards the hard landing scenario, history may well remember the “Silicon Valley Bank Collapse” as the watershed event marking the beginning of the 2023 Recession.
Despite the rally, investors still have an opportunity to park dry powder in high-quality bonds. Real yields are still positive. The Fed Funds Futures market implies a mere 3 cuts by the end of the year. The conviction that we are headed for a recession is simply not baked into the price you pay for bonds today. And, in the event that we avoid recession, the downside for rates seems more and more like the Fed stays parked near 5% for a prolonged period rather than continuing to hike to, and perhaps beyond, 6%.
This type of bimodal economic outcome points to liquid, high-quality bonds as a critical component in broad asset allocation. The usefulness of modeled GDP forecasts, optimized efficient frontiers, and projected asset return ranges should be heavily discounted for the time-being. Economic and investment return outcomes are not set up to be normally distributed right now. Rather, tails are fattening with confidence and sentiment in the driver’s seat. The Treasury market volatility is telling us that loud and clear.
Source: Bloomberg as of 3/20/23. Figure 1: A value below 1 for the Bloomberg Financial Conditions Index measures tight financial conditions. The US Bloomberg Intelligence FI Fed Minutes Hawk Sentence Score is a sentiment score representing the Fed’s current policy stance. A lower score corresponds to a dovish Fed, and a higher score to a more hawkish slant. Figure 2: Shows the day-over-day change in the 2-year Treasury Yield. Figure 3: US 2s10s represents the yield differential between the 2- and 10-year Treasury yields. The shaded grey area represents past recessionary periods. The views contained in this report are those of Income Research & Management (“IR+M”) and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. Investing in securities involves risk of loss that clients should be prepared to bear. More specifically, investing in the bond market is subject to certain risks including but not limited to market, interest rate, credit, call or prepayment, extension, issuer, and inflation risk. It should not be assumed that the yields or any other data presented exist today or will in the future. It should not be assumed that recommendations made will be profitable in the future. Actual results may vary. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management. “Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by IR+M. Bloomberg is not affiliated with IR+M, and Bloomberg does not approve, endorse, review, or recommend the products described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any IR+M product.