Strategy Question: How could the Fed pause, banking stress and the debt ceiling impact markets?
Starting with the Fed, are we at the end of the Fed’s historic hiking cycle and what does it mean for markets?
Over a year and 500bps since the start of the tightening cycle, the Fed raised its policy rate this week by 25bps to a target range of 5.00% - 5.25%, the highest since 2007. The FOMC also removed a key line from its official statement that said it “anticipates that some additional policy firming may be appropriate”, hinting that this latest hike may be the last of the cycle and future moves will be data-dependent. Markets seemed to have broadly expected the outcome, and they reacted with yields down and stocks selling off.
We think it is likely that we have seen the last rate hike this cycle, unless there’s an unexpected reacceleration in growth, or if inflation fails to slow from here. The recent stress in the banking sector means that lending standards have tightened more swiftly. Before this bout of banking stress the Fed appeared to be targeting a higher terminal rate, but financial instability and the resulting slowdown in credit growth has a similar effect of a couple of rate hikes. Looking forward, the ongoing credit tightening will be in focus. This is likely to slow growth, which supports our base case for a U.S. recession in the back half of this year, with rate cuts to follow. Small businesses are already reporting that credit is harder to find. The office real estate sector will likely continue to struggle. Jobs data is starting to show early cracks. Chair Powell acknowledged that tighter credit conditions will weigh on economic activity, hiring and inflation, but the extent of those effects remain uncertain. The Fed’s data-dependent approach means they may keep the door open to additional hikes if the economy remains resilient with strong wage growth and above-target inflation, which is one of the potential risks on the horizon. Chair Powell also stressed that policymakers are still committed to conquering inflation, and it looks like more weakness in the labor market is needed to get it back to the Fed’s 2% mandate.
With the Fed near (or at) the end of its hiking cycle, many market participants have asked what the end of a hiking cycle tends to mean for markets. Starting with fixed income – in the average recession back to the 1950s, the Fed has cut its policy rate by an average of ~300bps over the following year (excluding Volcker’s 1980 reign). Today, the market only has ~120bps of interest rate cuts priced in over the next 12 months, suggesting rates have room to fall more from here. That means two things: 1) reinvestment risk is real, and 2) longer duration can still offer compelling returns.
Reinvestment risk is the possibility that an investor will have to reinvest money at a rate lower than its current rate. Given that T-bills only have a maturity of a couple years, and we expect rates to fall further from here, that ~5% yield has a looming expiration date. What’s more, with inflation also around ~5%, the real yield on T-bills is flat at the moment.
Alternatively, longer duration core bonds are still offering historically compelling yields (~5% in investment grade bonds), and the opportunity for price gains and portfolio buffer over the next year.
Putting it together: Upon the Fed’s last hike over the past seven cycles, U.S investment grade bonds have outperformed T-bills by ~14% on average (~27% vs. ~13% in T-bills). With the hiking cycle nearing its end, reinvestment risk is now a bigger enemy of a long-term investor than interest rate risk. Over the past seven hiking cycles, extending duration has outperformed money markets by an average of 14% in the 24 months after the last rate hike.
For equities, it depends on what happens next in the economy. On average equities have trended higher following the last Fed hike. But looking beneath the surface, what matters more is whether the hiking cycle causes a recession. In the cycles when a recession resulted from higher rates, equities were either down or nearly flat over a two year time horizon, however in cycles when the Fed hiked but did not tilt the economy into a recession, equities were up by a larger margin. Thus the hard vs. soft landing debate becomes much more relevant for equities. From our perspective, with recession risks remaining high, we recognize the risk/reward in fixed income as being more attractive than equities.
What’s next after the latest bank takeover?
Stress in the U.S. banking sector does not seem to be over, and J.P. Morgan’s takeover of the troubled regional bank First Republic is just the latest episode in this saga. Since Silicon Valley Bank’s failure, ~4% of U.S. small bank deposits have flocked to the safety of big banks and money market funds (MMF). In April, small bank deposit outflows stabilized, which is a clear positive. The Fed’s quantitative tightening (QT) continues to drain aggregate liquidity, while deposits increasingly leave the banking sector in favor of MMFs. In business cycles dating back to the late 1980s, MMF AUM has grown by an average of 20% in the 12 months after the last Fed rate hike. Assuming May 3rd was the last Fed rate hike for the cycle, history suggests MMF AUM will likely rise by $1tr in the coming year. Until the Fed cuts rates, banking stress is unlikely to be alleviated.
All banks will likely have to pay higher yields to prevent deposits from fleeing to MMF; however, with confidence impaired and deposits already depleted, small banks will likely see some of the highest deposit rates (reducing profitability and hampering lending activity). Additionally, U.S. regional banks have a higher concentration in commercial real estate, where loan impairment is most at risk. This means smaller banks are more vulnerable, and we believe the small bank lending channel could potentially impact GDP even if the office sector itself isn’t big enough to.
All banks share some headwinds, however, with interest rates high and growth slowing – namely, increasing loan loss provisions, competing with higher money market fund yields, and declining net interest margins. Importantly though, we’re staying defensive, not fearful, with an acute focus on well-capitalized institutions when making investment decisions.
How could the debt ceiling saga play out?
Another issue that the market is concerned with is the U.S. debt ceiling debate. Treasury Secretary Janet Yellen warned that the U.S. government may run out of cash by June 1st if Congress fails to raise or suspend the debt ceiling. The statement pulled the date of potential default, or the “X-date”, forward by over a month, as most estimates were pointing to a July/August deadline. While we believe an actual U.S. government default is unlikely, this sets the stage for markets to relive some of the drama of past debt ceiling fights under a divided government. Market reactions amid historical episodes varied, with most accompanied by a dip in the prices of bonds that were potentially subject to delayed payments around the “X-date”. Nonetheless, in the 2011 episode when Congress increased the ceiling just days before the X-date and the credit rating of U.S. debt was subsequently downgraded, markets saw a significant risk-off move with IG credit spreads widening to over 250bps and a rally in Treasuries.
For investors, we see a couple of ways to hedge against a disorderly episode. Shorting T-bills due to mature around the “X-date” would be a straightforward way to hedge. Alternatively, we can consider shorting the USD against alternative reserve assets including EUR, CHF, JPY and gold. The below chart shows USD underperformance against each of those assets in the lead-up to the 2011 episode. The rally in gold was also significant especially amidst the immediate debt-ceiling related volatility, making it another source of protection that investors can consider.
While markets are being buffeted by various sources of volatility and uncertainty, we’re staying defensive and balanced in portfolios. Yields have fallen off their highs, which reminds us that bonds can provide protection during times of stress. We still see opportunity here as the growth outlook is likely to worsen and pressure yields downwards, which makes us focus on high-quality investment grade credit. Equity markets could remain volatile and range-bound, and we are looking for protection and quality. Volatility could stick around, and we like structured notes that can both protect gains and build in some downside protection. We also continue to see opportunities in certain sectors (industrials, healthcare and reasonably-priced tech) and markets (China).
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