The Fed has been relentlessly delivering the message of “higher for longer” in its battle to kill off a foe that may already be dead.
We’re seeing more signs pointing to a temporary period of impending deflation – rather than an economy that is revving up, like we did coming out of COVID in 2020 and throughout 2021.
Commodities were ripping higher on a daily basis. Shipping rates were all anyone could talk about. And demand for goods and services was off the charts.
Now we’re seeing a major slowdown in energy demand, which prompted OPEC to deliver a surprise production cut a few weeks ago. That sent oil up 16% overnight. Yet oil has now completely retraced that entire move.
Even Tesla reported a rise in inventories in its earnings release on Wednesday despite marking down prices on all its models.
In fact, demand is slowing everywhere – and we’re only in the beginning stages of that development.
That is why for the better part of the year, the fixed-income market has been pricing in rate cuts for the second half of this year. And it’s not just because of the banking crisis. They were pricing it in even before that.
And the stock market may not like the reason why…
When the Fed cuts rates, it’s usually in response to a crisis. And the rate market seems to once again be ahead of the curve.
According to Fed swaps, the first potential rate cut will occur around November, with an increasing probability of it happening in December.
I think the next FOMC will still see yet another 25 basis point (bps) rate hike, but that will likely be it.
Especially with comments fromt Federal Reserve Bank of Chicago President Austan Goolsbee – a newly appointed dovish voice among otherwise hawkish Fed members. Here’s what he recently said…
Everybody is forecasting some growth slowdown for the second half of the year. How intense that will be is going to depend a lot on the financial part… My message is to be prudent, be patient.
That’s actually a welcome thought given how the Fed is steamrolling along with rate hikes amid a slew of deflationary indicators setting up another policy error in the making.
The thing with inflation is that it comes and goes. Right now, it’s time for it to leave for a bit…
Take a look at this chart. It compares the trajectory of the consumer price index (CPI) when inflation broke out in the 1970s to the way it did now…
If the same pattern continues – and every indication is pointing to that fact – it won’t be because retailers developed a sense of altruism and decided to lower prices on goods and services.
It will be because demand will be shot.
This is why the topic of deflation has become a predominant thesis among the macro crowd of late. Tighter lending practices will only cause demand to fall more… and, as a result, push the overall price level of goods and services down.
But the Fed has yet to see this. That makes sense since the Fed has been about 10 months late to just about every adverse economic situation.
Directly after news broke out about Silicon Valley Bank (SVB), rates dropped so much that the market thought there was a chance of a rate cut at the March 22 Federal Open Market Committee (FOMC) meeting.
That didn’t happen. According to Powell, the emergence of banking failures were just isolated incidents. They were not important enough to relinquish the inflation fight by pausing now.
But the fact that the yield curve exploded in response to the bank failures tells us at least one part of the market is already pricing in much weaker economic conditions.
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Cracks in the System
Like it or not, SVB appeared like a Bear Stearns 2.0 (though not exactly the same).
When banks get tight, it’s never a good macroeconomic sign. And when it’s one, it means the cracks are there for all of them, whether we can see it yet or not.
One of the most concerning charts we’re tracking right now is the Markit AAA-rated CMBS index…
Real estate took off after the COVID shock and 30-year mortgage rates below 3% led to a frenzy… Refinancing burgeoned.
But now real estate prices are dropping. The new value backing all those bank loans isn’t sufficient to keep many of them above water.
And since mortgage rates are now around 7%, commercial real estate operators can’t refinance at lower rates to pay off loans coming due or getting called.
But the real problem may be hidden from the typical boom-and-bust dynamics… It runs a little deeper.
We had a conversation with a close friend in the real estate business about why the AAA-rated commercial mortgage-backed securities (CMBS) have been falling so hard – as you can see in the chart above.
His response, delivered with a shaky laugh, was shocking: “What you see on your chart was never AAA-rated to begin with… Rating agencies just haven’t marked these properties to market yet.”
That means that the AAA rating is a rearview mirror look at what real estate was priced at during the previous assessment. That doesn’t happen frequently in real estate.
But in this market, things change quickly. And already we are seeing defaults like with Brookfield’s $161.4M default on an office building portfolio in the DC area.
A Classic Boom-and-Bust
It’s shaping up to be a classic case of a Fed-induced boom-and-bust cycle. They set the stage for excess risk-taking and leverage from easy money policies… which eventually implode.
As that process evolves, banks get increasingly tighter. They lend less and cause demand to crater, bringing overall price levels down.
The recent trend among inflation forecasters is to describe this as deflation. But it doesn’t matter what you call it.
It’s no longer inflation we need to worry about – but rather a massive slowdown. That slowdown is being seen everywhere. And all scenarios point to lower rates.
But the problem with inflation is that once it arrives, it doesn’t leave easily.
During inflationary cycles, it spikes. Then it subsides…and then it appears again.
And all of this – inflation cycles, mortgage rates, banking troubles, etc. – is eerily similar to other precarious periods in the market…
That means we’re not out of the woods yet.
Regards,
Eric Shamilov
Analyst, Trading With Larry Benedict
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