All METARs recognize that the Federal Reserve has controlled the Macroeconomic Trends and Risks in the U.S. for many decades. Using the Fed’s control of the short-term fed funds rate (FFR), the Fed under Paul Volcker controlled intractable inflation while inducing a deep recession in 1980-1982. After the mild 2001 dot-com bubble recession, Alan Greenspan and the following Fed FOMC kept the fed funds rate suppressed for long periods after the recessions ended, blowing asset bubbles that popped in 2008 and 2022.
All the asset markets – stocks, bonds, real estate, crypto, etc. – are totally addicted to negative REAL interest rates. They are in shock that the Fed has raised the FFR to combat inflation. The market believes that the Fed will cut rates as soon as possible so they can get back to blissfully sucking in free money for speculation.
As an investor and your humble METAR weather reporter, I watch the seasons change while TPTB act. I’m always astonished that the right hand doesn’t seem to know what the left hand is doing. Even while the financial press constantly reports on the movements of trillions of dollars by the main actors – the Fed (monetary) and Congress (fiscal) – which are non-productive but controlling entities. Almost like the Greek gods that push humans around the scene in the Iliad (by Homer).
The right hand (Congress) and the left hand (the Fed) hardly seem to cooperate at all. The Fed is using monetary actions to try to control Consumer Price Inflation which is caused by consumer demand vs. supply of goods and services. Monetary actions only marginally affect consumers by changing borrowing rates at second-hand. (Monetary actions more directly impact asset prices than consumer prices.) The Fed is still dealing with a rising CPI that was caused by tremendous Covid-related monetary and fiscal stimulus in 2020 and 2021. (As well as other factors.)
Within the Fed itself, the right hand doesn’t seem to know what the left hand is doing.
Stress Testing Wouldn’t Have Saved Silicon Valley Bank
The Federal Reserve fails to account for interest-rate risk.
By Joseph R. Mason and Kris James Mitchener, The Wall Street Journal, March 15, 2023
Even if midsize banks had been subjected to the same scrutiny as large banks [by Fed bank regulators], it isn’t clear that stress testing them would have led to changes that would have prevented failure. Why? Because the tests asked the wrong questions. They failed to encompass the scenarios that ultimately led to SVB’s demise—large and rapid increases in interest rates.
In its February 2022 Stress Test Scenarios, the Fed’s “severely adverse scenario” asked banks to assess their riskiness over a three-year horizon in a hypothetical world in which the three-month Treasury rate stays near zero while the 10-year Treasury yield declines to 0.75% during the first quarter of 2022 and doesn’t change in the subsequent two quarters. Even in December 2021, however, the Federal Open Market Committee’s Summary of Economic Projections was showing the Fed likely targeting interest rates double those of 2022 in 2023, far higher than what it used for bank stress tests.
A reasonable observer would expect FOMC’s policy objectives to have been embedded in the 2023 Stress Test Scenarios. But by February 2023, the Fed still hadn’t changed its regulations to match its monetary policy. While FOMC’s December 2022 projections show its policy rate reaching 5.1% by the end of 2023, the February 2023 severely adverse scenario was almost identical to that used in February 2022: The three-month Treasury rate falls to near zero by the third quarter of 2023, while the 10-year Treasury yield falls to around 0.5% by the second quarter, then gradually rises to 1.5% later in the scenario.
The 2023 severely adverse scenario’s assumptions bore no relationship to reality…[end quote]
It’s simply stunning that the Fed’s Stress Tests, which are designed to assess Risk, failed to include rising interest rates as a risk factor even while the Fed was actually raising rates, publishing dot plots, and being transparent that the situation was changing rapidly so even higher rates might be needed in the future. How could the right hand not know what the left hand was doing? Don’t the people who work for the Fed even bother to listen to what Fed Chair Powell says in his public speeches?
Actually, the Fed was aware of the problems at Silicon Valley Bank.
Before Collapse of Silicon Valley Bank, the Fed Spotted Big Problems
The bank was using an incorrect model as it assessed its own risks amid rising interest rates, and spent much of 2022 under a supervisory review.
By Jeanna Smialek, The New York Times, March 19, 2023
Silicon Valley Bank’s risky practices were on the Federal Reserve’s radar for more than a year — an awareness that proved insufficient to stop the bank’s demise.
The Fed repeatedly warned the bank that it had problems…In 2021, a Fed review of the growing bank found serious weaknesses in how it was handling key risks. Supervisors at the Federal Reserve Bank of San Francisco, which oversaw Silicon Valley Bank, issued six citations. Those warnings, known as “matters requiring attention” and “matters requiring immediate attention,” flagged that the firm was doing a bad job of ensuring that it would have enough easy-to-tap cash on hand in the event of trouble.
But the bank did not fix its vulnerabilities. By July 2022, Silicon Valley Bank was in a full supervisory review — getting a more careful look — and was ultimately rated deficient for governance and controls… [end quote]
There are bound to be changes in the way the large but not “too big to fail” banks are supervised. But banking sector issues could propagate and lead to recession.
Problems in the banking sector could spread and affect communities all over the country.
Local Banks Could Leave Gaps That Are Hard to Fill
A weakened position for small banks would harm small businesses and less-urban areas
By Justin Lahart and Telis Demos, The Wall Street Journal, March 18, 2023
Tighter belts for smaller banks could count as a big problem for some parts of the country…An emerging concern is that customers at community and regional banks, worrying that their deposits aren’t safe, might pull their money, putting it into money-market funds or accounts at bigger banks…
Even if any outflows are halted or reversed, small banks may now grow cautious, such as by simply sitting on more of their cash as a defensive measure. Doing so would effectively reduce their capacity to extend credit…Loans to small and midsize businesses that rely on smaller banks are often based on so-called soft information that local lenders have built up over years. …The median distance between small-business loan borrowers and their lenders’ nearest branch was less than 7 miles…nearly 80% of banks with less than $10 billion in assets characterized “largely all” of their commercial and industrial loans as going to small-business borrowers… [end quote]
Even though the local impact of SVB’s collapse was mitigated by the Fed’s new Bank Term Funding Program (BTFP) the problem could spread. Banks can use eligible government securities on their books like Treasuries and agency mortgage backed-debt to guarantee the BTFP loans. But the small local banks have C&I loans which aren’t eligible for Fed borrowing from the BTFP.
Analysis: U.S. bank loan plan provides Fed rate hike path amid SVB fallout
By Gertrude Chavez-Dreyfuss, Reuters, March 15, 2023
A U.S. lending program to stem deposit outflows in the wake of Silicon Valley Bank’s (SIVB.O - | Stock Price & Latest News | Reuters) collapse gives the Federal Reserve scope to continue raising interest rates if needed to slow inflation without exacerbating losses on bonds held by banks… [end quote]
That’s only true for banks that hold Treasuries and agency mortgage bonds, not C&I loans. The smaller community banks may not be on the Fed’s radar at this time. Or perhaps they are writing off small towns the way they wrote off ordinary risk-averse savers when they suppressed interest rates for so long.
This could lead to an erosion of the economy in huge swathes of the U.S. outside the big cities.
The Fed is in a zugzwang position. The next Federal Open Market Committee FOMC) meeting is March 21-22. Anything they do – even if they don’t do anything at all – will rock the markets. Last week’s high CPI report caused the markets to expect the Fed to raise the fed funds rate 0.5%. But the banking crisis is pressuring the Fed to pause their rate raises.
The CME is reporting a 2/3 probability of a fed funds rate of 4.75% - 5% for the next meeting and a 1/3 probability of no change.
The entire Treasury yield curve dropped last week in flight-to-safety buying. Gold popped. The stock market is uneasy but nowhere near revulsion or panic. It’s continuing an established sideways channel that began in the beginning of 2023.
The Fear & Greed Index is in Extreme Fear.
Oil and natgas fell.
The METAR for next week is unsettled weather. The stock and bond markets are uncertain and could have a lot of volatility. But there’s no sign of a panic.