The Federal Reserve raised the fed funds rate only 0.25% at their last meeting instead of the 0.5% they hinted at because the last inflation report was higher than they wanted. The Fed is caught between the banking crisis and inflation. They are on thin ice and tip-toeing carefully. They even reversed their QT program, which is probably the reason that long-term Treasury yields plunged last week.
Until a couple of weeks ago, the Fed seemed to be on a stable glide path toward a soft landing. As all METARs know, a financial crisis can ruin the best-laid plans. There’s a lot of financial risk built into conventional and shadow banks right now. A huge amount of money from Covid-related fiscal and monetary stimulus.
As the Fed kept the fed funds rate near zero by extending their Covid-related emergency suppression until 2022, many financial interests bought long-dated bonds, including Treasuries, mortgage-backed securities and others, in a stretch toward even a little yield. Even the AAA-rated bonds with no default risk had significant duration risk. Those bonds lost value throughout 2022 as the Fed raised the fed funds rate.
Although fiduciaries (including the Fed itself) are allowed to report the par value of bonds as long as they are held to maturity the market value has dropped significantly. This risk is spread throughout the financial system.
Where Financial Risk Lies, in 12 Charts
Data show worrisome trends in real estate, banks and private markets
By Shane Shifflett and Danny Dougherty, The Wall Street Journal, March 26, 2023
[The first chart shows that the market value of securities has plunged to 89% of cost in 2022 and early 2023. The second shows a loss of $550 billion, mostly in mortgage-backed and commercial mortgage-backed securities. Unrealized losses on banks’ mortgage-backed securities were $368 billion at the end of 2022. ]
A growing share of the funds deposited with banks exceeded the Federal Deposit Insurance Corp.’s insured limit of $250,000. Nearly $8 trillion of deposits at the end of 2022 were uninsured, up nearly 41% from the end of 2019…Nearly 200 banks would be at risk of failure if half of uninsured depositors pulled their money from the banking system…
To address the risk that rising interest rates will force other regional banks to sell their holdings at a loss, the Fed will offer loans at 100 cents on the dollar to banks that pledge assets such as Treasurys that have lost value. [But not commercial real estate loans which are a large part of the portfolio of medium-size banks. – W]
At the end of last year, banks held $17.5 trillion in loans and securities, while equity in the banking system was more than $2 trillion, FDIC data show. Estimated unrealized losses on total bank credit reached $1.7 trillion…
Private markets’ (so-called shadow banking) total assets under management reached $11.7 trillion last June…Private-equity firms have raised record amounts of cash in recent years and announced nearly $730 billion in investments… [end quote]
That is a LOT of money that is at risk of losing significant value. This article doesn’t address derivatives which are opaque and were the threads that unraveled the financial system in 2008.
The most striking action in the markets last week was the sudden plunge in Treasury bond yields across the entire yield curve. Since bond prices move opposite to interest rates, this immeditely boosted the value of every existing bond portfolio.
The Fear & Greed Index improved to Fear from last week’s Extreme Fear. Financial stress spiked last week and so did the VIX. But neither spiked to a crisis level. There was a tiny blip of lending to banks through the Fed’s discount window but that wasn’t significant.
Barring a crisis or rising inflation later, bond yields are likely to decline.
The stock market has been in a neutral channel since last November, moving up and down.
The Federal Open Market Committee released its meeting notes. Their median prediction of December inflation was 3.5% in Dec. 2023, 2.5% in Dec. 2024 and 2.1% in 2025. Their median prediction of December fed funds rate was 5.1% in Dec. 2023, 4.1% in Dec. 2024 and 3.1% in 2025. This indicates that the Fed projects a REAL fed funds rate of + 1% to + 2% in their intended long-term plan. That’s a far cry from the 0% fed funds rate (negative REAL fed funds rate) that the markets got used to in 2020 to 2021.
Those bubble prices are not coming back. They were juiced by zero rates that the Fed doesn’t intend to bring back. But the stock market still seems to have plenty of animal spirits. There’s no sign of revulsion.
The METAR for next week is partly sunny. The Fed and Treasury together seem to have brought the banking crisis under control, at least for the time being. The METAR is a short-term forecast. It’s possible that the strains in the system may raise their ugly head later. But I’m not seeing it short-term.