Summers and El-Erian
March 12, 2023 – weekly comment
Last week I wrote this (emphasis added) in my ‘Won’t Risk a Backslide’ missive:
Every so often, big name pundits proclaim the Fed is losing credibility or is way ‘behind the curve’. Obviously, the Fed was late in starting this hike cycle. However, it has been an incredibly aggressive year in terms of Fed adjustment. At the end of 2021 mortgage rates were sub-3%. On Friday the 30-yr fixed was 7.1% [7.02 on Friday 3/10]. The 2/10 spread is unambiguously reflecting tight policy, at a low for the cycle at -89. On Friday, Larry Summers was on BBG tv: “The Fed right now should have the door wide open to a 50 bp move in March. A reasonable assessment of where the Fed is would say that they have not been this far behind the curve for a year or so.” That is NOT a reasonable assessment, it’s blather for tv. The Fed just started to hike one year ago. The ’rules-based’ chart above shows how much the Fed has closed the gap. In any case, it’s worth noting that the Fed has more to think about than Larry. For example, there’s this clip from the Monetary Report Summary under ‘Financial Stability’:
Valuations in equity markets remained notable and ticked up, on net, as equity prices increased moderately even as earnings expectations declined late in the year. Real estate prices remain high relative to fundamentals, such as rents, despite a marked slowing in price increases.
I ended last week’s missive with this clip:
“For a while there, Financial Stability was almost thought of as a 3rd mandate for Fed policy. Now it’s back to the dual mandate of inflation and employment, dominated of course by considerations relating to the former. However, a couple of big blow-ups can put stability right back on the front burner.”
And here we are.
All of a sudden financial stability vaulted into the forefront with the failure of Silicon Valley Bank. It’s a symptom. Obviously the rapid hike cycle is causing cracks, just like hiking cycles always do. I think back to the rapid rate hike cycle in 1994 when rates went from 3% to 6% from Feb 1994 to Feb 1995, culminating in the tequila crisis. But this cycle has been much more aggressive, from a base of zero rather than 3%. We’re gonna need more tequila.
The Fed has been sensitive to the idea that the effects of previous hikes are still winding through the system. In the Fed minutes of the Jan 31-Feb 1 FOMC, the staff noted tightening C&I and commercial real estate lending standards (citing Sr Loan Officer Survey SLOOS). “…in the January SLOOS banks reported expecting a deterioration in the quality of business loans in their portfolio over 2023.” BOOM! [Overall staff viewed risks as moderate].
In the participant section:
In their discussion of issues related to financial stability, several participants discussed vulnerabilities in the financial system associated with higher interest rates, including the elevated valuations for some categories of assets, particularly in the CRE sector; the susceptibility of some nonbank financial institutions to runs; and the effect of large, unrealized losses on some banks’ securities portfolios.[HELLO SVB!]
Against this backdrop, and in consideration of the lags with which monetary policy affects economic activity and inflation, almost all participants agreed that it was appropriate to raise the target range for the federal funds rate 25 basis points at this meeting.
It’s not as if this SVB episode is completely out of the blue. The Fed was sensitive to banks carrying fantasy valuations. However, big names like Summers and El-Erian helped push everyone to one side of the boat. CNBC headline on March 2: El-Erian says the Fed should go back to raising interest rates more aggressively. Then on March 8, (twitter) “The Fed’s ‘flip-flopping’ on mon-pol is threatening to send the economy into recession.” Well, Larry and Mo, you’ve had your say. Maybe now we should listen to what Curly has to offer:
[Cash and Carry is a particularly appropriate Stooges episode to explain the current problems. I don’t want to give away the ending, but our heroes blow up the US Treasury. Sound familiar?]
Starting at 5:44. Curly: “Five hundred dollars? Hmm, that’s almost a million.” Moe, to the kid, “Why don’t you put the money in the bank?” The kid responds, “Will the bank give it back to us?” Curly, “Oh sure. They didn’t used to! But now they do.” Larry, “And when you take it out, they give you some more.” [not this time, Larry]
Uninsured depositors at SVB will almost certainly be made whole, though probably with a delay. The US can’t afford a bank run where every large deposit suddenly goes only to TBTF institutions. A shotgun wedding is likely.
The Fed is meeting Monday. I would guess that any hike for March is now off the table. It’s all about providing liquidity.
I have previously noted a large buy of SFRZ3 9550/9750 call spreads for 33-35 on Feb 1. This call spread was immediately crushed in the post-Feb 3 NFP blow-out. However, with Friday’s 52.5 rally in SFRZ3 to 9516, this guy picked up 17.75 on the call spread which settled 30.5. I have also flagged the consistent buyer of 20k clips SFRH4 9625/9725 and 9612.5/9712.5 call spreads for 9.0 to 9.5 (total >100k). On Friday, SFRH4 was the star performer, up 54 on the day and 74.5 from the low settle on Wednesday of 9480.5. Settles on Friday: 9612.5/9712.5cs 22.5 and 9625/9725cs 20.25. On Thursday, I had a client pay 4 for the expiring 9500c on midcurve March. Up 51 bps in a day!
The question is of course, what now? All I can say is that the market (as of Friday) is still pricing a hike at the March 22 FOMC, as FFJ3 settled 9510 or 4.90%. Current EFFR is 458, a hike of 25 will mean 483 or 9517, so there are still some who think 50 is still plausible. Not Curly….the other two.
So what are the calendar spreads saying? For the past two months, the lowest one-year SOFR calendar has been Z3/Z4. Since January 3 it has been in a range of -119.5 to last week’s low of -158.5. Range in March has been -127.5 to -158.5, extremely wide for a 1-yr calendar. Settled Friday at -133.5. There has been, and still is, significant ease priced for the year of 2024, which squares with the last Fed projections at the Dec 22 FOMC: year-end FF projection for 2023 was 5.1% (up from 4.6 in September) and for 2024, 4.1, up from 3.9 in September. So the Fed had 100 bps of ease penciled in at the last FOMC. The problem is, despite banking issues, service inflation doesn’t seem to be coming down quickly. Biden’s budget plan is inflationary. So, the Fed doesn’t necessarily have to hike a lot more, but they must convince the market that relatively high rates will continue. They can do that by significantly raising the 2024 projection even though SVB likely takes all near-term hikes off the table.
Consider the June one-year calendars: On the week, SFRM3/M4 went from -81 to -124.5 as SFRM4 exploded and the market priced even more of an ease. However, SFRM4/M5 went the other way, UP 22.5 from -94.5 to -72.0. These are violent adjustments.
What about other financial institutions that are nursing losses which can bubble up to the surface? That’s what the Fed had WANTED. Powell often says he would like the labor market to come into better balance. (I’ll bet he’d like to see Elizabeth Warren out of a job). He should equally want asset prices that are forced to be more appropriately valued. As a client astutely noted: “…in 2001 you could watch the trainwreck center stage because all the no-profit tech companies were public, this time they are all in series C & D in the private markets so the problems are a little harder to see. … the amount of desperate inquiries for capital markets help on linked-in from private fintech companies that have to raise capital at half the value of their last round while their cost of borrowing has gone up 500+ bps is alarming.”
As Curly might say: We can make it better by making everyone poorer.
OTHER THOUGHTS/ TRADES
I’m a big fan of Mohamed El-Erian. I’ve also had a soft spot in my heart for Larry Summers ever since his characterization of the Winklevoss twins wearing ties and jackets on the Harvard campus:
“One of the things you learn as a college president is that if an undergraduate is wearing a tie and jacket on Thursday afternoon at three o’clock, there are two possibilities. One is that they’re looking for a job and have an interview; the other is that they are an asshole. This was the latter case.”
Ever since 2008 the Federal Gov’t balance sheet has ballooned as private debts were transformed into public debt. You can see it on the latest Fed Z.1 report, released last week. In 2007 Fed’l Gov’t Debt was $6.07T. It’s now well over 4x higher at $26.85T. In comparison, non-financial business sector debt went from $10.14T to $19.88T, not even 2x, and Household debt from $14.35T to just $18.95T (and that HH debt currently includes the billions in school debt that Biden wants to forgive).
This year the 30-yr bond yield has been in a range from 3.53 to 4.00, ending the week at 3.69, down 19 bps. The high last year was 4.38. Obviously we’re in the throes of flight-to-quality. However, the most indebted sector is Gov’t. Implied vol is at the high of this year (MOVE 140 Friday vs low 97 in Feb; high in October was 160). Worth buying US vol on any pullback and/or accumulating cheap US put spreads as the yield temporarily declines towards 3.5.
| 3/3/2023 | 3/11/2023 | chg | ||
| UST 2Y | 485.6 | 458.8 | -26.8 | |
| UST 5Y | 425.1 | 395.8 | -29.3 | |
| UST 10Y | 396.2 | 369.1 | -27.1 | |
| UST 30Y | 388.5 | 369.3 | -19.2 | |
| GERM 2Y | 321.4 | 309.7 | -11.7 | |
| GERM 10Y | 271.5 | 250.8 | -20.7 | |
| JPN 30Y | 141.4 | 138.7 | -2.7 | |
| CHINA 10Y | 292.1 | 288.1 | -4.0 | |
| SOFR M3/M4 | -81.0 | -124.5 | -43.5 | |
| SOFR M4/M5 | -94.5 | -72.0 | 22.5 | |
| SOFR M5/M6 | -20.0 | -17.0 | 3.0 | |
| EUR | 106.35 | 106.42 | 0.07 | |
| CRUDE (CLK3) | 79.79 | 76.78 | -3.01 | |
| SPX | 4045.64 | 3861.59 | -184.05 | -4.5% |
| VIX | 18.49 | 24.80 | 6.31 | |
