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Things are getting crazy. Breaking! This is out of controoool! The Fed MUST cut rates now! We've heard it all and more over the past day or two. I'm not convinced. Have we learnt nothing over these past two years?
Right, let's start with the obvious. How the market's flipped from higher for longer to rate cuts imminent in a few short days.
Here's a great graphic showing how rate pricing has evolved over the past week 👇
And it's not just the Fed... 👇
Peak rate projections have fallen across the board.
Does this ENORMOUS re-pricing make sense?
All because one horrifically-managed bank went to the wall?
And another horrifically-managed bank is (always) in trouble...?
I don't want to play down the risks in the banking system too much, but we've been here many times before, especially with European banks. Their overall capitalisation looks to be fine. Basel III capital rules did their job in that regard.
Accessible liquidity is a far trickier beast and something to monitor closely.
Whether this is suddenly systemic risk, really depends on how much everyone panics.
Ironically, these epic rate moves have raised the value of the assets we're supposed to be so worried about...
Anyway, are we to believe that financial stability is genuinely under threat now, or was this more a massive positioning squeeze with some de-risking panic thrown in for good measure?
It's a bit of everything.
Let's start with the positioning dynamic. We've been here before (and we'll do it again).
There's a massive difference between position unwind, de-risk, panic mode and What's the market pricing?
Remember those INSANE energy prices when European energy markets broke? Quick reminder 👇
What was the market pricing then? Nothing. Those prices had no informational value other than "this market be broke"
Or when the UK pension funds got found out with their LDI strategies 👇
Things broke spectacularly. Market pricing became dysfunctional. The Bank of England stepped in and things calmed down. Pretty similar to what's happened this week.
It isn't exactly the same dynamic, but the market was positioned heavily for more hikes. We were even talking about a 6% Fed terminal rate and 4 x 50bps ECB hikes in the central bank pipeline.
For me, it's undeniable that some of the recent moves are a positioning squeeze compounded by the general panic. A market caught totally one-sided. Quantifying that is another matter entirely. I'm not even going to try.
Right now, the market looks like it's pricing in a load of cuts, but calmer, more rational minds are starting to take the other side of those bets.
We'll see more repricing after the ECB meeting today. Then more again after the Fed meeting next week (with the accompanying dot plot and economic projections). By then, the picture should be far clearer.
Will they still be ultra-hawkish?
Yes, but we won't believe them. This was a classic "right for the wrong reasons" post 👇
I argued that growth concerns were likely to overtake inflation as the dominant narrative.
The last few days have seen Financial Stability take centre stage instead. Which means that we've moved away a little from the laser focus on inflation.
Maximum employment is still the least of central bankers' worries. That box is ticked. Unemployment's near record lows. That'll be tomorrow's problem.
Financial stability concerns can be curbed by liquidity swap facilities to bridge any duration mismatch.
It's not ideal, but it's an option. These facilities aren't cheap or free money. Interest is charged at prevailing rates (much higher now than they were) so it's no party for the banks.
Confidence is another matter entirely...
Inflation is still running hot around the world. Purely on that basis, central banks can't stop. Not if they want to actually deal with price instability.
If central banks pause (or cut!) now, they've fumbled the ball, we go mad, and do it all again...
At least for a while. We're not to be trusted. We like nice things. And fun.
So, if nothing's changed in the economy, just keep hiking!! Can they afford not to?
Keep going. Although I sort of disagree with this too.
The entire point of a tightening cycle is to tighten financial conditions, and make people fearful about the future. That's the natural evolution of credit tightening.
Scared money don't spend money. Scared lenders don't lend money. That process had already started 👇
On the back of recent events, how much more 'shadow' tightening is in the works?
So far this is a financial market problem not a real economy problem. The two can seem to co-exist independently for years at a time. But not indefinitely. Credit is the fuel & lubricant of the economic engine.
Now that everyone's looking at banks, their unrealised losses, shoddy lending practices, liquidity situations and likely interest margin compression (lower profits) as they pay higher rates to maintain/attract deposits, lending caution is sure to set in.
As the economy slows, inflation probably does too. As long as central banks stay the course. Or at least make a decent fist of convincing us that they will.
Which brings us back to why central banks are 'always wrong'.
They'll likely choose the path of least regret.
For the ECB today, this is probably a 50bps hike - purely because they're further behind the inflation curve - and cautious guidance.
For the Fed, it's to keep doing 25bps per meeting until the economic data tells them not to.
How about that US rate pricing? Somewhere between the red and green lines seems reasonable to me. Rates at or around 5% and then a cut or two towards the end of the year... 👇
Maybe more cuts. All depends how the economy evolves. If they stick to the script (hawkish rhetoric), I think the recession will arrive right on schedule in Q3/Q4.
I don't think we'll see the Fed Funds rate curve return to the prior extremes. The game's up. Now that they've 'broken' something, we can all be scared enough to slow down. Ironically, the odds of a soft(er) landing have probably increased on the back of this.
As long as central bankers stick to the script and stay the course...