In this first edition of our new finance column Week at Close, we talk (among other things) about the broken promise of temporary inflation, Jerome Powell speaking and markets reacting, and the collapse of the Silicon Valley Bank.
Remember the word “temporary”? Whether you closely follow economic news or not, you may recall that it was the main adjective used to describe the surge in prices coming out of the pandemic: temporary inflation, they said.
The evolution of the economy made this word disappear. Nothing was temporary about it. It started being treated like a word that could not be said. But you know what? It is back, albeit not for the best reasons.
That’s because we just realized that what ended up being “temporary” was disinflation. Over the last few months, markets and policy-makers, especially in the US, started believing that a deceleration of prices was coming, and coming big. Not anymore!
On Tuesday and Wednesday, the Chair of the Federal Reserve Jerome Powell addressed Congress in a hearing that marked a reversal in the prior narrative and guidance of monetary policy. A true “flip-flop,” as people are calling it.
Where we were before this week:
On February 2nd, the Fed opted for a 25 basis point hike in the funds rate. Twenty-five, after long months of 0.50% and 0.75% increases. Why? Due to the old fears of recession plus a brand-new variable: projections of disinflation, which had not been assumed up to that point.
In the usual post-decision news conference, Jerome Powell finally brought it to the table, referring to disinflation 15 (!) times. We would have understood the message with only 4 or 5. He went for 15. Markets loved the idea of a finally-ending price cycle.
But then came February. A completely unexpected boom in the jobs report, an increase in month-over-month prices, and hotter-than-expected inflation prints in Europe’s major economies.
Sentiment shifted from 8 to 80. From the 8 of recession risk to the 80 of forever-lasting inflation, investors started selling off their holdings in treasury bonds once again, in expectation of further rate hikes down the road. Price down, yield up – the finance version of Einstein’s theory of relativity – made yields spike.
Where we got to during this week:
The week started with the 3-month dollar LIBOR rate topping 5%. Last time it happened? Sixteen years ago. The exact year the first iPhone was released. But back then this was not such a big deal. In 2007, we hadn’t had a prior decade of near-zero rates. If the situation had been as outstanding as it is now, probably Steve Jobs wouldn’t have launched the iPhone at 5% 3-month rates.
The US 2-year yield, one of the most closely watched as it heavily reflects the expected path of monetary policy, also reached the 5% mark. The 2-y yield is usually looked at jointly with the 10-y to evaluate the shape of the yield curve.
Long story short: when the long-term (10y) rates are at lower levels than the short-term (2y), the curve is said to be inverted. Why is it important? It is an empirically good predictor of recessions. It means that the market is anticipating that the Fed will have to cut rates in the future after raising them over the next couple of years. The reason is one: economic slump. The second-order effects of monetary tightening. Remarkably, the further down the road a recession comes (if it indeed comes), the more the Fed will have to do in the meantime, and the higher the damage that the economy may suffer.
Powell spoke (day 1):
The inversion reached 110 basis points after Powell’s hearing. Last time? 1973. Coincidence or not, the year of the first-ever call made via a cellular phone (not with an iPhone, though, as you might imagine).
The truth is that the movements in the market that follow relevant news are being amplified by the extreme data dependency of policy-makers. The fact that this environment cannot be pledged to any historical experience brings difficulties in terms of Central Banks’ communication. Powell’s banger on Tuesday, opening the door back to a 50bp hike, forced big market swings. Take a look:
The implied probability of a 50 basis points increase moved frenetically from 31 to 81%, as the middle bar in the below graph shows.
Data from: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
- The Federal Funds Rate’s peak went from a priced-in 5% at the beginning of the year, to 5.48% before Powell’s speech, to 5.69% right after.
Powell spoke (day 2):
On the second day of the hearing, Powell took a small step back from his prior day’s speech, by bringing up some “if’s” that allowed him not to commit to a 0.50% increase in the next FOMC meeting. He asked investors to not look at single data points but to evaluate everything together.
The truth is that you can confirm your narrative from every single data point – no matter which narrative it is. As an example, the Jobs report released on Friday showed both a higher-than-expected increase in jobs created (bad for the Fed) and an increase in the unemployment rate at 3.6% from last month’s 3.4% (good for the Fed).
The fact that these reports are being traded as strong impactors of forward policy, and that each participant has his/her own thoughts, brings in a lot of noise following the data releases.
Where we ended this week at:
The noise materialized in a big way on Friday, following the introduction of a new risk to the market playbook: the systemic risk of financial stability.
The current turmoil arrived to the banking system and affected the Silicon Valley Bank (SVB), which failed after the deadly combination of unhedged interest rate risk and a lack of Venture Capital funding (an important activity of the bank). The bank ended up facing a run by its VC depositors after failing to raise new capital.
This made the 2-year yield fall. The curve flattened back to where it was at the start of the week, making it look as if nothing had happened until Friday. This can be quickly explained: the imminence of financial stability concerns implies a narrow window of action for the Fed tightening, which made investors price-in rate cuts in 2024, while still discounting a higher terminal rate than that with which we started the week. The higher the rate ends up in 2023, the more may have to be priced in terms of cuts for 24’ and 25’.
The probability of a 50 basis point hike shifted back down to 39.5%. If the Fed eventually ends up tightening by 0.5%, we may have to fasten our seatbelts. It may imply that the Central Bank is not here to deviate from its price mandate, albeit the financial instability that might bring.
We are now in the middle of a mind-blowing sequence of events andmarket movements. Heads are shaking, eyes are popping. We are sitting in our workplaces but we could as well be in Parco Sempione riding the rollercoaster that’s there installed as part of the Luna Park Meneghino.
If you want to experience it, you have until today (Sunday the 12th) to go there. You’ll be able to somewhat relate to the current financial environment, so don’t forget to fasten your seatbelt.