Kashyap’s Mid-March 2023 Market Outlook
Pause, cut, or hike? 25 bps hike incoming.
The economy is not doing well. People are going into debt to maintain their spending pattern. When food inflation is over 10%, desperation leads to debt fueled consumption.
But, interest rates on credit card debt went through the roof (19.07% according to the Fed's tracker) thanks to the Fed's rate hikes. This does not capture the plight of sub-prime borrowers, who are paying 25% due to usury price caps, but perhaps more when you consider late fees.
This has had the effect of sending delinquency rates higher, but overall still manageable for lenders.
How is that possible? Well, people are drawing down savings. Personal savings exploded higher during the pandemic when the government gave out free money via PPP loans and unemployment benefits. That has now been completely exhausted. Savings are now down to the historical norm.
Which means delinquencies are yet to pick up.
So, has the Fed overtightened? That depends on the outcome they wanted. A paper published last October by the Fed notes that excess savings contributed to inflation, and the way to bring inflation down was to exhaust all those "excess savings". Which they've now pretty much done. Don't take my word for it.
Read the article here
"Over the pandemic, historic levels of government transfers boosted household income while household spending was severely curtailed by social distancing. This led the personal saving rate to soar, and we estimate that U.S. households accumulated about $2.3 trillion in savings in 2020 and through the summer of 2021, above and beyond what they would have saved if income and spending components had grown at recent, pre-pandemic trends."
"At the same time, excess savings have fueled high levels of spending for some households, which may have contributed to persistently high inflation amid constrained supply.
These effects may be amplified or reduced by the extent to which the excess savings are held by lower-income households, many of whom typically hold very little liquid wealth, as an increase in liquidity may lead to notable changes in their spending behavior... We estimate that households in the lower half of the income distribution were still holding about $350 billion in excess savings as of mid-2022."
"As of mid-2022, household wealth had increased by nearly $25 trillion since 2019, even after accounting for the large equity price declines in the first half of this year, most of which accrued to the top half of the income distribution."
So if the goal is to reduce household wealth and exhaust personal savings in order to bring down inflation, they are close to the end of the rate hike cycle. But the job is not done until unemployment picks up, housing and equities collapse, and the $25 trillion in wealth creation from the Fed's money printing is brought down to whatever level they think is appropriate.
I see more pain ahead. The Fed has to deflate the prior bubble at least to some extent before blowing a new one, else we get Turkey or Argentina. That's not profitable for the commercial banks, and the Fed is a private institution owned by the commercial banks.
Gun to my head, I'd say there will be NO PAUSE next week. A 25 bps hike seems most likely, with the SVB collapse killing all hopes of a 50 bps hike.
But let's take the other side of that bet. What happens if the Fed pauses now, or even cuts?
With inflation at 6%, pause or cut amounts to the same thing. Everything will fly. Crude oil goes limit up. Gold goes up $100 in the few seconds it takes the algos to digest the news and act. Bitcoin goes straight to $30k without stopping. S&P, Nasdaq, Dow - the indices go up at least 4%. Yields plummet, with 2Y going to at least 2% (4.2% currently) and the 30Y yield goes to zero. We'll see the dollar index get trounced, the euro go to 1.3, the yen to 120 or lower, and even the third world currencies gain 2% plus.
Because a pause or cut after Powell testified twice earlier this month about his growing hawkishness, and in direct contravention with their forward guidance and talks of an evidence-based approach, will mean that the markets won't trust the Fed's statements anymore. Since 2009, markets have been addicted to QE and Zero Interest Rate Policy (ZIRP). It took a year of rate hikes to convince the market that the "new normal" is "higher for longer", that the old era of ZIRP won't ever come back. Any change to that signalling now will mean the Fed is willing to let inflation get out of control and let the dollar slide in order to save a few of its most undercollateralized banking buddies.
Foreigners will see this as a return to the monetary policy of the 1970s, and the result would be a massive dumping of treasuries and US assets.
I have thought through the logical chain of events that will succeed a Fed pause or cut next week, and I just don't see it happening given the monumental consequences that will follow. While Powell may regret his Senate testimony, he's now bound by it, regardless of which bank goes under.
This is my long-winded way of saying STAY SHORT.
There's a lot of chatter about an impending Fed pivot but I don't see it happening. Now I may be wrong, which is why I'm glad we own the banks. And I've sized my positions so that if every single stock I am long/short gets stopped out at the same time, I'll be down 10%, give or take execution related slippage. But the futures and put option positions will take a hit. So in the unlikely event we get a pause or cut, cover those at market right away.
If I'm right, we'll be shorting into an economy entering a deflationary depression. I like my odds.
One last point. Look at treasury yields. Are they pricing in a rate cut?
Current Fed funds range is 4.5-4.75%. 6 month t-bills are higher, pricing in 25 bps either next week or in May. But yields are definitely not pricing in a rate cut.
Disclaimer: Not investment advice.
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