Banks Thrown a Curve

Just ask any Big Leaguer, when you are thrown a curve, you swing defensively. Last week, was a tough pitch to hit and mighty SIVB has stuck out.

Tuesat11 from two weeks ago:

"The inverted curve, as an indicator, is either being ignored by the momentum/repositioning buyers or it is a failed metric that has lost efficacy. I find it hard to believe the latter, but I'm not the market."

I posted this a couple of weeks ago prior to the failure of a bank that nobody outside of a few tech bros had ever heard of. Then all hell broke loose. Who, saw it coming? Why did it suddenly morph from a bank with a mismanaged balance sheet into a systemic risk of global proportions? And more importantly for equity investors - is it over?

The answers are mostly conjecture. But guesswork is the essence of risk-taking. You pays yer money, you takes yer chance.

My messages have been consistent on a few points recently. I have argued the main driver of the upside to the equity markets has been the positioning (investors underweight risk assets), and sentiment (a low level of optimism). I have said it is not a classic bull market supported by a new growth cycle, but one driven by traders. I have believed that the equity markets offered only transitory attractiveness and a structural bull phase was not possible until the yield curve normalized. Ominously, I also said that normalization, whenever it occurred would be very painful for investors.

So in essence, I did 'see' it coming, just not at a granular level. I wasn't smart enough to be short the KRE let alone SIVB.

How did it morph into a global issue? Again, any reader of my musings would have heard my message about the many behavioural imperfections in markets. Recency bias, attribution bias, and anchoring have contributed to the sudden shock effect on overall confidence. The benign level of the 'VIX' was a 'tell' that I pointed out. It was cheap insurance two weeks ago, but paying for insurance never seems like a good thing until it is. And it was. Again, the message of an inverted curve was universally ignored.

Now to the hard part - is it over? Not really - not until the curve normalizes fully. And the rally today is actually furthering that inversion. Not a good sign.

Imagine a business with negative gross margins that is struggling to survive. When asked, the CEO, with the hubris that comes with that position, says " we lose money on every unit we sell - but we make it up on volume! That is the banking system now. When the rates on deposits exceed the returns on their assets, I don't like their chances.

Through a series of interlocking mistakes, the Fed has now put the financial system in just such a position. They were so anchored by their experiences from the GFC they are compounding their errors with acts of commission and omission. By keeping the liquidity accelerator on the floor, suppressing rates, while allowing the financial system to run on cruise control, they shouldn't be surprised that they created a crash.

In tomorrow's Fed decision, the markets will likely see what they are now 'pricing in' a 'dovish hike'. A move of 25 basis points higher in Fed Funds, combined with language that acknowledges the risks to growth due to the banking crisis. The implications are clear that inflation-fighting will become subordinate to financial stability in Chair Powell's workflow plan. But this just kicks the can down the road. Inflation will stay stubbornly high as a result and there will be a price to be paid for that.

Financial conditions, credit spreads, and even equity volatility are not reflecting an imminent recession. The Atlanta Fed's indicator - GDP Now - is looking for a 3% growth rate this quarter. So my question is this - where is the safety valve for the economy to let inflation bleed off? Unfortunately, it seems the financial sector is the answer - you know, the one that loses money on every unit and is unaware that it can't make it up on volume!

If the bounce we see in the markets continues on today's restoration of confidence, we will be back to square 1. The systemic problems will remain in the banking sector. Deposits will cost more, loans will grow more slowly and regulation will increasingly play catch up, adding to costs. I've never seen a durable low in equity markets that is followed by a true bull market without a 'V" shape recovery in the banking sector.

I'm not a perma-bear. But at this juncture in the financial cycle, it is only prudent to imitate one. The good news is that, with all the bad news this week, were that much closer to the final chapter of the bear market. But don't be fooled by the relief rally here. There is a structural problem that remains unresolved and another strikeout could be just around the corner.

Risk Model - 2/5 - Risk Off

This was the most unimpressive bank panic I have ever seen. This dip is being bought. The positioning rally is alive and well. The past 5 days saw the largest inflow into the SPY in over a year. It seems that the FOMO-driven investment thesis will never die. That's what makes this phase of the market cycle so interesting and yet so frustrating to trade. Investors have again pulled the trigger after being prepared for bad news with lots of cash. The choppy uptrend continues to hold, especially when you exclude the banks. Apple was seen as a 'flight to quality' asset along with gold and bitcoin. The Nasdaq is up 7% from the lows already.

This is why the markets are so tricky. There is a massive decline in correlation underneath the broad averages. It is a market of stocks, not a stock market. And despite all the talk of volatility, the chart (below) shows a decidedly unperturbed VIX that barely registered relative to past crises. Call me back when the market's inverted curve ball dis-inverts - if it ever does.

VIX - 25 Years