Tide's Out

"Only when the tide goes out do you discover who's been swimming naked." Warren Buffet.

Last week, investors discovered who that was - Silicon Valley Bank, Signature Bank, and Credit Suisse. The abrupt demises of these mismanaged franchises caught the markets by surprise. Each has now been dealt with by swift actions from their regulators. But the question of 'who's next' still looms large. There are the usual suspects - over-levered homeowners, used car dealerships, and various other profligates. We are also hearing about distress in commercial real estate finance as cap rates depress values just as the WFH craze crimps occupancy rates.

Then there was the Bernie Madoff of this cycle. We saw the demise of a speculative financier who used leverage to turbo-charge his bets - Sam Bankman-Fried. Just don't dare imagine what he looks like naked though - you won't be able to unsee that!

The 'tide' to which I refer is the fixed income duration/interest rate relationship known as the yield curve. Sorry to keep coming back to this topic, but it is the only thing that matters now. The problem is, that due to a complexity never before seen, the Fed has lost control of its main tool. The current dichotomy between their 'dot plot' - the OMC's projections of interest rates - and the implicit forecast embedded in the Fed Funds futures market is glaring evidence of that fact.

In past economic cycles, the relationship between interest rates and output was highly correlated and directly controllable. Goods-producing industries dominated the economy and through the transmission mechanism of higher or lower rates, the Fed could change the levels in a fairly linear fashion. But the Covid fiscal top-up and structural shift to a services economy have obviated that once trusted model from economist's toolkits.

Beginning with the Greenspan Fed, forward guidance was meant to proffer a forecast from the Governors of what they expect the markets to do. Not this time Jerome. The huge difference in the market and Fed charts say it all - "I have some real estate in Florida to show you".

And speaking of Florida real estate, I'm right in the heart of it as I write from our winter place on Anna Maria. I see no evidence that the rate hikes are causing distressed sales or anything that looks like 2008. Sales are slowing and prices have peaked, but interstate migration is levitating the markets here. A soft landing is a real thing if you accept that Florida is representative of the broader economy. But it isn't. This morning's Case Shiller housing data is confirming the top is in.

Commercial and Industrial loans have held steady so far but increased lending standards affect output with a lag. Some estimates are that the bank crisis will tighten these conditions by as much as 100 basis points. That would effectively tip measures of financial conditions into restrictive territory (chart below), as the Fed has been desperately attempting to do for six months. They have been behind the curve for so long that the markets have given up expecting them to succeed. But remember they were coming from so far behind their policies at first seemed more bark than bite. With the sudden existential threat of a bank crisis now creating a defacto rate hike, that is about to change.

FED Financial Conditions Index

The fact markets have rallied into ever-weakening economic signals is proof of the mismatch between investor expectations and the economy itself. Since October, the cashed-up buyers who jumped the gun on the recession call and sold early, have subscribed to the 'Powell Pivot' thinking. They even bought the 'bank crisis' dip last week as I pointed out. That prevented a complete rout of equity markets as the yield curve bull steepened ( short rates rallied harder than longer-dated bond yields) and funds flowed into the Growth/Quality segment of the market.

But will they succeed in finding the true bottom? Time will tell. I hope that they don't get revealed as naked swimmers at some point this year. The economy feels to me like a giant Jenga game that holds up longer than you expect, only to come tumbling down when the key piece is removed. Was that piece bank lending to commercial real estate and industrial borrowers? Stay tuned, as the tide continues to recede. I think there are more naked swimmers out there than we first thought.

Risk Model: 3/5 - Risk On

As we approach quarter-end with many unanswered questions, I am giving the model the benefit of the doubt for now. But a sideways drift into a window-dressing phase is my best guess. Day trades only.

A lower VXV - regaining the signal line - is especially comforting to see, especially with the exogenous shocks from CS & SVIB still fresh in our minds. As I said last week, this was the easiest bank crisis I have ever seen. The market was relatively untroubled by what it deemed to be a series of idiosyncratic blow-ups.

VXV -3 Month Volatility

With the bounce in the market last week and the rotation from Growth to Value (chart) stemming from lower long rates, there is a calm but cautious tone this week.

Growth/Value ETF: Relative Price

More troubling has been the sudden detrending of Copper/Gold. The economic implications of the suddenly tight lending standards are reflected in this breakdown of an indicator that I never dismiss.

Copper/Gold Ratio