Do You See A Butterfly?
Updated
March 7, 2023
3
m
TLDR:
It’s like a Rorschach test. Everyone looks at the market picture, and sees what they want to see. That sums up last week’s price action. There was some economic data last week, but what moved markets were Fed speeches. Stock hit their local lows on Thursday, then began a monster rally that was supercharged by an aftermarket speech by Fed governor Waller.
Stocks are actually higher than the close last Tuesday, yet sentiment is arguably worse with chairman Powell’s pronouncements earlier today. During his testimony to Congress, he mentioned potentially accelerating the pace of hikes if necessary. Markets went for a wild ride, with increasing divergence between stocks and bonds.
Why is this happening? Why aren’t long bonds going down more? Well, we are seeing the most massive curve flattening in half a century.
The yield curve tells you what the borrowing cost is for a given period of time. In general it is an upward sloping yield curve since intuitively you have to pay more to lock in funding for a longer term. That relationship is generally true except on rare occasions. The blue line below represents the yield differential between 2 year and 10 year treasuries.
When long term growth prospects diminish, or short term funding situations worsen, short term rates end up higher than long term ones, causing an inverted yield curve (blue line going below zero). This usually happens prior to recessions (gray bars).
That’s why many market participants have been forecasting a recession this year given the enormously inverted yield curve we are seeing in the market today.
The only time we have observed more extreme inversion was in the 80’s when rates were north of 10%. So it is all the more impressive how inverted the yield curve is today given the fairly low level of yields. This has never happened before.
Yet the Fed continues to push the yield curve into more negative territory with today’s speech. Why?
This is where stocks and bonds diverge. Chairman Powell said they’ll consider a faster pace of hikes if warranted by the totality of the data they are looking at. Unfortunately, since they only control short term rates, the market responded predictably with short term rates going up.
In fact, the CME’s FedWatch tool shows the probabilities of hikes went from 25 bps as the most likely to 50 bps at the FOMC’s meeting later this month. It was nearly exactly the opposite probabilities just the day prior.
It took a few minutes for bonds to get their bearings, but long term rates began to drop shortly following the announcement. The reason is that the more aggressively the Fed hikes today, the more likely they’ll have inflation under control, and sooner rather than later. This means that long term inflation will be well anchored, thereby increasing the odds that you’ll get decent real yields despite buying bonds at sub 4%.
Stocks on the other hand, have not taken the news lightly. After a volatile session, they are at the session lows as higher rates crimp on economic activity, and potentially hurt profit margins.
Stepping back a bit however, it’s worthwhile to consider whether this is actually a long term negative for stocks. They have weathered the fastest pace of hikes in living memory. Yet stocks are down by less than 20%.
Will the next 1.5% of hikes generate a proportionate level of shock? It is doubtful. Markets adapt, and despite inflation coming down slowly, we are already within 1.5% of the actual inflation rate whether you prefer PCE or CPI.
Meanwhile in crypto…
Silvergate Bank failed to file their 10-K on time last week, raising concerns that it may not be able to continue as a “going concern”. Many big players have taken proactive measures to stop processing their bank transactions through SEN, Silvergate’s real-time cash settlement network.
The news sent shockwaves through the crypto ecosystem especially considering their earnings call in January where they detailed a disastrous but survivable hit to their balance sheet. This development is definitely negative as they were one of the few unabashedly crypto friendly banks in the ecosystem. Silvergate’s failure could leave crypto companies with few options to bank in the US, potentially causing many projects to move offshore.
This also leaves Coinbase as one of the few publicly traded US-based crypto companies left.
Powell’s testimony caps off a volatile week. But we’ll see a lot more volatility ahead as different markets are being pulled in opposite directions. As the Fed has reiterated however, it’s a one way street for inflation. Whether it is higher for longer, or comes down quickly, the Fed will get it under control, regardless of the costs. It’s time for stocks to adjust to that reality. Will that mean another 10% drawdown? I don’t think so.
Looking ahead, the bigger questions that will need to be answered include:
Each of these issues will have big ramifications on markets. Ok, maybe less so for crypto regulation, but it’s definitely a topic dear to my heart. That’s all for now, see you next week!
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