Summary

• Fortunately, the Squirrel’s first (and only) experience at the business end of a bank failure took place 6 months into my career. The bond market has decided that the failures of SVB and Signature have created enough of an issue with respect to stability of the US financial sector that the Fed’s inflation fight may now need to take a back seat.

• We break down Jerome Powell’s price stability versus financial stability dilemma. H has the toughest press conference of his career coming up on Wednesday.

• l seesthe “pivot” crowd salivating to buy risk assets but is happy to watch and wait. We go into this critical week sitting with our highest cash level in almost 12 months.

• Separately, we have had a eureka moment on artificial intelligence and feel uncomfortable about its implications from both a societal and investment perspective.

• Finally, we cannot help feeling that we are getting close to a place where oil is now both pricing both a bone-crunching global economic recession and a return to “The End of History” in terms of geo-politics. Enough!

Squirrel in The Matrix

Fortunately, the 🐿️’s first (and only) experience of the business end of a bank failure took place 6 months into my career when I had very little at stake (although it certainly did not feel like that at the time).  One thing is for certain, the stakes were generally a lot lower in the less financialized days of February 1995!

The collapse of Barings due to Nick Leeson’s £450m (yes, that’s an ‘m for million’ in the headline) losses in Nikkei index options was an early lesson in the perils of selling volatility and probably the first time that the words moral hazard held any meaning for me.  

At the time, the Bank of England and a supporting cast of senior bankers decided that the demise of the 200-year old merchant bank was not going to pose a risk for financial stability.  On the contrary, bailing the venerable House of Baring out of its 'spot of oriental bother' risked creating unacceptable moral hazard.  After a nerve-wracking week, Barings was acquired by ING for a pound; the sky did not fall in; and my £400 (no ‘m’ after that number!) graduate trainee bonus was honored in full by our new Dutch owners!

The failures of Silicon Valley and Signature banks could not have happened at a worse time for Jerome Powell.  The Fed’s emergency provision of liquidity via its regular discount window and the new BTFP facility have already - within a matter of days - unwound 50% of the balance sheet shrinkage achieved from 8 months of Quantitative Tightening.  The bond market has decided that the failures of SVB and Signature have created enough of an issue with respect to stability of the US financial sector that the Fed’s inflation fight may now need to take a back seat.  It is now pricing aggressive rate cuts for this year.

The equity market has taken one look at these lower interest rates and seems desperate to return to the post GFC playbook of buying the dip in large cap technology stocks.  The 🐿️ feels no strong urge to follow the mob while banks are in the process of blowing up.  I think we can afford to wait and see.

I do not envy Mr Powell’s task for next Wednesday.  Let’s break down his dilemma:

Price Stability (i.e., inflation).  Based on hard data, his work on (core services) inflation is arguably still (very much) ‘in progress’.  Services inflation (ex-food and energy) continues to move stubbornly higher.  Our view is that food and energy inflation could well be back again soon (we are overweight both Ag and energy commodities).  

Source:  Bloomberg; my️ annotation.

Whether or not, inflation is under control ends up being a recession call.  There is no precedent for the scale, pace, and aggression of this recent rate hiking cycle.  The employment (especially blue collar) still appears to be robust, but we are persuaded by those commentators screaming that the effects of the rate hikes lag, and that this situation could change very rapidly.

My verdict:  The Fed has probably hiked enough to create a recession.  The problem is that they will be judged with hindsight on their inflation mandate.  If it comes back (recession or not), Powell will be seen as an Arthur Burns and not as a Paul Volcker.  For this reason, we suspect he errs on the hawkish side.

Financial Stability.  Central bankers have been keen to point out that these recent bank failures do not represent a systemic risk.  For now, the problem is liquidity, not solvency.  Mixed messages from the US administration (yes you, Mrs Yellen) and regulators have triggered a flow of deposits from regional banks (who normally do most of the lending) to the big money centre banks (who do not).  For evidence, TS Lombard’s Dario Perkins shared this fascinating chart this week.  How can a reduction of lending to the real economy not be deflationary?

   Source:  TS Lombard (Dario Perkins)

🐿️ verdict:  This is not 2008 (and interest rates are not supposed to be the tool with which central banks fix stability of financial institutions), but with smaller banks losing access to cheap funding (deposits), credit contraction or at least tighter lending standards (and therefore slower growth) looks to be on the cards.  This would suggest that Powell could afford to ease off a bit.

Financial conditions.  These have undoubtedly tightened but we need the dust to settle from the avalanche of offside positioning unwind before we can do a proper assessment.  Trend following / CTA and leveraged interest rate traders have clearly had a torrid time.  Bodies in hedge fund land have started to float to the surface.  This has created significant volatility from wide bid-offer spreads – even in sovereign bond markets.  The question is, how long will it take to settle down.
 

Clockwise from upper left: 1. The trend-following CTAs had just about their worst day in recorded history on Monday. 2. Chief culprit for the loss being their (and the macro hedge funds) record short positioning in US Treasuries (pink boxes). 3.  CTA and DBMF are 2 examples of ETFs which employ the trend-following strategies. 4. With these moves, casualties start to float to the surface.

Sources:  Saxo Markets; Bloomberg; TradingView.

My verdict:  Too early to tell, but this volatility probably passes with time as the risk unwind cycle completes.  The problem for Powell is the risk of equity and credit markets exploding to the upside in response to a perceived dovish move from the Fed.  This will re-loosen financial conditions rapidly. No bueno for inflation.

Has the market already started to front run this?  The week’s bid to the FANG (large cap technology stocks) in the face of March 2020 levels of bond volatility is notable (see chart below).  What we do not know yet is how much of that bid came from the ‘front-runners’ versus how much will be attributable to (i) a general risk unwind (also seen in crude) triggered by the violence in the rates market and (ii) natural option dealer hedging flows as March expiry put protection, particularly in large cap tech names, rolled off at the end of this week (watch Cem Karsan provide an (as ever!) elegant description of this phenomenon).

MOVE index of US treasury volatility versus the QQQ (large cap tech) ETF.  Source:  TradingView.
 

We also saw a return of this type of nonsense 👆 last week.  Crypto ‘boyz’ are salivating at the prospect of a return of the money printers.

Bottom line:  This Wednesday, Jerome Powell has the toughest press conference of his career.  I do not envy him.  The market is pricing a 25bps hike.  Either a larger (50bps) hike or no hike at all seems very unlikely.  We suspect that this will be accompanied by some warm words about the state of the banking system and some very hawkish language on inflation and the economy to keep ‘animal spirits’ in check.  

I speak to many investors keen to revert to the traditional post GFC playbook and buy risk assets as the central bankers go back to easing monetary conditions.  As mentioned above, I am not yet ready to join them.  The portfolio enjoyed a windfall gain from the rally in short-end treasuries which offset losses elsewhere in the book (especially commodities).  We aggressively took down risk at the beginning of the week and go into this critical week sitting with our highest cash level in almost 12 months.  Happy to watch and wait.

Artificial Intelligence.  The cover image for this week’s note was generated by MidJourney’s image generator with the prompt: “Blind Squirrel bending over backwards to dodge bullets from The Agents in slow motion using the bullet time effect as in the scene from The Matrix movie. Hyper - realistic. Image inspiration: [link to still image of Keanu Reeves in the movie on the web].” Amidst the chaos of this week’s volatile markets, the 🐿️ fortunately managed to get a few big calls right (and I feel great about going into next week with very little risk on). 

I have been in the camp that this AI thematic is a bit faddish and gimmicky, going as far as to ridicule the AI ‘buzzword bingo’ that dominated the most recent corporate earnings season.

However, this week marked a shift in view for me.  For readers with a RealVision subscription, I highly recommend watching this interview with the founder of Stability AI, Emad Mostaque.  If you do not have a subscription, get in touch and I will be happy to share my notes.  I also came across several developing use cases stemming from the launch of OpenAI’s ChatGPT-4 and Midjourney’s v.5 that are nothing short of mind-blowing.  I am not going to try and describe them, please just check out the links to the tweets below.  It’s not just professional services, AI is coming for the artists and storytellers too.

I have always slightly dismissed the "but innovation and technology trump all" arguments that the perma-bond bulls roll out when the “debt and demographics” arguments do not convince this curmudgeonly inflationista.  However, the rapid growth in capability of these machine learning modules is nothing short of terrifying. 

The implied productivity gains from AI technology must be deflationary in the long run.  And it is a very scary form of disinflation – in which prices come down because white collar workers (the engine room of consumption) no longer have a job to go to to pay for things.  Am still thinking through the societal and investment implications of this.  I certainly do not think the answer is “buy Microsoft, Google and NVidia!”.  I suspect that the opportunities will be on the short side (or that the long duration bond bulls end being right after all).  No position for now.

A quick note on Oil.  We were wrong last week.  Last Friday’s move up alongside the 2-year note and the precious metals was a total head fake. 

WTI Crude (Black) vs Gold (gold), Silver (silver) and US 2-Year yields (turquoise).  Source:  TradingView.

Oil certainly got caught in the ‘risk off’ wholesale liquidation event of last week but I cannot help feeling that we are getting close to a place where oil is now both pricing both a bone-crunching global economic recession and a return to “The End of History” in terms of geo-politics. Last week was certainly not a $10/bbl down in terms of news flow (the worst weekly move since last summer).  It felt like one giant margin call.  We are close to adding length to our (longer dated) crude futures position.

Good luck this week.  It is going to be a big one. 

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