Squirrel In The Matrix



  • 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.

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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).  

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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.