Credit Cycle

Credit Cycle Looming

We have seen several large banks fail or need a bailout over the last few weeks which means that loan officers will begin to restrict credit by tightening their underwriting standards. Recessionary periods are denoted by a restriction in credit creation so the economy is more likely to slowdown in the coming months. If true, the Fed will get lower prices and succeed in fighting inflation. However, the unintended consequence of fighting inflation this aggressively is that something breaks and in this case it is the regional banks that are suffering from poorly managing their interest rate exposure.

There are many places to lay blame regarding the recent spate of bank problems but the Fed created a culture of zero rate volatility for over a decade. It was only a matter of time before inflation ramped up and the pandemic became the accelerant to fuel inflation. The recent failures of Silvergate, Silicon Valley, and Signature Banks are not isolated incidents. All banks now hold long-dated debt of commercial and residential real estate which have dropped significantly in value and need fresh capital as investors will be punishing bank stocks as this information becomes more widely understood.

What Will the Fed Do Now?

The timing couldn’t be better for a Fed policy decision and we get one on Wednesday (2PM). The Fed will now need to weigh the solvency of banks with fighting inflation. Earlier this month consensus was 50bps but that has dropped to 25bps and maybe even unchanged. Some are now calling for rate cuts. However, the European Central Bank raised 50bps on Thursday despite Credit Suisse needing a recapitization so maybe that is a clue that the Fed will continue to push higher.

For perspective, I have included the graphic below to illustrate how destructive inflation is over long periods of time. The Core PCE (the Fed’s inflation measure) is around 4.75% but the Core CPI is around 5.5% and that would imply losing 40% of your purchasing power over a ten year period. This could be used as a guiding principal in pushing rates higher until inflation reaches 2% but the clock is running out on when the next credit cycle begins in earnest.

Compounded Inflation
Provided by Elliott Wave International

The Bond Market

Bond yields have volatility now and you can see how far yields fell over the last month when comparing the grey line to the blue line. This kind of movement warns of a slowdown in the making and the dramatic fall in 1Mo T-Bills is a direct result of stress/risk at depository institutions. The belly of the curve will continue to gyrate depending on what happens on Wednesday and the messaging on the banking outlook. Not to mention the moral hazard that will arise if banking executives are told all of their depositors are fully insured.

US Treasury Yield Curve

The Stock Market

The S&P 500 dropped down to the 38.2% FIB at $380 this week and rebounded to close out at $390 which was not bad considering all the banking issues. The green trend line is still being respected but losing the 12/22 pivot at $375 will likely bring in another wave of selling and we have the potential for a catalyst with the Fed. So, there is support in the $375/$380 zone but that will need to hold through next week’s rate decision. The potential for a pivot by the Fed is high and I want to point out that markets typically fall when the Fed cuts rates so their messaging this week will be significant.

S&P 500 ETF

Economic Data

  • The February Producer Price Index (PPI) showed signs of slowing (good) to 4.6% from 5.7% last month. The core rate was higher by 4.4% vs 5% in January. Last month’s number was also revised lower so the Fed may be getting the slowdown it wants.
  • Initial Jobless Claims fell below 200k to 192k which was 13k below expectations and vs 212k last week. This metric should rise sharply if/when the labor market weakens.
  • The March NAHB Home Builder Index rose slightly this month. The NAHB commented in their report, “…a follow-on effect of the pressure on regional banks, as well as continued Fed tightening, will be further constraints for acquisition, development and construction (AD&C) loans for builders across the nation. When AD&C loan conditions are tight, lot inventory constricts and adds an additional hurdle to housing affordability.”
  • The Fed’s balance sheet is now back to the same size as last November which is likely attributed to the banking woes.
  • The February CPI rose 6% while the core came in at 5.5%. The details of the report show services rose 7.3% while goods are up only 1% as the supply chain improves.
  • Both the NY and Philly manufacturing indices were well below zero, extending the manufacturing recession into March.

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Paul McCarthy, President of Kisco Capital, LLC

Paul J McCarthy III

President, Kisco Capital

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.