Powell's Fight Against Recession and Inflation is Failing

From what we've seen over the past three months, long-term rates can't continue to rise without systemic risk. A hard landing by the Federal Reserve and rate cuts this year are more likely as a result. Growth stocks will also benefit from it. 

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I'm sorry, I made a mistake 

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As a way to keep myself honest, I periodically host 'mea culpa' posts that look back over a long period of commentary and analysis and examine where I've gone wrong.

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There are a couple of reasons why you should do that now. A number of bank failures in the US, as well as the near-failure in Switzerland, have changed the risk landscape hugely over the last few years. As a second benefit, the end of the quarter is a perfect time to reflect on the past year - and look ahead to the future.

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Four things are important to me: if my recession call still holds water; if higher interest rates for longer periods make sense; if big tech is no longer synonymous with growth, and if a banking crisis is causing crypto to emerge early from its winter.

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Is Jerome Powell the next Paul Volcker?

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Fed Chairman Jerome Powell doesn't want to be like Arthur Burns - who headed the Fed in the 1970s - who was blamed for inflation spiraling out of control. As a result, he wants to emulate Volcker, the inflation slayer who led the U.S. into four decades of low inflation and growth.

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Whatever the truth of the stark narratives, it doesn't matter. Whatever Powell's fate is in history, it will depend on his ability to confront an inflation scare. Volcker is his role model, so he is channeling him to the best of his ability, but he is aware that too much of Volcker will pose severe risks to employment and economic growth.

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Inflation tends to be a Scylla for Powell, while recession tends to be a Charybdis for him. As it stands, the USS Federal Reserve looks more like it's going to crash into Charybdis than sail smoothly through.

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Treasury selloffs cannot be sustained in a hard landing 

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Throughout the year, I've told you a recession is my base case. A potential credit crunch resulting from the regional bank liquidity crisis makes that outcome more likely. In addition, recent events increase the likelihood of a hard landing, in which unemployment grows above 5% due to a contraction in the economy - something I did not expect.

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I leaned toward earlier in the year aggressive steepening of the yield curve triggered by the sale of longer-maturity Treasuries. That view is out the window now. As the market came to understand the Fed's policy on inflation, I told you long-term yields would increase. In February, they did rise - significantly. In spite of this, Silicon Valley Bank succumbed to deposit withdrawals when yields rose across the curve at a rate that triggered a liquidity crisis.

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Ten-year yields are currently around 3.5%. The Fed sets the overnight rates, so these rates put significant pressure on the balance sheets of investors who hold safe assets like Treasuries. As a result, portfolios throughout the fixed-income world could experience massive additional mark-to-market losses if the Fed convinces the market it means business about longer-term rates averaging 5%. 

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I thought that would be a likely scenario at the beginning of the year. My relationship with SVB no longer exists after the collapse of the company. There's a danger that the Fed will inadvertently push the economy into recession with the intent of cutting rates in order to address the systemic risk. If it pushes forward, a recession will likely result in the Fed cutting rates.

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It's unlikely there will be a steepening of the curve now unless rates are cut more aggressively than the markets expect. As long as the Fed raises rates in response to inflation pressure, I doubt that it would risk another liquidity crisis. 

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Solvency crises are triggered by liquidity crises

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As I have explained before, the Fed can move aggressively until something breaks. That is why I sound very dovish now. As of a month ago, it didn't seem as though anything had broken at all - even the economy seemed to be re-accelerating as consumers continued to spend, so it could even be said that nothing had broken. There have been a lot of breaks since then, so the Fed needs to either stop short or risk more breakage and crisis in the near future.

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In spite of the fact that we have been in such a liquidity crisis, it is manageable. All evidence suggests that the crisis has already started to recede. The Fed has demonstrated that they are capable of handling these situations as it did in March 2020, when a pandemic started and the Fed greased the skids and ended a financial market panic. In my opinion, I do not consider SVB to be the first domino of many that have been falling down, as policymakers have been proven to be capable of short-circuiting liquidity crises. If only policymakers and regulators make a greater effort to address financial system problems, the acute liquidity issues will fade.

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Recessions change the calculus. As defaults instead of forced asset sales crystallize, recessions transform liquidity crises into solvency crises, which reveal concentrated risks. As an example, thrift banks did not collapse en masse during Volcker's onslaught via liquidity crisis during the 1980s savings and loan crisis. After the rate hikes and the early 1980s recession, they began hemorrhaging losses as poor loans soured.

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This quote from the Federal Reserve's website sums up the crisis nicely.

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During the thrift industry meltdown, Texas was at the epicenter. FSLIC-insured thrift institutions accounted for nearly 40 percent of failures in 1988 (including assisted transactions), but the losses soon spread to other states as well.

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It is clear that the oil bust caused a lot of economic harm to Texas, which resulted in a greater number of loan losses and, consequently, a higher number of small and medium-sized loan failures. However, this did not occur during a period of economic crisis, but rather at the tail end of the boom. Note that you cannot simply brush these things off the table. In spite of regulatory forbearance for the S&Ls, fraud resulted, making the crisis worse, and financial crisis.

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I think one of the reasons I am less concerned about the current liquidity crisis in this context is the likelihood that the high vacancy rates in generic office real estate will remain high for a longer period of time due to industry-specific losses arising out of the downturn.

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A look at the numbers

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In 4Q 2022, the office vacancy rate was the highest since 1992, and during the S&L crisis

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Industry landscape changes

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As a result, there is a possibility that the story today will be more difficult to be told than I had imagined, which could make it more difficult to maintain a monetary policy approach that is higher for longer periods of time. As a consequence, lower discount rates will be a huge benefit to companies like those in technology that expect to generate a large amount of cash flow in the future.

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Taking Tesla as an example, although it isn't strictly a technology company, it nevertheless relies on growth in income and cash flows five to ten years from now to justify its valuation. I wrote about Tesla in December, and the highlights are as follows:

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Musk will be able to maintain his wealth, even grow his wealth, if he gets his strategy right. Markets are cruel, though. In the very near future, the share price of Tesla shares could fall by another two-thirds after being cut by two-thirds already. It is equally likely that either outcome will occur.

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I positioned a near-term low for Tesla at $120 a share back then, when it traded at around $140 a share. As the recession lies in the future, we still face the risk of poor execution and a deep recession, which could result in a low of around $60 a share. I wrote about Tesla a couple of weeks ago, when the company was trading around 40% above that level.

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I was leaning toward a bad outcome in December when Tesla might eventually bottom at $60 per share. Tesla is still a market leader. A lower discount rate has helped to significantly increase Tesla's share price. Isn't that the takeaway for big tech too? As people consider what a recession means for valuations, a mini-rotation into technology seems to be taking hold as the Nasdaq is back in a bull market and a mini-rotation into tech looks like it's taking hold.

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There is a trend going on today that favors growth over value in a world in which any growth is king. We don't know how long this phase will last, but companies with earnings growth will be benefited if the Fed does not keep raising rates.

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A crypto-based alternative to banks

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My last thought has nothing to do with cryptocurrency. Cryptocurrencies were born out of distrust in the financial system during the Great Financial Crisis. It is an industry that has developed from the ashes of the Great Financial Crisis. The narrative was that the existing financial system was faulty and over-leveraged and destined for a bust. From the ashes, a new, decentralized, trust-free, and centralized financial world would rise, embracing cryptography as the core.

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The SVB situation forces investors to think about alternatives, even if there were allegations of fraud and failure in crypto in 2022. Bitcoin bounced up from $17,000 to levels above $28,000 at various points, even though it ran up against the SVB situation.

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What are our next steps?

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In conclusion, I was wrong in assuming too much of the stability of the US financial system following rate increases from the Federal Reserve. Recent events are likely to calm down, but they indicate that stress has been building up and are a sign of more to come. My chances of a hard landing were probably overestimated, and I overestimated the ability of the Fed to raise rates without adversely impacting the solvency of debtors (and even banks).

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Because of the credit crunch, I believe that the world is more likely to enter a recession. Consequently, we will soon discover how robust non-systemic players' balance sheets are, both inside the financial system and in shadow banking, which is less regulated. With strong balance sheets and good existing business models, creditors will be able to manage writedowns as monetary policy tightens, leading to defaults. Poor fundamentals and weak balance sheets will lead to problems.

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In a non-zero rate environment, I mean a company that does not have good fundamentals. Although policymakers know now how many distortions that zero-rate world created, they probably won't go back to zero anytime soon — even if rates don't stay at the high plateau near 5%. As a result, some businesses suffer when free money isn't available.

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Since Charles Schwab earns half its income from net interest margins, its cost of funding is likely to rise. Regional banks, for example, will likely need to raise deposit rates. In light of any increase in funding costs, the question arises: what is their source of income to offset the increase? Buying generic office space could prove problematic. Long-dated government papers will also pose a problem, but that's a longer-term and fundamental problem. As Schwab reinvests low-yielding maturing government-backed securities, the company actually sees margin opportunities, not shrinking ones.

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Private equity is one area that is gaining scrutiny since it is outside the jurisdiction of most regulators and is becoming an increasingly important part of US financial institutions. Leverage plays a key role in that question, along with whether it will lead to large writedowns if the economy turns down. 

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Although the economy and markets seem to be headed where I would have predicted, government bond markets have performed better than I anticipated, and the banking system is probably doing worse than I had expected.

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It's more likely that we are at the tail end of a garden-variety business cycle with normal workout issues to resolve than I was when the year began. But I don't think we are in a financial crisis. Even so, when things go south, there are always surprises to be found. This time, they will not disappoint.