“Take it to the Limit. One more time“
The Eagles, Take it to the Limit
Last week, we discussed the two dominant schools of thought in the macro space that have evolved in relation to the implications of the US bank credit ‘event’ on the US economy (and thus monetary policy) going forward: Those who think the impact is modest and contained, the ‘nothing to see here’ contingent; and those who see the impact as a more direct recessionary precedent. We also discussed the fact that we subscribe to neither camp, rather that the event will likely exacerbate our core view - that inflation will fall faster than markets anticipate through 2023.
As this week has evolved, the topic of debate has returned to the front and centre, as the tailenders of the Q1 earnings season (from a banks perspective) highlight continued fragility in deposit retention and thus profitability. This is not to mention the fact that the whole affair has shone a spotlight on the disparity between money market (or CD) rates and ‘back book’ bank deposit rates at very substantially lower levels, to many who may have otherwise remained ignorant.
The problem is that lower deposits lead to lower lending; lower profitability equates to lower lending (higher deposit betas to retain deposits reduce profitability and thus reduce lending); and lower share prices lead to lower lending (via an inherently more conservative strategy, and the sharply reduced ability to raise capital through equity). Also, any move towards improved security or retention of operational deposits involves higher liquidity against them (likely future regulation will have the same effect) which will lead to, you guessed it, lower lending. From the perspective of aggregate demand momentum, it is no longer just about the cost of credit, but also now the availability of credit.
Looping this back to our core views on inflation, the prospect of further significant declines in bank lending (lending has been declining in nominal terms for some time now, as rates rose - part of the traditional monetary transmission channel) have important connotations for aggregate demand. The current ‘sticky inflation’ camp is at least in part predicated on a tight labour market, and by extension the conjecture of excess demand. However, with the small bank lending more significantly concentrated in small business lending, in addition to the fact that small businesses account for somewhere in the region of 70% of labour demand growth, an acceleration of the rebalancing of supply/demand in the labour market seems more likely.
We have also been clear in recent weeks that we feel that the Fed has gone far enough in tightening monetary policy. Excessive monetary stimulus of the ZIRP/QE/FAIT era has propagated a global economy where debt has ballooned (arguably the main intention of the stimulative monetary settings) and now policymakers appear intent to combat above target inflation with further tightening - despite the fact that headline inflation in the US peaked in June 2022. As the Fed moves further into restrictive territory, the risk that policy hits excess debt, and not excess demand, is high… and rising.
If we are right on inflation, then the current policy setting becomes even more restrictive (higher real rates). In our view, consumer demand is weaker than the traditional labour market metrics might suggest (tight labour markets at the low end of the income spectrum does not imply a uniform upshift in consumption and may not even be positively correlated to aggregate demand on a forward-looking basis). Thus, the markets are right to price sharply lower rates over the second half of 2023 and first half of 2024 - SOFR futures currently imply between 6 and 7 25bp cuts over the period.
While we have clear reservations against further rate hikes in the US, markets are convinced (perhaps rightly as a function of Fed speaker guidance over recent weeks) that the FOMC will vote to hike rates by a further 25bps on 3rd May. Given the current Fed’s desire to avoid decision-day market volatility, it seems likely that the Fed will deliver on expectations. Volatility from regional bank reporting (deposit retention fragility) has not deterred market pricing for the May meeting, but it has reaffirmed rate cut expectations further out the curve.
There is one final data release that may alter the Fed’s confidence in delivering on its promised 5.00-5.25% policy rate and that is the SLOOS - Senior Loan Officer Opinion Survey on Monday 1st. However, anything but a horror story narrative on the banking system is likely to be too little too late - even if we are of the view that the Fed has gone too far too soon!
“People in the UK need to accept they are poorer” - BoE Chief Economist, Huw Pill
Across the pond in the UK, the situation is perhaps more exaggerated. We have spoken at length about our concerns of asymmetric downside risks to consumption in both the UK and the US, as the pandemic demand shock plays out fully and excess savings give way to excess debt and the negative wealth effects of falling house prices weigh more heavily on demand choices against a reality of high nominal prices, high cost of money and high absolute tax levels (in the UK predominantly).
This week, Bank of England Chief Economist, Huw Pill made the remarkable comment that “people in the UK need to accept they are poorer”. Essentially, Pill is making the same point that we are about downside risks to consumption, just from a different angle. Indeed, I have seen a very interesting chart this week that corroborates this premise, which takes data from the Bank of England and compares collective income against consumption - or effectively looks at the ability of the UK to finance its own consumption. The decline is striking.
The point is that current demand growth or consumption is essentially unsustainable, and as a good friend of mine once said, “That which is unsustainable, will not be sustained”.
From a policy perspective, the dilemma is also perhaps greater in the UK. Absolute levels of inflation are higher (both headline and core) and the turning point is less pronounced - even if base effects likely mean that both fall shapely over the course of 2023. However, conditioned on market rates, the Bank’s own forecast show that inflation likely falls significantly below target at the forecast horizon - at any other time this would elicit rate cuts from the Bank, not hikes.
In both the US and the UK, markets are convinced that the next move (both over the coming weeks - after the Coronation of King Charles III in the UK) will be a 25bp hike. While the Fed and the BoE are not in the habit of disappointing resolute expectations beyond the blackout period, we remain of the view that upcoming moves are a step too far. Indeed, it is perfectly feasible that the higher they go now, the more they will need to cut - back towards the significantly lower equilibrium rates - at a later stage. You could say, one step forwards, two steps back. Either way, from our perspective, Fed and the BoE may hike rates ‘one more time’ but it is far more likely that they are now ‘taking it to the Limit’.
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Bloomberg, Huw Pill, April 2023 - https://www.bloomberg.com/news/articles/2023-04-25/boe-economist-says-uk-people-need-to-accept-they-re-worse-off
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