April 2023

April 24, 2023 | Derrick Lahey


“You cannot reason a person out of a position that he or she did not reason themselves into in the first place!”

-- Jonathan Swift

Stock and bond markets have been a bit schizophrenic so far this year which has frustrated both the bulls and the bears. In January, stocks and bonds bounced on better inflation readings and the subsequent fall in long interest rates. Then February reversed most of the gains based on stronger employment and inflation data that implied still more interest rate hikes may still be needed to break inflation. We know inflation is trending lower, but it will obviously not be a straight shot back to the 2% goal so markets as well as the US central bank are interpreting every data point.

US Federal Reserve has a dual mandate of 2% price stability and full employment. After ignoring high inflation for too long, the Fed is now prepared to sacrifice full employment in the quest to get inflation down to the target of 2%. I actually think the Fed made the decision last year that a recession is likely necessary to bring the tight labor market back into balance. Not great news for the millions of people that will lose their jobs on this journey, but it is for the greater good of price stability as we don’t want high inflation expectations being anchored at 7%+. So until unemployment gathers momentum likely on its way to 4.5% (currently 3.5%), the Fed is going to keep draining liquidity and talk tough. We are back to a world where “bad news is good news again”. Good news like good employment numbers causes the fear or additional interest rate hikes which pressures asset prices lower. Remember, every asset under the sun is value with the interest cost of money.

The Fed has a history of hiking rates too high until something breaks and once again, after a very aggressive hiking cycle that began just over a year ago, we are starting to see stuff break. The banking turmoil last month is a sign of strains building in the system. So far, the stress has been well contained with just a couple of high-profile USA bank failures and one in Europe. The regulatory response was fast and predictably included another round of lending facilities which were originally fashioned during the Great Financial Crisis. Confidence is still a little shaky as money moves from smaller banks to larger banks but the government refuses to let individual depositors be punished for bad risk management and regulatory missteps. Expect more turmoil and most likely additional bank failures along with a wave of bank consolidation in the months to come in the USA. The additional regulatory burdens will be too much for many small players. Unlike the Canadian and European model, there are literally thousands of banks in the USA with many of them being privately owned. It is hard to watch all of them closely so the regulators watch the large systemically important ones the most and will likely regulate many of the smaller ones out of existence.

What we did learn in March is how fast banks can fail these days. Silicon Valley Bank was the second largest bank in US history to fail (second only to Washington Mutual which was a casualty of the 2008 Great Financial Crisis). It had grown deposits from the technology venture capital sector very quickly over the last few years, with 88% of deposits in excess of the $250k federal deposit insurance maximum coverage. These were not household bank accounts but were huge balances across fewer account holders. Somewhat ironically, technology contributed to the pace of the failure because in the age of instant communication and electronic wire requests, deposits can flee very quickly. In fact, it was reported that it took less than 4 hours for $42 billion of deposits to run out the door of Silicon Valley Bank. Once confidence is lost, a bank does not have much longer than the Titanic had after hitting the iceberg.

While that sounds scary, any comparison to the Great Financial Crisis (GFC) of 2008 is nothing short of hyperbole and happily anyone doing such fearmongering has been harshly corrected. Rather than holding opaque and toxic mortgage debt instruments like they held in the GFC, banks are under current stress for holding US government bonds that fell in value in response to the many interest rates hikes over the last 12 months. But the US government bond market is the biggest market in the world with very efficient price discovery. So the US Treasury decided to back their own debt at 100 cents on the dollar if any institution needs liquidity. No doubt this turmoil is leading to a credit contraction as banks stop lending or charge more for credit risk and may even start calling in loans. This is a deflationary shock to the economy which is estimated to be the equivalence of an additional 0.5-1% hike in interest rates.

In spite of this credit shock and an uncertain outcome as to its impact on the economy, the Federal Reserve pushed ahead with another quarter percentage rate increase just 2 weeks after the SVB collapse. When there was a very good argument for pausing and assessing, the Fed charged ahead anyway and is also forecasted to make another quarter percentage rate increase in May. There is no doubt in my mind that this will just shorten the period of time between the last rate increase and the first rate cut which the market now expects to be by early Fall. The Fed is overtightening into a slowdown because it is laser focused on low unemployment which is the most lagging of economic indicators! By the time unemployment starts to climb, the economy will be slowing probably faster than even the Fed wants. The challenge is orchestrating a mild recession without causing something worse and for whatever reason, the Fed thinks it is up to the challenge with all historical evidence to the contrary!

So as I said last Fall, I think the Fed will overtighten (remember my oversteering on an icy road analogy?) and will rush to provide liquidity with interest rate cuts and if necessary, more money printing. Wash, rinse, repeat.

With the Bank of Canada going on pause months ago, many would conclude it is doing a better job than the Fed but this has more to do with the different mortgage term structure in this cycle. In Canada, many new homeowners decided to go with variable mortgages during Covid when interest rates were rock bottom and now many of those are being reset to higher interest rates. And for closed terms, the longest Canadian mortgage term offered by the large banks is 5 years so every year, about 20% of mortgages come up for renewal. Compare this to the US where a 30 year mortgage term is pretty standard. Since most Americans maintain a large mortgage for tax-deductibility reasons, most homeowners took the opportunity to refinance for 30 years at less than 3% when rates were the lowest on record. These homeowners are feeling very confident now and continue to spend because of this interest rate certainty. But it is slowly dawning on them that home values are down substantially as mortgage rates have doubled in a year. And since mortgage portability is not a standard feature in American mortgages, most don’t want to move and give up their great mortgage rate so the US housing market is therefore grinding to a stop just like our housing market. But in Canada, new home construction contributes twice as much to our GDP when compared to the American economy. We feel the slowdown faster and it hits harder here!

As we approach the end of the interest rate tightening cycle, on the horizon will be rate cuts that will eventually be the wind at the back of asset prices and a new business cycle. We are not quite there but it is on the horizon. We are still playing defense but getting closer!