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SUMMARY
- The Fed has been forced to shore up the US banking system.
- This complicated the Fed’s fight against entrenched inflation.
- Fed policy to stay restrictive in the near-term.
A banking crisis came seemingly from nowhere in March 2023, creating uncertainty for many smaller institutions. This would typically be cause for a Fed pause in interest rate hikes, if not outright easing. However, given the disparity between the Fed’s 2023 forecasts for core inflation versus its current level, we believe the Fed will not start cutting rates anytime soon.
In today’s Weekly View, we created a concise synopsis of three visuals from our April 2023 Chart Pack that summarizes a few key takeaways.
The 2023 Banking Crisis; Fed to the Rescue (Again)
The financial crisis in 2008 was a credit issue, as ill-advised real estate loans failed spectacularly. Thus far, 2023’s bank run is not a credit issue, in our view - credit quality remains solid across most banks.
Rather, it is one of interest rate sensitivity. Smaller banks with large government bond holdings have had trouble meeting near-term liquidity needs, as collateral value held in government bonds dropped significantly with interest rates rising.
This is a ‘solvable’ problem for the Fed, in our opinion, as they can accept collateral at par to keep banks solvent. However, this increases the Fed’s balance sheet size (see chart below) and injects short-term uncertainty into the market.
Inflation — ‘Flexible’ Retreating, but ‘Sticky’ Elevated
The Consumer Price Index (CPI) basket can be divided into two groups: ‘flexible’ and ‘sticky’. As their names suggest, prices in flexible CPI – which contains items such as heating and motor fuel, autos, hotel rooms, and food at home - is highly volatile. Sticky CPI, which contains prices of rent, medical care, education, furnishings, restaurants, and recreation, changes more slowly.
According to the Cleveland Fed, the ‘sticky’ price measures may be useful in discerning where inflation may be headed. Comparing these two readings highlights the Fed’s difficult task - while flexible CPI (orange line) has retreated, sticky (blue line) has not shown definitive signs of moderation yet.
Wages: Fewer Raises May Mean Lower Future Inflation
There are some encouraging signs that inflation may moderate in the future. This may be related not only to the Fed tightening money supply, but also due to the slowing US economy itself.
Recent business surveys suggest fewer firms are expecting to raise compensation in the future versus its peak last autumn (orange dotted line) … a condition that historically has been correlated with lower core CPI inflation (blue line) over the next 12 months.
However, the percentage of firms planning to raise compensation is still elevated relative to history.
Conclusion:
The Federal Reserve’s task – maintaining full employment while working to keep inflation close to 2% - has never been easy. But as we move into the second quarter of 2023, the Fed perhaps faces one of their most difficult tests yet. They must simultaneously try to reduce inflation while protecting jobs… and now banks.
We do not believe this Fed wants to repeat the mistakes of the late 1970s and early 80s, whereby the Fed was forced to reverse course and hike interest rates multiple times to finally get inflation under control. Throughout any rate hiking campaign of the past five decades, the Fed has never stopped hiking before the Fed funds rate was above the Consumer Price Index (CPI). By this rubric, we are getting closer.
While we still believe that inflation is moderating, hope is not a strategy. Our asset allocation portfolios remain relatively conservative in our positioning. Our portfolios’ equity weightings are roughly neutral relative to our target benchmarks, with a slightly elevated level of cash for additional flexibility during uncertain times.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.