The Breakdown - Fed Raises Rates to 22 Year High and Says No Recession Is Coming

Episode Date: July 26, 2023

The Federal Reserve has again raised interest rates -- this time to a 22-year high. NLW explores the discussion around the raise and why market observers are moving back to watching real economic data rather than Fed whispering. Today's Episode Sponsored By: In Wolf's Clothing -- The first startup accelerator exclusively for Bitcoin and Lightning startups -- Applications for Cohort 3 open NOW -- https://wolfnyc.com/apply ** Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Wednesday, July 26th, and today is a Fed Day. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly. down pod. All right, friends, today is an FOMC day, and frankly, I was thinking about it, we have had so much going on in crypto with cleanup from last year and new narratives and legal decisions

that we really haven't had as much time to catch up on the macro. Now, in addition to whatever's been going on in the crypto space, another part of why macro has been perhaps a little quieter is one, seasonality, summer is historically a quieter time in markets, and second, there's been this really interesting dynamic where markets that otherwise might have looked pretty bad due to interest rates due to geopolitics have been held up by a particular type of enthusiasm, in this case the excitement around AI. So the specific context for today's show is that we've got a rate hike decision coming up this afternoon. Now likely that has happened before you're hearing this, but it was recorded before. Now one super quick note before we get to the meat of today's

episode. You've heard it before. I'll say it again. Wolf in Wolf's clothing, the accelerator for Bitcoin and Lightning startups is the sponsor of today's show, and they are right now accepting applications for their third cohort. This is an incredible accelerator program with mentorship, funding, access, you name it, for companies that want to go change the world through Bitcoin and Lightning. If you want to get a sense of the type of companies that have applied, go check out my interview series on Bitcoin Builders. But I can't recommend the program enough, and I'm really hoping some breakdown listeners end up applying for this next cohort. To learn more, go to wolf-Nyc.com, and thanks to those guys for supporting the show. Now, by way of diving in, let's do a little bit

of background context. At the previous FOMC meeting held in June, the main takeaway was that the Fed felt the need to take a break from their relentless rate hiking cycle, but at the same time not surrender the narrative of a break. The decision was made to hold rates steady at 5.25% after 10 straight meetings delivering rate hikes, which of course added up to the fastest rate hiking cycle in living memory. Now, in the press conference around that meeting, Fed chair Jerome Powell went to pains to avoid the narrative that the FOMC were shifting to a rate pause, or especially that the hiking cycle was over and this represented any sort of pivot. Instead, he painted the decision as being more about the Fed wanting to see more data before making a decision on whether or not

to continue hiking rates. He emphasized that this month's meeting would be very much a quote-unquote live meaning, in other words saying that a rate hike was firmly on the table as an option. Now, of course, alongside the meeting, the Fed published their quarterly summary of economic projections, which gives a sketch of the forecasting of individual FOMC members. Broadly speaking, forecasts of this year's GDP had shifted up, and the end of your unemployment rate was much lower than previously anticipated. This estimate that the U.S. economy would remain robust throughout the end of the year left some commentators wondering why the Fed would choose to take a break at the June meeting instead of press-easing.

on with their inflation fight. The reasoning behind the rate decision was particularly confusing, given that FOMC members had penciled in two additional rate hikes to bring the terminal rate to 5.75% by the end of the year. This clear foreshadowing of more rate hikes to come ultimately led analysts to label last month's rate decision as a quote-unquote hawkish pause. Now, back in June, the macroeconomic and financial stability picture was much less clear than it is today. Inflation was showing early signs of cooling, but it was viewed as unclear whether this would be the beginning of a robust downwards trend, given in particular non-housing services inflation, which had remained stubbornly high up to then, was just beginning to move lower. Since then, June

inflation data showed a continuation of this trend of moderating inflation. This past month, CPI hit 3%, which, while the Fed went out of its way to remind us was well above the target of 2%, still represented pretty clear progress. Now, when it came to the labor market, it was showing signs of loosening, but it was also beginning to become clear that inflation was moderating despite a tight labor market, rather than because of labor market slack. Since then, labor market data has shown some additional loosening. However, it didn't really present any evidence that would point to the beginning of any sort of outright collapse. Given all that, the big outstanding concern was financial stability. The sharp rate hiking cycle had been broadly viewed as a major contributing factor in the

collapse of three bank failures over the spring, and in June there were still lingering fears that the banking sector was structurally weak. The six weeks in between meetings featured no additional bank failures or major symptoms of contagion, so concerns of systemic risk appear to have been overblown. Overall, the macro picture that has been confirmed by recent data is inflation is still too high, the labor market is still too tight, and the banking system is showing no signs of imminent collapse, which of course brings us to what market participants are expecting this time around. Basically, markets and analysts have firmly written in a 25 basis point hike at this meeting. Indeed, as soon as Powell finished his June press conference, markets had already priced

in a 70% chance of a single rate hike in July and became progressively more confident in that positioning as this month's meeting approached. On July 18th, Charlie Bellalo wrote, probability of a Fed rate hike next week is approaching 100%. 25 basis point increase to 5.25% to 5.5% done deal. On July 21st, Daniel La Cale, Chief economist at Tressis wrote, next week's FOMC meeting should have no surprises, a 25 basis point hike and no change to the guidance. Indeed, coming into this meeting, a rate hike was so thoroughly supported by economic data and market pricing that it was barely remarked upon. Instead, analyst speculation has really focused on how Hawkish Powell's forward guidance would be. Assuming today's decision is

a rate hike, only one additional hike has been forecast over the final three meetings of the year. Vincent Reinhart, chief economist at Dreyfus and Mellon and former Fed official said, quote, the question after the meeting is, do they go again? You listen at this meeting to see how much Powell at the press conference embraces the summary of economic projections or put some distance in. Bloomberg chief U.S. economist Anna Wong said, with recent economic data seemingly bolstering the chances of a soft landing, the FOMC is unlikely to rock the boat. Powell will adopt a wait-and-see approach signaling a skip at the September meeting, a skip that we believe will turn into an extended pause. Now, of course, others note that given that Powell's worst fear throughout this hiking cycle

has been making the Arthur Burns mistake of declaring victory over inflation prematurely, that he is most likely to leave himself narrative room to do whatever he wants to later on in the year. City Group economist Veronica Clark said, they will be leaving all options open. They will certainly stay cautious after only a couple of months of softer inflation data, which is not enough for them to be convinced the job is done. Now, in his FOMC preview article published yesterday, Fed whisperer Nick Timmeros of the Wall Street Journal pointed out that Powell had signaled a willingness

to move more slowly into the end of the year, saying that quarterly rate hikes could be appropriate if the economic data remains in line with expectations. Now, I looked around to see if anyone is really trying to propose any sort of counter-narratives or surprises that they might be anticipating and there just really isn't any. Basically, at this point, with today's rate decision all but having been certain for several weeks now, market participants just view it very unlikely that Powell delivers any real surprises. Instead, what people are watching then is not so much what the Fed does, but what the underlying economic conditions suggest. For example, a big part of the narrative over the past year has been around whether a U.S. recession would arrive. We did have a technical

recession over the middle of last year, which continues to be a super weird term and concept, in which GDP growth came in slightly negative in two consecutive quarters, but during that period, the labor market remains strong, and since then, growth has returned. Yet, in spite of that strong growth, recession is still very much in the cards. The yield curve right now is still in the steepest inversion in decades, and multiple indicators point to a dramatic slowdown in the manufacturing sector. Jeffrey Sherman, the deputy chief investment officer at double-line capital, thinks that these conditions could put the Fed in a bind. He said, quote, the bond market is telling the Fed that they've overtightened and they will have to cut rates. But the Fed will be a little

late to cut, maybe in an emergency meeting. But the idea that the Fed is going to cut 25 or 50 basis points, and that's going to solve everything, isn't going to be the case. By the time they cut, it will be 100 basis points. Economist Alex Kruger writes, the Fed will hike rates again today. It may be the last hike or not. My base case scenario is one last hike coming. The Fed is almost done regardless, which makes the hike by itself actually unimportant. What truly matters now is how long the Fed holds rates up, how long before it pivots. That is data dependent, and we are unlikely to learn much new on that front today. That said, it is preposterous that the Fed is still hiking with CPI back to 3%, and core CPI trending consistently lower. Real rates are now firmly positive.

The Fed started hiking in March 2022, and monetary policy can lag up to 24 months. Fed officials know this they should thus stop hiking now and observe how the economy evolves before their next move. So, TLDR, summing up, for the moment, emphasis on the Fed is actually quite low, relative to how markets normally are. Instead, they are watching what the real economy does, and starting to zoom farther out not to whether the Fed hikes again, but when their hand is forced and they have to start cutting. Now, one more quick thing on the macro side, troubled, misguided regional bank, Pac-West has finally thrown in the towel, announcing that it will be absorbed by the smaller bank of California on Tuesday.

Pack West was among the banks earmarked as distressed during the spring bank runs and never fully truly recovered. After the merger is approved and completed, the combined bank will have 30.5 billion in deposits. A meaningful drop from the 34 billion held at just PAC West at the beginning of the year. At the end of March, Bank of California was around a quarter of the size of Pac-West. Now, perhaps unsurprisingly, the tainted Pac-West brand will be retired, and some consolidation of branches is expected. A press release said the combined bank will, quote, have the strength in market position to support the banking needs of small and medium-sized businesses in California. The merger will, of course, still require final approval from regulators.

Now, interestingly, the combined entity will raise $400 million from private equity firms as part of the merger. Warbur Pinkus and Center Bridge partners who have already committed to the deal will own about 20% of the Bank of California on closing. The firms received a significant discount to the book value of the bank in exchange for their cash injection to recapitalize the combined bank. They also received warrants to purchase additional shares over seven years. Analyst Janie Montgomery Scott said, This $400 million private equity infusion is certainly one of the largest that I have seen in my career since 1992. There have been several transactions with both strategic investors and private equity over the past 15 years since the great financial crisis. Oftentimes, the PE component was not 100%, and the capital

raises were far less than $400 million. Now, perhaps the most important question is whether this move marks the start of another chapter of this year's banking crisis, or is simply a weakened bank finally being dealt with. The Fed's bank term funding program, which is the emergency facility that was set up after the failure of Silicon Valley Bank, has shown signs that banking stress is receding. Over the past two months, loans have been paid down. However, although banking weaknesses seem to have been stabilized for now, banking regulators are prepared to release plans on Thursday to tighten capital standards. Fed Vice Chair for Supervision Michael Barr said that the largest banks will likely need to hold an additional 2% of capital against their assets, a move that

could precipitate the further sale of assets within the banking sector. Now, through all of this, it's a reasonable question to ask, how has Bitcoin done? Well, in many ways, it appears that Bitcoin is just kind of ignoring what's going on in the rest of the world. BTC has been stuck just above 29,000 since its dip on Monday. That 29,000 number is close to a one-month low. Now, when it comes to explanations for that, some pointed out that it might be Fed Day coming up. However, others thought it was more linked to the release of WorldCoin dominating liquidity across the broader crypto markets. Ethereum has been similarly range-bound at the lower 1850 level in recent days after losing its $1900 support last week, and basically things overall have just been flat. Vivian Fang, the head of financial products at Biodes,

bit said, the increase in liquidity is volatile and is currently quite flat. This is because many central banks are still tightening, and China's policy is still unclear. So it's still too early to call for a bull market in digital assets. Noel Atchison wrote in her crypto's macro newsletter on Tuesday, inflation and rate concerns could be what has been keeping crypto prices depressed. These usually recover relatively quickly, but the new lower Bitcoin levels seem to be holding, reinforcing the idea that there are just not enough new buyers ready to take positions yet. Now, for a little more on that analysis and why we are likely to just be in a low, flat period for some time, go check out my interview with James Check.

James is an analyst with GlassNode and has a really interesting set of insights that come directly from on-chain data, and you can find that on the Bitcoin Builders feed. For now, I want to say thanks once again to my sponsors for this show in Wolfs Clothing, wolfnYC.com to learn about applying to their upcoming third cohort. And thanks, of course, to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.