The Breakdown - Regional Bank Turmoil Accelerates as Fed Raises Again with "Hawkish Pause" on Horizon

Episode Date: May 4, 2023

First Republic failed this week. Did that mean Powell and the Fed would pause their hikes? Absolutely not. NLW covers the "Hawkish Pause" press conference and the 25 bps interest rate raise.  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 “The Breakdown” is written, produced and hosted by Nathaniel Whittemore aka NLW. Research is by Scott Hill. Editing is by Rob Mitchell and Kyle Barbour-Hoffman. Our theme music is “Countdown” by Neon Beach.

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 Thursday, May 4th, and today we are talking about regional bank turmoil. The Fed raising rates anyways, but a hawkish pause on the horizon. Before we get into that, 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 of the show notes or go to bit.L.Y slash breakdown pod. All right, friends, well, you know what day it is. It's FOMC day, or rather FOMC recap day for all of us over here at the breakdown.

This week presented Jerome Powell and the Fed another interesting opportunity. Of course, you'll know that on Monday, the FDIC seized First Republic Bank, much beleaguered First Republic Bank, after weeks of speculation of what would happen to them, and immediately moved them over in a pre-negotiated sale with J.P. Morgan Chase. As of Monday morning, all of First Republic's locations were opened as branches of J.P. Morgan. Now, and so doing, First Republic knocked off Silicon Valley Bank as the second biggest bank failure in U.S. history. And perhaps unsurprisingly, then, other regional banks have seen significant turmoil throughout the week. So the question was, would Powell acknowledge the banking crisis and the shaky ground it seemed to suggest the economy was on, or would he plow through

with the anticipated hike that the markets had been pricing in? And then, of course, if he did go through with that hike, would his presser afterwards give any indication about whether the market was correct in their belief as well that whatever happened at this meeting, it was the likely end of the tightening cycle? Nick Carter summed this up, saying, the Fed tomorrow. The banking crisis is really over this time. We mean it. It's over. We promise. For real, okay? Banks, please stop collapsing. Well, sure enough, on Wednesday, the FOMC delivered a 25-bases-point hike in the Fed's policy interest rate. This is what had been priced in by the markets. That brings the rate to a range between 5% and 5.25%, which is the first time Fed rates have been above 5% in 17 years,

dating back to the 2006 hiking cycle. No changes to the Fed's quantitative tightening program were announced. Now, of course, as we were just discussing, the economic outlook has begun to show some deterioration. GDP growth is below trend, and there's early signs of labor market softening. Yet despite these early signs of economic weakness and the narrative that maybe the recession is finally here, Powell still put forward the analysis that, quote, overall labor demand still substantially exceeds the supply of available workers. Now, one new point of emphasis was deteriorating credit conditions, which Powell said were a result of distress in the banking system. He anticipated that this would present further headwinds for the economy.

Powell confirmed that the baseline forecast is still for a mild recession with a smaller spike in unemployment than has been typical in modern recessions. Now, the way that many summed this up was what TXMC called a hawkish pause. He writes, This will probably be interpreted as a hawkish pause barring Powell throwing a surprise grenade at the presser. They're truly between a rock and a hard place. So let's go a little bit more into detail around what the Fed said and what it indicates about what might be coming in the future.

As one would expect, recent bank failures did loom large over this FOMC meeting. Powell opened his comments by attempting to calm nervousness around the stability of the banking sector. Conditions in this sector, he said, have broadly improved since early March, and the U.S. banking system is sound and resilient. We will continue to monitor conditions in this sector, we are committed to learning the right lessons from this episode, and will work to prevent events like these from happening again. During questions from the press, Powell was asked what he and the FOMC had done following a presentation in February. which presented the building risk of mark-to-market losses held on bank balance sheets. That was a presentation that had featured Silicon Valley Bank as the prime example of the risk.

Powell downplayed the presentation, saying that it wasn't presented as an urgent or alarming situation, it was presented as an informational, non-decisional kind of a thing. He pointed out that there was only one page which covered Silicon Valley Bank and that it did not address the risk of a bank run. Pushing back, the reporter noted that the report from Fed staff had said that SVB had failed risk measurements and represented a safety and soundness risk. Asking Powell why he did not find that alarming in February, Powell continued to shrug off the point, asserting that he came away from the staff presentation with the impression that, quote, were on the case. Later in the press conference,

when asked about what changes need to be made at the Fed, Powell leaned into the idea that the major issue was one of bank runs, recognizing that runs can now happen much faster than previously thought. The run on Silicon Valley Bank, he said, was out of keeping with the speed of runs throughout history, and that now needs to be reflected in some way in regulation and in supervision. No one thought that was possible. Ultimately, Powell recognized that the buck stops with him and acknowledged that there had been supervisory issues that led to the recent bank failures. I fully recognize that we made mistakes, he said. I think we've learned some new things as well and we need to do better. He did not, however, acknowledge that the ultra-fast hiking cycle had placed banks in this position

in the first place. Instead, Powell mentioned the need to strengthen regulation and supervision over mid-sized banks and foreshadowed that changes would be proposed in due course. In other words, this wasn't a policy mistake, it was a supervision mistake, and maybe they should have some more power. Now, what about this idea of coming to the end of the hiking cycle? Heading into this meeting, there was rampant speculation that it would be the final rate hike this time around. The Fed's press release, which is typically consistent in its language from month to month,

featured one significant change for this meeting. In March, the FOMC press release stated that, quote, the committee anticipates that some additional policy firming may be appropriate, but this time that phrase was removed, replaced with the statement that, quote, in determining the extent to which additional policy firming may be appropriate to return inflation to 2% over time, the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. Powell said that this was a, quote, meaningful change and that further decisions will be

driven by incoming data and made meeting by meeting. He emphasized that, quote, a decision on a pause was not made today, but did point out that the committee had forecast this level to be the terminal rate at the March meeting. When asked whether he agrees with the market, which is pricing in rate cuts later this year, Powell said, we on the committee have a view that inflation is going to come down not so quickly, but it'll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates. All right, so that was Powell, but how did the market react? Equity markets traded up slightly during Powell's speech, with multiple reversions as Powell did his best not to commit to any

particular path forward. However, by the time that Powell had finished speaking, Fed Day was overshadowed by news that yet another regional bank was, quote, reviewing its strategic options. That bank, of course, was Pack West, where again, rumors have been swirling that they're seeking a buyout. Pack West trading was extremely volatile and ultimately halted, and the rest of the S&P 500 closed the day down 1% from its Fed Day high. importantly, in aftermarket trading, Pac-West stock price was cut in half. Jeff Snyder tweeted, The FOMC's statement claimed the U.S. banking system is sound and resilient.

Right now in the after-hour session, the whole world is furiously hedging for how wrong that is, plus 20 basis point swings in many key contracts. Mike Green wrote, can he resign already? The entire regional banking sector melting after hours. Perhaps Powell meant the banking system is theoretically strong? By the way, as of recording on Thursday, things have gotten even worse. PAC West fell another 61% after confirming it was in talks to sell itself, and Western Alliance was down as much as 62% after the Financial Times report said that they were looking for a buyer, and they denied this.

Western Alliance had trading halted multiple times this morning and tried to stem the bleeding by saying, The bank has not experienced unusual deposit flows following the sale of First Republic Bank and other recent industry news. Another bank, First Horizon, fell 40% after IT and TD Bank said that they had terminated a merger agreement due to concerns around regulatory approvals. A TD Cohen analysis wrote in a note, quote, We believe the banks are having their game-stop-like moment where social media is amplifying non-traditional approaches to assessing solvency. This creates a self-fulfilling prophecy that pressure stock prices,

which then leads to more questions. In other words, the tale of markets are wagging the dog of the banks, but it doesn't ultimately matter if that creates insecurity among depositors. Pershing Square CEO Bill Ackman said, confidence in a financial institution is built over decades and destroyed in days. As each domino falls, the next weakest bank begins to wobble. Now, for a contra take, Bob Elliott from Unlimited funds said, most interesting tidbit from the presser was JP noting that the three banks that faced the significant pressure in March have all been resolved now, and that conditions more

generally improved since. Would be tough to say if the Fed was staring at a big regional bank run. Brent Donnelly wasn't so sure, responding, kind of reads like Bernanke's subprime is contained, no? Like, what else is he going to say kind of thing? Bob Elliott again says, I mean, the data doesn't show further bank runs. I suspect, given the put action, this is a meme stock in reverse like speculative attack, creating a deposit run more so than originated by a bank run reflected in the stock price. Again, you see this narrative that it is in fact the narrative driving a potential bank run, not a bank run driving a stock price fall.

Arthur Hayes wrote, this weekend is about finding more shoddy U.S. banks to put puts on. I wouldn't hold risk over the weekend. You never know what is the trigger that causes Yellen or Powell. to cave and bail everyone out. It's all politics now, and politics is more about power than rational decisions. So again, the question here is whether there is actual deposit concern at these regional banks, as was speculated, would be the case in the wake of these bank failures, or is it just markets trying to get out ahead of the likelihood that they believe there will be those issues? And perhaps most interestingly of all, doesn't matter. In other words,

wherever it starts, either with depositors being scared or with stock speculators getting out ahead of depositors being scared, it all ends up in the same place, with deposits leaving and the stock price going down. Now, I do think there is one other thing that's worth pointing out, which is a counterpoint to the narrative that bank crisis turmoil should necessarily mean a move to cut rates. Macro-analyst Andy Constan said, cutting rates to address the banking crisis only works if it causes the bank assets to rally enough to generate solvency. This isn't a credit crisis, so will giving up on inflation caused mortgage rates to rise or fall. One thing for sure, the deposit run isn't because MMF rates are so high. A run is for solvency, and the Fed needs mortgage rates lower, and a rate

cut won't necessarily solve that problem. I think that the point here is that generally speaking, there is a disconnect from the assessment of the problem, i.e. a banking crisis, and the presumption of the solution, which is the Fed ending its hiking cycle. I don't think for most people they're thinking about these things as one solving the other. I think most people are thinking about these things as one solving the other. I think most people are using the banking crisis as shorthand for the Fed needs to do something different. And since we've been tightening, what would be different would be cutting. It is almost certainly the case that a 25 basis point cut, for example, isn't going to do anything for bank balance sheets that are underwater on five-year loans with a 2% coupon. But however true that

might be, the narrative counter to the Fed is strong. Bologi Shrinivasa tweeted, 500 billion plus in bank failures in two months, that's just the appetizer. Remember, WAMU only failed on September 25, 2008, after Lehman failed on September 15th, 2008, and after it was acknowledged that a crisis was on. But Powell is still talking about soft landings, so people are still in denial. What happens when it's finally admitted that the Fed has caused yet another historical crisis? To sum up, the hawkish pause narrative was big leading into the FOMC meeting and the presser, and that's kind of how most people are interpreting Powell's speech.

All of the Fed's language seems to be about pausing and waiting for things to catch up, rather than pausing in anticipation of cuts. The Fed isn't giving any indication yet that there's room to move to cuts until inflation comes down dramatically. Interestingly, Nick Timrose from the Wall Street Journal points out, the FOMC statement used language broadly similar to how officials concluded their interest rate increases in 2006, with no explicit promise of a pause by retaining a bias to tighten. Now, one more thing to watch for with all of this is the Treasury, and the debt ceiling. When asked to speak to the rapidly approaching debt ceiling showdown,

Powell again pointed out that it isn't his place to discuss fiscal policy. He reiterated his view that, quote, it is essential that the debt ceiling be raised in a timely way so that the U.S. government can pay all of its bills when they're due. He noted that a failure to do so would be profoundly uncertain and detrimental to the U.S. economy. To make matters perfectly clear, Powell emphasized that, quote, no one should assume that the Fed can protect the economy from the potential short and long-term effects of a failure to pay our bills on time. When the topic was brought up a second time later in the press conference, Powell simply said, we shouldn't even be talking about a world in which the U.S. doesn't pay its bills. Just shouldn't be a thing. Now, earlier this week, Treasury Secretary

Janet Yellen had warned that the debt ceiling could be reached as soon as the start of June on the back of lower than expected tax revenues. Leaders from both side of the aisle have now hustled to get negotiations underway in a more serious manner. Ahead of the Fed meeting, the U.S. Treasury announced that it would be conducting repurchases of U.S. government debt next year, marking the first time buybacks had been conducted since the early 2000s. The program is intended to boost liquidity in the treasury market, with the Treasury purchasing older bonds which are less easily sold into the open market. liquidity has been rapidly deteriorating recently with the ability to easily buy and sell treasury sitting at its worst level since March 2000. Guy Labas, the chief fixed income strategist

at Janie Montgomery Scott, said, quote, The idea behind buybacks is to clear this less liquid inventory off dealer balance sheets and replace it with more liquid inventory. It is a question of market functioning rather than stealth quantitative easing. As much as the Treasury said that this is just some small program, many see this as a highly intermediary step. Mikey Polito from Blockwork summed up what I saw a lot of sentiment being on Twitter when he wrote, can we just skip to the part where the Fed owns all the commercial real estate debt? Anyways, guys, it continues to be brutal out there as I record. I'm seeing Pac-West down 59%, Western Alliance down 58%, First Horizon down 38%, and 38%, and

Metropolitan Bank down 18%. Huntington Bank down 16%, Zions, 15%, and more and more and more. 18 regional banks are down 10% or more on the day. So that is the macro view from here, banking crisis at the same time as rate hikes. What a world. I guess the next step is to see what this hawkish pause really means and whether the language changes over the next few months. Until tomorrow, guys, be safe and take care of each other. Peace.