The US is tightening – right up until they are not
March has proven to be where the US Federal Reserve’s (the Fed) increase in their cash rate got to a point where the US banking system broke. You will have heard of the collapse of Silicon Valley Bank (SVB), Signature bank, and Credit Suisse.This outcome is not unusual when the Central Banks increase their cash rates.
“Volatility is a symptom that shows people have no clue of the underlying value.” –Jeremy Grantham -GMO
The US is tightening – right up until they are not
So much happened in March that we find it difficult to know where to start with this month’s commentary. March has proven to be where the US Federal Reserve’s (the Fed) increase in their cash rate got to a point where the US banking system broke. You will have heard of the collapse of Silicon Valley Bank (SVB), Signature bank, and Credit Suisse.
This outcome is not unusual when the Central Banks increase their cash rates. The rapid rise in cash rates leads to an increase in lending rates, which leads to the companies (and people) that have borrowed too much money, or planned on lower rates for longer failing.
As shown below, most periods in history where the US Fed has increased rates now have a historical name. Some periods that most of you will remember are the 1987 stock market crash, the tech wreck of 2000, and the Global Financial Crisis of 2008.
Fed tightening constantly breaks something
Will the 2023 banking crisis earn a historical name? Time will tell. But at this stage, the Fed and other larger investment banks have supported the banking sector by providing liquidity to meet the run on capital as investors pulled their cash out of uninsured banks.
In 2022, the US Fed stopped its quantitive easing (QE) due to inflation concerns and started quantitive tightening (QT). QT is where it pulls the QE back out of the financial system. Since QE peaked in April 2022, the Fed has been tightening for 11 months. Over this time, they had withdrawn US$626 billion.
The Fed pumped US$392 billion into the banking sector in only two weeks when the banks started collapsing last month. This means that over 60% of all the QT during the previous eleven months was undone in only two weeks.
US Fed – Balance sheet
US economy tightening
Post the run on Silicon Valley Bank (SVB) and Signature Bank, the US Fed Discount Window has seen a record level of demand as US banks move to shore up their balance sheets. US banks have drawn down almost US$170 billion over the two weeks since the banking crisis commenced. As shown below, this discount window usage level easily exceeds the 2008 Global Financial Crisis and the 2020 Covid lockdowns.
US emergency borrowing may lead to tighter lending standards
Post previous banking crises, we have seen US banks tighten the rules around lending to businesses. We have already seen lending conditions tighten this time, with expectations of further tightening to follow. As shown below, this increases the risk of a US recession.
Tighter lending conditions increase the risk of a US recession
Bond markets pricing in a high chance of interest rate reductions
After the failure of SVB (and the corresponding bail-out), bond markets around the world repriced dramatically. As shown below, the NZ bond market anticipated the OCR would peak at just over 5.50% at the end of 2023. After the banking failure, market expectations were repriced to just over 5%.
NZ OCR Market pricing – Friday 10th March
NZ OCR March Pricing – Friday 17th March
This rapid change in the market pricing of future rate hikes occurred due to bond investors’ pricing in a higher chance of a recession and hence a rapid decline in central banks’ cash rates as they try to re-stimulate shrinking economies.
Bond markets have good reason to believe the US Federal Reserve will commence cutting rates if that economy moves into a recession, as they have done so regularly in previous recessions.
US Fed – cash rate changes during previous recessions
The Fed may not be able to meet the expectation of the bond investors by reducing the cash rate anytime soon, regardless of a recession. Inflation in the US does appear to have peaked (and now declining) as it has in the wider developed world, but it is still proving stubborn to get under control.
Below is the Personal Consumption Expenditure (PCE) inflation index. The PCE index is the Fed’s preferred measure of US inflation pressures. The circles show when the US Fed has previously changed the direction of their cash rate movements based on their 2% average inflation target.
From 1995 – 2020 inflation was very benign. Hence the Fed needed to only make small changes to the cash rate as the inflation rate traded around 2%. Post the Covid lockdown, the stimulus put into the consumer’s hands rapidly increased PCE inflation, which peaked at c.5.50% in mid-2022. PCE headline inflation has now dropped to 4.71% and is forecast to drop further as Covid price pressures abate. As shown, PCE inflation has a long way to fall before the US Fed feels comfortable the inflation outbreak is under control.
Core US PCE inflation (YoY % - with Fed 2% target & pivots (circles)
Are US share analysts too optimistic?
The left table below shows US share analyst’s consensus forecast (purple bars). The S&P500 earnings per share (EPS) are forecast to grow 15% into the end of 2023. The table on the right shows the consensus forecast for YoY GDP growth in the US. As shown, analysts forecasting growing EPS are also predicting a slowing US economy. We would agree if you think these two forecasts are at odds with each other.
Below is a table showing the same S&P500 forward earnings per share (dark blue line), which has slowed since it peaked in late-2021. The light blue line is a forward indicator for S&P500 earnings. This indicator comprises a survey of US credit managers and the ISM Manufacturing PMI index.
If the correlation between these two lines holds, it suggests the S&P500 EPS will decline by c.5% into the end of 2023. Quite a difference from the analyst’s forecasts of 15% growth.
S&P500 EPS vs. leading indicators
Even among share analysts, the dispersion of earnings growth into the end of this year is at historically high levels. This indicates the heightened uncertainty around whether the US economy will suffer a recession (two negative quarters) in 2023. Most indicators suggest a recession, but the tailwind for US growth is improving with China’s re-opening from the Covid lockdown.
The year-to-date S&P500 rally has been driven by Price to Earnings ratio expansion in anticipation of rising EPS. This suggests that the market may reprice lower if the analysts forecast EPS growth proves too optimistic.
NZ property market continues to decline
New Zealand house prices continue to fall as the sharpest increase in interest rates in four decades decreases the affordability of properties. Before this sell-off, New Zealand had one of the world's most overpriced housing markets. Given this, it is unsurprising that we are now having one of the worst declines in house prices in the developed world. To date, NZ prices are down 16.2% from the November 2021 peak, with Wellington dropping the most, down -22.9%, with Auckland a close second, down -21.6%.
NZ mortgage rates & quarterly house price inflation
Property Investors have been well rewarded over the past 20-years. According to data from REINZ, as interest rates in New Zealand have declined over this period, Auckland house prices have risen at 6.8% per annum or 372% over the last 20-years! Considering that most property investors borrow to purchase (or leverage), their returns on the capital they committed will be well in excess of 372%. No wonder property investors cannot understand why 100% property is not the best investment.
New Zealanders have benefited from a very positive “wealth effect” from rapidly increasing capital prices. The wealth effect occurs as people feel richer (even if it's only a paper gain) they will spend more. The exact opposite is now happening. As house prices drop, people feel poorer. Given this, it is unsurprising that New Zealand's consumer and business confidence index has fallen so dramatically.
ANZ NZ Consumer Confidence Index ( March 2023)
ANZ Business Confidence Survey (March 2023)
With prices falling in most areas, the average house price-to-income ratio has also reduced from 8.8 to 7.8 times. This ratio is still expensive and well above the long-term average of 6.0 times.
As wage inflation continues to drag incomes higher and house prices continue to decline, we can expect to see house prices bottom, maybe as soon as the end of 2023. If we see a rapid decline in interest rates on the back of a recession, we could potentially see prices increase again. As to when this occurs is anyone's guess. As discussed above, the uncertainty around inflation and interest rates remains high.
Summary
We have seen a historically high level of support for the US banking sector on the back of the collapse of Silicon Vally Bank (SVB) and Signature bank. The increased uncertainty in this sector has led to massive swings in the US interest rate market. Below is a chart showing the US short-dated interest rate market movement. At the start of 2023, the market was pricing a cash rate of 4.4% by Feb 2024. This had reduced a bit by the beginning of Feb 2023 to c4.2%. Inflation then started to surprise too the upside, and we saw a massive move in pricing from 4.2% to 5.6% over just five weeks.
US Yield Curve has been volatile from 1st January – 17th March 2023
Whilst this increase in interest rates was massive, it was nothing compared to the 1.8% drop that occurred over just ten days post the collapse of SVB. This collapse led to one of history's most significant moves in the US 2-year government bond rate.
At PWA, we continue to monitor these markets closely while maintaining a patient and disciplined approach to managing portfolios. Given this level of uncertainty, we continue to proceed with a high level of caution as we wait for clearing indications about where inflation is heading, when the US Fed will be able to stop tightening, and confirmation as to if we will see a global recession.
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