The trouble lurking within the markets and economy

Yesterday’s FOMC press conference was a noteworthy departure from what we saw in prior meetings during this tightening cycle, particularly from Jackson Hole onward.

But what had Chair Powell so concerned?

Let’s take a look at the data.

Money is not well supplied

M2 is shrinking in nominal terms for the first time ever, and in real terms for the first time since 1980. This is an ominous sign as it indicates there won’t be enough money to pay down the interest on debts, just as interest is rising across credit cards, corporate revolvers, and for everyone who is refinancing or issuing new debt.

3-month to 10-year yield curve is deeply inverted

At this point it’s the deepest inversion we’ve seen in decades, suggesting a rather nasty recession may lie ahead. Did that catch Chair Powell’s attention? Quite possibly. The Fed head’s preferred yield curve, the 3-month to 18-month spread, is also inverted by 100 bps, deepening by 50 bps since the December meeting.

Unrealized bank losses surged last year

This is a rather ominous sign, as eventually these losses would need to be realized unless FASB decides once again to suspend mark-to-market accounting (which is quite unlikely).

But it’s not just the unrealized losses, it’s also the lack of a buffer against them that may have caught the attention of FOMC policymakers. An excerpt from the Financial Times says that systemically important “too big to fail” banks have the same narrow buffer levels that we saw in 2006, leading up to the Great Financial Crisis.

Perhaps that helps to explain the borrowing at the Fed’s Discount Window last year, a mechanism banks tend not to employ unless absolutely necessary as it comes with some degree of scorn and stigma.

More families are struggling with their bills

We also see increasing signs of the consumer struggling meaningfully. 40% of Americans are having trouble paying their bills.

We also see auto delinquencies have risen to levels that exceed that which was experienced during the Great Financial Crisis. Another sign that consumers are struggling.

Vehicle sales are tumbling to multi-decade lows

While delinquencies are rising, vehicle sales are also falling. This is meaningful as the auto industry accounts for about 3% of US GDP.

Many consumers are stretched to the brink

Adding to that rather grim picture is the surging use of revolving credit, largely credit cards, by consumers to pay for essentials, like rent, utilities, groceries, and gas while their savings rate plummeted to lows approaching that which was seen during the 1970s.

The residential real estate market is in trouble

Meanwhile, the housing market is also showing signs of strain, with the worst affordability levels on record when factoring for the cost of a mortgage, taxes, and insurance divided by median income. Recent data shows that the cost of home ownership has more than doubled since the COVID crash. A slowdown in this market is of concern as it accounts for approximately 15-18% of GDP.

Rising rates and persistently high home prices have created an affordability crisis, which is leading to new and existing home sales collapsing back to the 1990-1999 average, but at the same time the population of the US has grown quite a bit since then. Another contributing factor to lackluster sales is that millennials, at their prime home buying age, are effectively priced out of that American dream.

The economy appears to be deteriorating rapidly

The index of 10 leading indicators is a leading composite that tends to be a rather prescient forecaster of recessionary environments, and it is falling fast. Suggesting that we are headed toward a rather nasty contraction in economic activity. It’s worth noting that since 1960, this type of negative reading for 6 months or more has always led to a recession.

Financial conditions have discounted the entire tightening cycle

While Chair Powell spoke about financial conditions having tightened over the last year, after having lamented about how loose they were in December (a perplexing contradiction), the reality is that financial conditions have effectively removed the Fed’s tightening efforts as we are back to levels of looseness we have not seen since February of 2022, which was before the first hike or QT.

Other central banks are effectively fighting the Fed

The Bank of Japan and the People’s Bank of China have been expanding their balance sheets as the Fed and ECB have been shrinking theirs. This, combined with the Treasury General Account spending in upwards of $150 billion a month, effectively juicing bank reserves as the Fed attempts to drain them, has more than offset the impact of QT for the past several months.

It’s also led to many, perhaps rightfully, questioning the resolve of the Fed. Particularly after yesterday’s apparent 180 degree shift, where Powell appeared to be complacent with their policy efforts being actively undermined by market participants, the Treasury, other central banks, and the legislature’s demand-driving bills, such as the CHIPS and Science Act as well as the ironically named Inflation Reduction Act.

A meaningful change away from the Chair’s previous demeanor, where he appeared visibly irritated by the efforts contradicting the Fed’s attempts to slow demand.

The market has become a bit of a casino

As the CBOE allowed more and more expirations and trading hours for all variety of options, we’ve seen an absolute surge not only in the amount of options trading, but also a significant decrease in the duration of options bought or sold.

With over $1 trillion of SPX notional options premium changing hands on a daily basis, and nearly 50% of that volume in options expiring the same day, we have entered into a market environment of zero conviction, and also minimal overnight carry cost.

That is to say, if one is speculating using 0DTE options in SPX or otherwise, and closing out completely by the end of the day, there is no cost to carry the settled cash overnight. Thus the impact of the Fed’s tightening, increasing the cost of carrying margined positions, has been effectively nullified.

Much of the single stock options activity is concentrated in delta squeezes, or high amounts of near to the money close to expiration call buying, in highly shorted stocks. Producing a rally by some of the poorest quality components of the market. Many of which may not survive given the stress they are experiencing. Examples include Bed Bath and Beyond, Carvana, and countless others.

In conclusion

The market has been fighting the Fed since early 2022, and twice it was wrong, with the bear market rallies that peaked in March and August giving back their gains and making new subsequent lows. Will this time be different?

Perhaps, as bulls and speculators got everything they wanted and more from the FOMC yesterday. A pseudo-hawkish Fed Chair who was visibly shaken, and seemingly with good cause as we see a variety of indications that the economy and financial system may be in trouble.

Does this mean that the bear market is over? We will see. There are plenty of challenges that remain. If indeed a new bull market was miraculously born here, it would be the most expensive valuations ever, suggesting that it would be short, shallow, and likely lead to a rather unpleasant ending.

After all, if the Fed is truly set to pause imminently, even with their policy efforts meaningfully undermined in a variety of ways, it is likely that we will see a resurgence of inflationary pressure, but from higher base prices, and with a consumer where 40% are struggling to pay bills, and 2/3rds of the same consumers are living paycheck-to-paycheck. Where many have taken on credit card debt that is compounding at ever increasing rates of interest, making it effectively impossible for most to pay down.

The market is even pricing in two rate cuts for 2023 in the back half of the year, up from a single cut before Powell began his press conference. This is despite the Chair saying he did not see cuts happening this year. But the market says otherwise, and after yesterday’s departure from the prior more aggressive tightening narrative, perhaps it is right.

That sort of policy mistake could set us up for a repeat of the errors of both Arthur Burns and Paul Volcker, and as a result, make it quite likely that inflation, which has become structural in nature, becomes deeply entrenched in the global economy. After all, none of the supply constraints in the labor market, energy, raw materials, or agriculture have been effectively addressed.

For now we believe that the worst is not yet behind us, but how the next phase of the economy and market play out will have a lot to do with what central banks and legislative policymakers do next.