By day's end, Monday appeared to have gone away quietly. Of course, this would be from the perspective of the broader, large-cap equity indexes. The real action was in Treasury markets and the keen eye would also pick up what was a disappointing finish for those already mentioned equities on elevated trading volume.
Perhaps the U.S. 2-Year Note made the most noise on Monday. This one Treasury debt security, often considered to be a guide for what the FOMC does with the Fed Funds Rate, saw incredible demand for the session, as its yield dropped a jaw-dropping 60 basis points by the time the closing bell rang at 16:00 ET for equities. At that point, the 2-Year Note paid as little as 3.99% after trading above 5.06% as recently as early Thursday morning. The 10-Year Note rallied in similar fashion, though not with the same kind of aggression as was witnessed for the 2-Year.
As there has been much less movement toward the short end of the curve, traders watched as the slope of the curve steepened significantly from the belly on out to the long end, while some spreads held their awful-looking ground.
Now, we know that a recession is almost always preceded by an inverted yield curve. This is old news. The onset of sustained inversion to overtly declared recession in the past can take anywhere from nine months to almost two years. A lot fewer folks probably realize that often enough in the past, the key spreads start to un-invert in the month or two just ahead of a recession, as the nadir of inversion has already passed by the time Main Street feels what Wall Street has already priced in. Things in this algorithmic, electronic age move more quickly, so of course all of this timing on lag effects is made with a best guess effort in the year 2023.
Check out what happened to the spread between the 10-Year and 2-Year Notes on Monday. This is stunning:
This particular spread, which is one of our better indicators for economic contraction, spiked to the point where, yes, it remained inverted but the smallest margin yet for 2023, just two days after hitting its most inverted level of 2023.
Interesting, right?
So, what did the yield spread between the 10-Year Note and 3-Month T-Bill (actually the single most important indicator we have) do on Monday? Move similarly? Not a chance:
This spread remained on Monday, as inverted as ever. This spread still tells the sad tale of the coming recession, but just not yet, while the 10/2 spread could be opening the door to what we have dreaded for so long: a recession that now feels like it might not end up being so soft or so shallow.
What Now?
So, is the U.S. 2-Year Note, which is now paying more than 4.14% as I work through the zero dark hours, front-running the FOMC's potential for action on March 22, or is it limiting what the FOMC might do? Is the 2-Year Note commander or follower?
As far as I can tell right now, Fed Funds Futures trading in Chicago are pricing in a 72% probability for a face-saving 25 basis point rate hike on the 22nd, as the Fed Chair Powell just told us last week to prepare for higher rates for longer and that the U.S. banking system was in good shape. This leaves these same futures with a 28% chance for no rate hike at all.
After that, the whole matrix for the Fed Funds Rate on the CME's FedWatch tool is a mess, with a terminal rate of 5% to 5.25% that is priced in for May 3 and then a rate cut as soon as June 14. Futures markets are now pricing in rate cuts or no change at all for at least the 10 meetings following the May 3rd hike. The FOMC meets eight times a year, so 10 meetings are quite a lot.
How Did This Bank Mess All Happen?
Perhaps Silicon Valley Bank ( SIVB) led off what appears to be broad weakness across the regional banking space due to the lack of diversity, both in its investment portfolio as well as in its typical depositor, or at least its typical large depositor. The basic problem, though perhaps less acute elsewhere, still must be addressed in a uniform manner before the collapse of two banks becomes the collapse of five or 10.
Understand that deposits are held as a liability on banking balance sheets. Banks try to generate traditional banking profits (non-fee based) by producing alpha through lending at higher rates than what is paid in terms of interest on deposits. This is what we mean by NIM or Net Interest Margin. NIM becomes more difficult as spreads invert. Hence, why you have not seen the rate paid on your savings account move higher with other kinds of interest rates such as what you're paying on your debt.
To make matters worse, the deposits are subject to immediate withdrawal, at least in standard savings or checking accounts at any time. A bank such as Silicon Valley might, or in this case did invest in longer duration U.S. Treasury and other debt instruments. These securities have lost some value in recent months. Trust me, one of my accounts is a pure bonds-only portfolio which has done me harm this year.
In Silicon Valley's example, the larger clientele were largely growth-focused or start-up type businesses who kept large amounts of investor cash at the bank to use (or burn) as these companies are in many cases not yet profitable or cash-flow positive. What happens or happened here is that enough of these accounts not only burned some cash for general corporate purposes, but started noticing that Treasury Bills as well as some other banks were now paying a better rate of interest than was their standard savings account. This, while money has never been easier to move from point A to point B.
So, enough of these depositors decided to move chunks of "dormant" capital somewhere where it might not be so dormant. In order to respond to these withdrawals, Silicon Valley was forced to liquidate large portions of its long duration bond portfolio at significant losses.
Now, this situation may have been acute at a bank primarily dealing with start-up businesses such as Silicon Valley or at banks heavily exposed to cryptocurrencies and associated businesses such as Silvergate ( SI) and Signature Bank ( SBNY) , but even at banks with more of a community feel, depositors are realizing that they can get paid at least a little something for their cash savings. Hence, conditions for improving net interest margin will likely get worse, not better for banks that try to attract depositors, as conditions are also likely to get much tougher for smaller to regional banks from a regulatory perspective. This will almost certainly slow economic activity.
Next Turn
What has occurred will or maybe I should say "could" end up expressing itself as a deflationary shock, especially if economic activity slows. This will take the pressure off the Fed in the fight against consumer price stability.
This sharp reduction in yields should result in lower interest rates at that consumer level, which is deflationary, and as long as monetary conditions are not eased in some way such as reversing the still-moving "quantitative tightening" program, then the inflation monster may not reignite. No promises, but there is a chance that the Fed has now driven the economy to the point where something broke, but the economy is not yet broken.
This would be where smart central bankers apply the Band-Aids (which they have done) where needed and pause to allow more clarity into the room. This is where smart central bankers allow foreign central bankers to watch from a distance without having to force some kind of action or reaction so as not to disrupt currency markets.
I understand that the Fed literally just signaled a "ramp up" in the fight versus inflation and may feel that a hike of at least 25 basis points might be needed in order to sustain credibility. I also think that credibility must be earned on a continuous basis and to act when clearly acting would be reckless, regardless of what this morning's February CPI report shows, would do more harm to said credibility than showing sensitivity to the seriousness of the current situation.
Equities
On Monday, as equity markets melted into the closing bell, the Nasdaq siblings (Composite & 100), both finished up for the day, while the S&P 500 showed a tiny loss for the session. As we move into smaller-caps, the day was far more treacherous, as the Russell 2000 gave up 1.6% and the S&P 600 took a beating of 2.43%.
We can not fail to mention the banks. The KBW Bank Index took a beating of the kind that we see around here only once in a while, surrendering 11.66% on Monday and now an incredible 27.53% over five trading days.
Readers will see that for the second consecutive trading day, the Nasdaq Composite (see above) hit resistance at its 50-day simple moving average (SMA), which it was unable to overcome.
The situation is a bit uglier for the S&P 500 (see above). Note that for those same two consecutive days that the S&P 500 has failed to even make contact with the all-important 200- day SMA. Also note the rising trading volume for each of the past three trading sessions, all "down" days. That bearish running triangle that we spoke about back in February may not have produced a selloff in textbook fashion, but I am starting to doubt its accuracy less and less all the time.
For Monday, six S&P sector SPDR ETFs actually shaded green for the session with more "defensive" type sectors taking the top three slots on the daily performance tables. One sector closed unchanged as four sectors closed in the red, led lower obviously by the Financials ( XLF) , and followed by Energy ( XLE) and Materials ( XLB) . Defensives up, key cyclicals down. Maybe the Two Year Note is indeed onto something.
As to breadth, losers beat winners by more than 5 to 2 at the NYSE and by more than 3 to 2 at the Nasdaq. Advancing volume took a 27.3% share of composite NYSE-listed trade and an almost impressive 47.7% share of that same metric for Nasdaq listings. As we mentioned, trading volume increased across the board on Monday, up a sharp 18.9% day over day and an incredible 64% over the Monday prior for NYSE-listed securities.
Did I Buy Much on Tuesday?
Define "much."
I did add to both Wells Fargo ( WFC) and Bank of America ( BAC) on weakness as I had written I would. That said, I consider my new level after my 50% reduction last week to be my new core.
These adds are trades, and not part of that core, though they are the back end of a capital-extraction trade. I am just trying to pick off some algos that buy these stocks in response to any headlines around increased deposits at the large money-center banks.
I bought back 40% of what I sold last week in WFC and 25% of what I sold last week in BAC. I have not touched the regionals at any point in the recent past.
Economics (All Times Eastern)
06:00 - NFIB Small Biz Optimism Index: LExpecting 90.6, Last 90.3.
08:30 - CPI (February): Expecting 0.4% m/m, Last 0.5% m/m.
08:30 - Core CPI (February): Expecting 0.4% m/m, Last 0.4% m/m.
08:30 - CPI (February): Expecting 6.0% y/y, Last 6.4% y/y.
08:30 - Core CPI (February): Expecting 5.5% y/y, Last 5.6% y/y.
08:55 - Redbook (Weekly): Last 3.0% y/y.
16:30 - API Oil Inventories (Weekly): Last -3.835M.
The Fed (All Times Eastern)
Fed Blackout Period.
