Ahead of the Fed's first meeting of the year next week, despite up to 99.6% chance the Fed will keep interest rates unchanged this January, the entire market is still looking to FOMC to “gauge” the Fed's stance. The market's biggest hope is that the Fed may cut interest rates starting from March.
Even, some parties are adding more confidence to the market by pointing out that:
.. next March will be the 8th month since the Fed stopped raising interest rates - exactly matching the average waiting time of the Fed before cutting interest rates in the past:
Viet Hustler does not completely refute this statistic but wants to emphasize that: the Fed does not always act “at the average”.
On the occasion of next week's FOMC, Viet Hustler will start a macroeconomics series consisting of 2 articles on the topic: Fed's Interest Rate Trajectory.
The first article this week will present Viet Hustler's own view on the Fed's current stance on the interest rate issue.
Why the Fed will continue to “wait and observe the economy” without rushing to cut interest rates from March; but at the same time, will also have to cut interest rates from mid-year due to pressure in the labor market?
Disclaimer: Some of the observations below are the personal opinions of the author and are not investment advice at all. Viet Hustler will not be responsible for any financial decisions based on these personal opinions!
Why is the Fed indifferent to the market's wishes?
Previous statements from Fed members, besides delivering strong messages to restrain the market, also show that:
The Fed will not follow the market's wishes but will cautiously make decisions based on economic data.
So what recent economic data make the Fed stick to its high interest rate policy “…for longer” of its own?
1- Mixed inflation data and persistent wage-price spiral
Inflation measured by CPI has turned back up from December data
Headline CPI: +3.4% y/y | Core CPI: +3.9% y/y.
However, the consumer-side inflation measure PCE reaffirms the downward trend of inflation.
December Core PCE drops to the lowest in 3 years: +2.9% y/y.
More notably, as Viet Hustler has emphasized before: market rental prices are continuing to decline.
Especially large cities on the West Coast and South of the US have strong rental price decline rates.
Although Viet Hustler still believes inflation is on a downward path, but the fact that Core CPI is still too high is always the biggest obstacle in the Fed's interest rate cut process.
However, inflation is not the most important factor in the Fed's current interest rate trajectory. The most important factor currently is the labor market!
Wage growth is still too high to lower inflation quickly!
Labor costs (business side) / income growth (consumer side) are affecting 80% of inflation.
Viet Hustler has always emphasized the relationship between wages and inflation: wage-price spiral.
It's not for no reason that wage growth - inflation or unemployment - recession are always accompanying pairs.
If next week's labor data and February's remain favorable => the Fed will certainly not cut interest rates at the March meeting.
2- Banking system and the “moral hazard” issue
The Fed's biggest motivation to cut interest rates always comes from liquidity risk, credit crunch (which directly leads to economic recession).
However, the current banking system is making the Fed doubt the severity of credit crunch, due to their own violations moral hazard of their own.
Everyone surely knows that “moral hazard” (tentatively translated as “moral risk”) is one of the 2 biggest risks in the debt and insurance markets:
Moral hazard is the situation where one party to an agreement (loan agreement, insurance…) intentionally performs high-risk actions (or actions different from the original committed purpose…),
…. simply because they do not have to bear the costs incurred when risks occur.
The actions of the party violating moral hazard often disadvantage the cost-bearing party – therefore, “moral hazard” only occurs after the contract is signed.
The most typical example of moral hazard is insurance contracts: car insurance buyers will take less care of their cars because they have the insurer bear the repair costs.
And current banks, according to Viet Hustler, are intentionally committing “moral hazard” from both aspects:
1- From the perspective of Fed borrowers:
Banks are not fulfilling the borrowing commitment from BTFP to perform their main role in the economy - ensuring credit supply to businesses… (what the Fed hopes banks will do).
Instead, banks use cheap capital from the Fed's BTFP to… deposit the money back with the Fed itself and invest in Treasury bonds (with higher interest rates and no risk).
This form of arbitrage is no different from a “free money printing machine” (The Economist) – which according to Viet Hustler is a quite typical moral hazard violation.
This is why the Fed officially announced last week to end the BTFP program from mid-March and immediately increase the BTFP lending rate!
The Fed increasing this lending rate will make the market's credit crunch problem even more severe because not all banks exploit BTFP for arbitrage.
Small banks (regional banks) without BTFP assistance might have gone bankrupt (red line)…
=> they are the ones who really need BTFP but are cut off from this assistance.
Meanwhile, large banks seem to be thriving thanks to BTFP (green line in the chart above).
2- From the lender's perspective:
Banks seem to be trying to refuse responsibility for implementing financial system risk prevention measures and lending according to Basel III standards.
Since July, the US financial supervisory agency has officially issued a new framework on mandatory reserve capital requirements for banks
- the final phase of implementing the Basel III Accord (Basel III, the End games).
FYI: Basel III, the End games basically and detailed Basel III agreement.
Basically, Basel III requirements are to strengthen reserve capital to prevent aspects of banking risks - especially credit risk.
For example: If commercial real estate loans (CRE) default causing banks liquidity difficulties => Mandatory reserve capital will be used in emergencies like this!
Banks in the EU and UK have completed their Basel III commitments under the supervision of ECB and BOE, even if they complained.
Meanwhile, the attitude of US banks is quite resistant to this necessary strengthening of reserve capital:
…. negotiations between regulators and banks have dragged on for half a year:
There are quite a few articles “lamenting” that liquidity will be even tighter if banks fulfill Basel III commitments and increase reserve capital.
Another reason they give is that US banks are more severely affected than their counterparts in Europe and other continents.
And that tighter capital regulations will force banks to raise lending rates.
Last week, the US Office of the Comptroller of the Currency officially responded that: banks can cut dividends or buyback programs (repurchasing their own shares)...
“there’s a choice to be made with capital” (roughly “there are always other choices to have enough capital”)….
From evidence of moral hazard from large banks (Basel III also focuses on large banks), the Fed and US financial supervisors have the right to suspect that there aren't many liquidity crises in this group of banks.
=> This may cause the Fed to downplay the severity of the credit crunch in the market.
This could be one of the motivations for the Fed to decide: wait and observe the macroeconomic situation before deciding to pivot - instead of cutting rates early in response to liquidity risk complaints from banks (which the Fed now suspects).
Warning from the “labor recession” indicator: Pressure for the Fed to cut rates early from mid-2024
Viet hustler previously introduced to readers the labor market recession indicator: the Sahm Rule.
Content of Sahm Rule:
Recession begins when the U3 unemployment rate (from the Bureau of Labor Statistics - BLS) 3-month moving average (3 month MA) rises above +0.50% from the low in the past 12 months.
=> This 0.5% increase is called Sahm recession indicator — an “empirical” measure of recession.
Although criticized for being based on only 1 data point, Sahm Rule carries the meaning of warning about the potential rapid escalation of unemployment once it has gained sufficient momentum!
Related article: Risk of recession through economic fluctuations… (middle part of the article).
Currently, Sahm Rule is sounding the recession warning bell again!
Now there are already up to 20 states in the US with unemployment rate increase speeds within the Sahm Rule recession alert threshold,
i.e., 3-month average unemployment rate increase > +0.5% compared to the recent low.
Note that in September 2023, only 3 states in the US exceeded this +0.5% threshold.
Among them, California and Columbia are the 2 states with the highest unemployment rates (up to 5.1%).
The fact that 20/50 states already show signs of “labor recession” according to the Sahm Rule measure is a major warning to the Fed about the possibility of recession in the entire economy.
Because the aggregate unemployment figure from 50 states usually matches 100% with the BLS establishment survey unemployment figure!
And of course, the Fed will have to cut rates if there is clear evidence of recession!
CONCLUSION
With the above data on inflation, wage growth, and the “dark corners” of the US banking system, it is completely understandable that the Fed is not “too hasty” to cut rates.
Viet Hustler believes that, The Fed is in a “wait and see” phase for additional labor and inflation data for at least another 3-4 months. In particular, the labor market will be the key factor for the Fed to “fine-tune” the timing of rate cuts and stopping all forms of QT.
Given that 20/50 US states have reached the “labor recession” threshold according to the Sahm rule, Viet Hustler believes the Fed won't need to wait too long to clearly see the weakening of the labor market. The Fed cutting rates from May or June is entirely possible.
Another issue mentioned above, but which received less attention in the financial markets last week, is: the half-year negotiation between the supervisory authority and the banking system on implementing increased reserve capital under the Basel III agreement is nearing its end.
If the supervisory authority wins, there could be a significant amount of capital retained in the banking system in the form of cash reserves.
On one hand, banks will naturally use this as an excuse to raise lending rates (citing reduced liquidity).
But on the other hand, if you are a buyer of bank sector bonds or a depositor there, you are also assured of a higher level of the bank's liquidity in the worst-case economic scenario thanks to this reserve liquidity buffer.
Comments (0)
No comments yet
Be the first to comment
Login to comment