Sive Morten
Special Consultant to the FPA
- Messages
- 18,116
Fundamentals
Despite that recent week is short due Easter holidays, we have multiple important events and data releases. Speaking on the US domestic statistics - no drastic shifts but still, numbers in general were weaker than expected. Structural crisis stands under way showing slow but gradual progress. If in the beginning of the crisis process everybody were signing high inflation and watching for its trend, now inflation is replacing by production - it is dropping across the Globe, showing the next stage of the crisis.
On global economic background there are two events worth to mention - first is, formal, but still, D. Trump legal pursue and second - massive OPEC+ demarche with 1.5 mln bls extraction cut. At first glance, it has mostly political reasons. But it also has important consequences for global economy either. This situation looks like a vivid anti-American demonstration (especially in combination with the story with Trump), but, by and large, it is purely pragmatic.
The crisis in the global economy continues, private demand is falling, and the demand for oil is falling. In such a situation, reducing production is a completely natural policy, another thing is that it was difficult to implement it earlier in a situation of obvious opposition to the United States. But times are changing and the authority and political resource of this country are significantly reduced, in a sense, before the eyes of all mankind, and the objective needs of specific countries are beginning to come to the fore.
Of course, not all of them are adequate to the situation, who only today does not write about the lack of political subjectivity in most EU countries, but in general the trend is obvious. And as the crisis develops, it will manifest itself more and more brightly. Moreover, we assume that the relevant processes will develop faster and faster, while in any case, this trend is clearly noticeable.
Market overview
U.S. Treasury yields climbed and U.S. index futures closed modestly higher after employment data for March indicated the labor market remains tight, but was largely in line with market expectations. Nonfarm payrolls increased by 236,000 jobs last month, the Labor Department said, compared with the 239,000 expectation of economists surveyed by Reuters. Data for February was revised higher to show 326,000 jobs were added instead of 311,000 as previously reported. The unemployment rate dipped to 3.5% from 3.6% in the prior month.
U.S. stock index futures erased losses and turned higher after the report, while the dollar strengthened and U.S. Treasury yields rose as expectations the Federal Reserve will hike rates at its May meeting increased. Still, the jobs report heightened expectations the Fed will raise rates at its next meeting, with the market pricing in a 69% chance for a 25 basis point rate hike, up from 49.2% on Thursday, according to CME's FedWatch Tool.
In the bond market, the Fed’s preferred recession indicator plunged to fresh lows in the past week, bolstering the case for those who believe the central bank will soon need to cut rates. The measure compares the current implied forward rate on Treasury bills 18 months from now with the current yield on a three-month Treasury bill.
Markets will also watch first-quarter earnings, which start in the coming week with major banks including JPMorgan and Citigroup due on Friday. Analysts expect S&P 500 earnings to fall 5.2% in the first quarter from the year-ago period, I/B/E/S data from Refinitiv showed.
Analysts also said that while the jobs report showed strong gains, there are sectors that have seen moderate declines specifically the manufacturing and construction industries. (Structural crisis?!)
With nonfarm payrolls out of the way, investors are now focused on the U.S. consumer price index (CPI) for the month of March. Economists polled by Reuters expect core CPI of 0.4% last month and 5.6% on a year-on-year basis. Tom Simons, U.S. economist, at Jefferies, wrote that he expects CPI "will continue to show uncomfortably high core inflation pressure."
The International Monetary Fund expects global economic growth to dip below 3% in 2023 and to remain at around 3% for the next five years, Managing Director Kristalina Georgieva said on Thursday, flagging increased downside risks. The IMF chief called on central banks to stay the course in the fight against inflation as long as financial pressures remained limited, but to address financial stability risks when they emerge through appropriate provision of liquidity.
Rising geopolitical tensions and the resulting fragmentation of the global economy could increase financial stability risks, reducing cross-border investments, asset prices, payment systems and banks' ability to lend, the International Monetary Fund said on Wednesday.
SLIGHTLY DEEPER VIEW ON RECENT DATA
First of all, take a look at production numbers and PMI's across the Globe - everywhere industrial production and manufacturing are dropping. In fact, recent US Durable Good orders data is another confirmation of this, and recent Manufacturing PMI drop as well. But when you're looking at data of other countries - the scale of crisis becomes more visible. That is, formally, the transition to a steady industrial decline has not yet occurred, then a negative trend is clearly taking place.
Let's not close our eyes and hide our heads in the sand: there is a serious industrial recession in almost all major economies of the world! But situation with the US labor market seems even more interesting. Yes, most popular data shows good numbers, including recent upside Feb NFP revision. But, as we've mentioned in our reports few times - the methodology of calculation rises many questions on reliability of this data and on degree how correct it reflects the overall situation. Of course this is not some rough manipulation, but the details are hide in maths. The same as with CPI calculation method that we've discussed.
Meantime, if we take a look at "secondary" indicators, such as vacancies, average weekly hours, continues claims we could see that they are contradict to idea of economy and job market expansion:
Taking together both bulk of data it is difficult to recognize upside momentum in the US (and Global) economy. Industry has taken over the baton from inflation, if a year ago each review was accompanied by record price growth, then recently we have noted a drop in industrial production indicators. At the same time, most likely, the process will continue for some time due to the state of the banking system, which is loosing deposits-
There are other problems for banks, for example, the growth of debt. In conditions of higher rates, this increases risks, and a stop in tightening monetary policy will inevitably lead to a rapid increase in inflation. … In general, despite the fact that the banking crisis that took place a few weeks ago was man-made, it is possible that it will already receive an objective continuation.
All this is happening against the backdrop of the rising cost of living. As an example, we can give a graph of the share of car sales that require monthly payments of more than $ 1,000 per month:
Thus, overall picture doesn't look like absolutely "healthy". It seems that system has some margin of safety and situation has not reached yet the bifurcation point, but gradually is coming to it. In general, against the background of the clearly ongoing structural crisis, we have clearly unbalanced financial markets, the credibility of which is also falling for political reasons. Inflation data in the US will be released next week, and if they turn out to be not very good, we can already expect some sharp reactions, both from the markets and from the monetary authorities.
WHY WE THINK THAT BANKING CRISIS IS NOT OVER YET
In last few weeks it was seemed that Fed has taken situation under control and it was possible to plug the holes in time. Now situation is calming down a bit. But we think that this is just a temporal relief, because major problem of interest rates term inversion is not resolved. Banks still need to attract money at high rate while the bulk of investment portfolios stand with the low rates due because they were low in two recent decades. It means that interest rate margin continue to decrease which is major risk of banking system insolvency and Fed somehow should solve this problem. We think that they will go with printing machine.
First is, take a look at banking deposit momentum. It is a habit to talk about deposits since SVB crash, and that they have dropped for $450+Bln in recent four weeks. But this is only among small banks. In large banks however, the tendency lasts for months already and started for long time before hot stage of crisis. This tendency clearly reflects market society reaction on Fed policy:
If one company defaults on a loan then the company that lent that money might not be able to repay its own creditors. This form of contagion can amplify the effect of credit losses from monetary policy tightening. Fear of loan delinquency caused interbank lending to dry up and ultimately led to a credit crunch during the GFC. To date, we have not seen a rapid rise in either corporate failures or loan defaults (although the delinquency rate on consumer loans has started to rise gradually).
But monetary policy acts with long and variable lags, and so the possibility of defaults increasing further down the line cannot be ruled out. Indeed, as the chart below shows, there is a clear relationship between the rate of corporate failures and changes in the policy rate. This is to be expected — the reason that monetary tightening is expected to rein in inflation is that it slows aggregate demand. Corporate failures, though undesirable, are part of the transmission mechanism of monetary policy.
For this reason, Fathom maintains that the US economy is likely to enter a recession later this year and that there is likely to be a rise in loan defaults and business failures. If this proves correct, banks could suffer significant losses and it is entirely possible that the US banking system will find itself under a second round of pressure, with talk of a systemic banking crisis rearing its head once more
So, you do not need to be an economics professor to make the following conclusions.
The banking crisis (which, in fact, is financial one) will not be over until the tough financial conditions, manifested primarily in high rates, are normalized. It could be done only by two ways - either cut Fed rate or crash long-term bonds and hike long-term rates. First way is impossible to use now due to immediate jump of inflation right after. So, Fed has no choice but to keep rate hike and use liquidity to plug the holes when somewhere something will break.
The extreme increase in the Fed rate leads to the realization of interest rate risk in the US banking system, roughly speaking, a sharp reduction in the interest margin of banks. This happens when the growth rate of interest expenses on liabilities begins to exceed the growth rate of interest income on assets, and when does this happen? Primarily because of the temporary structure of assets and liabilities. Due to the specifics of the loan portfolio, loan income has an inertial characteristic.
For example, many mortgage loans in their profile are long-term (15 or 30 years) and have a fixed rate, and this loan portfolio was formed during a 13-year period of low rates from 2009 to 2022. Deposits, on the contrary, are mostly short-term and rotate faster in accordance with current market rates.
Accordingly, competition for depositors, investors and rising rates are inevitable (interest costs will increase), especially against the background of fragmentation of the banking system, when there is a redistribution of the deposit base from small and medium-sized banks to large ones.
These processes will reduce banks profit margin (btw it is interesting what coming earning reports will show). To compensate for these processes, banks will have to raise interest rates on loans, which, on the one hand, will cool the demand for new loans, but also reduce the stability of borrowers in the framework of refinancing current loans under new conditions. This will lead to an increase in delays and write-offs, which, with low interest margins will significantly increase the cost of creating reserves for loan losses, further undermining the stability of banks.
As a result: market and interest rate risk (losses on securities due to rising rates and a reduction in net interest margin) - > credit risk (increased costs of credit losses) - > losses of banks - > new bankruptcies and cash gaps.
Speaking about recent outflow of deposits for $473Bln in four weeks - is absolute record. Most of the deposits – over 300 billion were distributed to money market funds and related structures, which supported the demand for bonds and allowed the Fed to resume sales - this is how Fed solves the problem of demand drop for national debt. Next step is to grab money from cryptocurrencies and stock market.
Besides, the US themselves make situation worse with the chain of domestic political scandals. Why we've mentioned OPEC+ decision? Currently, both OPEC+ and the whole of Asia are shifting away from the US in their coalition agreements. And the main idea: you cannot keep your reserves in a currency that you do not control, do not issue, and you have big risks in this regard. As a result, US starts selling oil from SPR again. And now is a big problem to export inflation out to support the US Dollar, because new contracts are not in dollar.
Crude oil price seasonally starts to grow in the 2nd half of summer, and there we will see what consequences will be. The housing boom in G10 countries is over, problems with commercial real estate are already become visible. Until they form a critical point, and then one-two-three-four banks lay down. And so again another wave of negativity accumulates, and then a blow that will be more powerful.
And in this paradigm, they have no other choice but to start all support programs again, because without them the market will simply collapse. The Fed is the last resort, there will be no one in the United States to keep this system. Actually, the Fed is the whole system. The time of commercial banks is running out, they are not mobile. The model was brought money, placed it - it stops working in the digital world. The hostages of this system are commercial banks. And it turns out that the whole country of the USA is under attack, where commercial banks are the basis of the entire system.
Still, in short term perspective, at least until the May-June, July maybe (then there will be pause in August) market should keep driven by short-term factors - coming inflation reports and Fed meetings results. The turning point could come in June. As we've said - now majority is sure that May rate change will be the last one. We think that market is wrong and Fed will keep rate hike for 0.25% on every meeting.
It means that until May, EUR/USD could keep upside trend on disparity of expectations. Markets expect 0.5 rate change from ECB (and maybe more later) while are waiting "the last" 0.25% rate change from the Fed. Trend could change drastically and with a big screams on June, when these expectations will be broken. That's why we think that it is early totally deny long-term bearish scenario on EUR/USD.
Another risk factor for EUR is the same banking crisis. Hardly EU and the US banking system is significantly different. But it is totally uncertain by far in what way this crisis will reach EU and when. EU processes are the same - high inflation, drop of consumption, production etc. That's approximately what we think on nearest 1-3 months.
Despite that recent week is short due Easter holidays, we have multiple important events and data releases. Speaking on the US domestic statistics - no drastic shifts but still, numbers in general were weaker than expected. Structural crisis stands under way showing slow but gradual progress. If in the beginning of the crisis process everybody were signing high inflation and watching for its trend, now inflation is replacing by production - it is dropping across the Globe, showing the next stage of the crisis.
On global economic background there are two events worth to mention - first is, formal, but still, D. Trump legal pursue and second - massive OPEC+ demarche with 1.5 mln bls extraction cut. At first glance, it has mostly political reasons. But it also has important consequences for global economy either. This situation looks like a vivid anti-American demonstration (especially in combination with the story with Trump), but, by and large, it is purely pragmatic.
The crisis in the global economy continues, private demand is falling, and the demand for oil is falling. In such a situation, reducing production is a completely natural policy, another thing is that it was difficult to implement it earlier in a situation of obvious opposition to the United States. But times are changing and the authority and political resource of this country are significantly reduced, in a sense, before the eyes of all mankind, and the objective needs of specific countries are beginning to come to the fore.
Of course, not all of them are adequate to the situation, who only today does not write about the lack of political subjectivity in most EU countries, but in general the trend is obvious. And as the crisis develops, it will manifest itself more and more brightly. Moreover, we assume that the relevant processes will develop faster and faster, while in any case, this trend is clearly noticeable.
Market overview
U.S. Treasury yields climbed and U.S. index futures closed modestly higher after employment data for March indicated the labor market remains tight, but was largely in line with market expectations. Nonfarm payrolls increased by 236,000 jobs last month, the Labor Department said, compared with the 239,000 expectation of economists surveyed by Reuters. Data for February was revised higher to show 326,000 jobs were added instead of 311,000 as previously reported. The unemployment rate dipped to 3.5% from 3.6% in the prior month.
U.S. stock index futures erased losses and turned higher after the report, while the dollar strengthened and U.S. Treasury yields rose as expectations the Federal Reserve will hike rates at its May meeting increased. Still, the jobs report heightened expectations the Fed will raise rates at its next meeting, with the market pricing in a 69% chance for a 25 basis point rate hike, up from 49.2% on Thursday, according to CME's FedWatch Tool.
In the bond market, the Fed’s preferred recession indicator plunged to fresh lows in the past week, bolstering the case for those who believe the central bank will soon need to cut rates. The measure compares the current implied forward rate on Treasury bills 18 months from now with the current yield on a three-month Treasury bill.
Markets will also watch first-quarter earnings, which start in the coming week with major banks including JPMorgan and Citigroup due on Friday. Analysts expect S&P 500 earnings to fall 5.2% in the first quarter from the year-ago period, I/B/E/S data from Refinitiv showed.
Analysts also said that while the jobs report showed strong gains, there are sectors that have seen moderate declines specifically the manufacturing and construction industries. (Structural crisis?!)
With nonfarm payrolls out of the way, investors are now focused on the U.S. consumer price index (CPI) for the month of March. Economists polled by Reuters expect core CPI of 0.4% last month and 5.6% on a year-on-year basis. Tom Simons, U.S. economist, at Jefferies, wrote that he expects CPI "will continue to show uncomfortably high core inflation pressure."
The International Monetary Fund expects global economic growth to dip below 3% in 2023 and to remain at around 3% for the next five years, Managing Director Kristalina Georgieva said on Thursday, flagging increased downside risks. The IMF chief called on central banks to stay the course in the fight against inflation as long as financial pressures remained limited, but to address financial stability risks when they emerge through appropriate provision of liquidity.
Rising geopolitical tensions and the resulting fragmentation of the global economy could increase financial stability risks, reducing cross-border investments, asset prices, payment systems and banks' ability to lend, the International Monetary Fund said on Wednesday.
SLIGHTLY DEEPER VIEW ON RECENT DATA
First of all, take a look at production numbers and PMI's across the Globe - everywhere industrial production and manufacturing are dropping. In fact, recent US Durable Good orders data is another confirmation of this, and recent Manufacturing PMI drop as well. But when you're looking at data of other countries - the scale of crisis becomes more visible. That is, formally, the transition to a steady industrial decline has not yet occurred, then a negative trend is clearly taking place.
Let's not close our eyes and hide our heads in the sand: there is a serious industrial recession in almost all major economies of the world! But situation with the US labor market seems even more interesting. Yes, most popular data shows good numbers, including recent upside Feb NFP revision. But, as we've mentioned in our reports few times - the methodology of calculation rises many questions on reliability of this data and on degree how correct it reflects the overall situation. Of course this is not some rough manipulation, but the details are hide in maths. The same as with CPI calculation method that we've discussed.
Meantime, if we take a look at "secondary" indicators, such as vacancies, average weekly hours, continues claims we could see that they are contradict to idea of economy and job market expansion:
Taking together both bulk of data it is difficult to recognize upside momentum in the US (and Global) economy. Industry has taken over the baton from inflation, if a year ago each review was accompanied by record price growth, then recently we have noted a drop in industrial production indicators. At the same time, most likely, the process will continue for some time due to the state of the banking system, which is loosing deposits-
There are other problems for banks, for example, the growth of debt. In conditions of higher rates, this increases risks, and a stop in tightening monetary policy will inevitably lead to a rapid increase in inflation. … In general, despite the fact that the banking crisis that took place a few weeks ago was man-made, it is possible that it will already receive an objective continuation.
All this is happening against the backdrop of the rising cost of living. As an example, we can give a graph of the share of car sales that require monthly payments of more than $ 1,000 per month:
Thus, overall picture doesn't look like absolutely "healthy". It seems that system has some margin of safety and situation has not reached yet the bifurcation point, but gradually is coming to it. In general, against the background of the clearly ongoing structural crisis, we have clearly unbalanced financial markets, the credibility of which is also falling for political reasons. Inflation data in the US will be released next week, and if they turn out to be not very good, we can already expect some sharp reactions, both from the markets and from the monetary authorities.
WHY WE THINK THAT BANKING CRISIS IS NOT OVER YET
In last few weeks it was seemed that Fed has taken situation under control and it was possible to plug the holes in time. Now situation is calming down a bit. But we think that this is just a temporal relief, because major problem of interest rates term inversion is not resolved. Banks still need to attract money at high rate while the bulk of investment portfolios stand with the low rates due because they were low in two recent decades. It means that interest rate margin continue to decrease which is major risk of banking system insolvency and Fed somehow should solve this problem. We think that they will go with printing machine.
First is, take a look at banking deposit momentum. It is a habit to talk about deposits since SVB crash, and that they have dropped for $450+Bln in recent four weeks. But this is only among small banks. In large banks however, the tendency lasts for months already and started for long time before hot stage of crisis. This tendency clearly reflects market society reaction on Fed policy:
If one company defaults on a loan then the company that lent that money might not be able to repay its own creditors. This form of contagion can amplify the effect of credit losses from monetary policy tightening. Fear of loan delinquency caused interbank lending to dry up and ultimately led to a credit crunch during the GFC. To date, we have not seen a rapid rise in either corporate failures or loan defaults (although the delinquency rate on consumer loans has started to rise gradually).
But monetary policy acts with long and variable lags, and so the possibility of defaults increasing further down the line cannot be ruled out. Indeed, as the chart below shows, there is a clear relationship between the rate of corporate failures and changes in the policy rate. This is to be expected — the reason that monetary tightening is expected to rein in inflation is that it slows aggregate demand. Corporate failures, though undesirable, are part of the transmission mechanism of monetary policy.
For this reason, Fathom maintains that the US economy is likely to enter a recession later this year and that there is likely to be a rise in loan defaults and business failures. If this proves correct, banks could suffer significant losses and it is entirely possible that the US banking system will find itself under a second round of pressure, with talk of a systemic banking crisis rearing its head once more
So, you do not need to be an economics professor to make the following conclusions.
The banking crisis (which, in fact, is financial one) will not be over until the tough financial conditions, manifested primarily in high rates, are normalized. It could be done only by two ways - either cut Fed rate or crash long-term bonds and hike long-term rates. First way is impossible to use now due to immediate jump of inflation right after. So, Fed has no choice but to keep rate hike and use liquidity to plug the holes when somewhere something will break.
The extreme increase in the Fed rate leads to the realization of interest rate risk in the US banking system, roughly speaking, a sharp reduction in the interest margin of banks. This happens when the growth rate of interest expenses on liabilities begins to exceed the growth rate of interest income on assets, and when does this happen? Primarily because of the temporary structure of assets and liabilities. Due to the specifics of the loan portfolio, loan income has an inertial characteristic.
For example, many mortgage loans in their profile are long-term (15 or 30 years) and have a fixed rate, and this loan portfolio was formed during a 13-year period of low rates from 2009 to 2022. Deposits, on the contrary, are mostly short-term and rotate faster in accordance with current market rates.
Accordingly, competition for depositors, investors and rising rates are inevitable (interest costs will increase), especially against the background of fragmentation of the banking system, when there is a redistribution of the deposit base from small and medium-sized banks to large ones.
These processes will reduce banks profit margin (btw it is interesting what coming earning reports will show). To compensate for these processes, banks will have to raise interest rates on loans, which, on the one hand, will cool the demand for new loans, but also reduce the stability of borrowers in the framework of refinancing current loans under new conditions. This will lead to an increase in delays and write-offs, which, with low interest margins will significantly increase the cost of creating reserves for loan losses, further undermining the stability of banks.
As a result: market and interest rate risk (losses on securities due to rising rates and a reduction in net interest margin) - > credit risk (increased costs of credit losses) - > losses of banks - > new bankruptcies and cash gaps.
Speaking about recent outflow of deposits for $473Bln in four weeks - is absolute record. Most of the deposits – over 300 billion were distributed to money market funds and related structures, which supported the demand for bonds and allowed the Fed to resume sales - this is how Fed solves the problem of demand drop for national debt. Next step is to grab money from cryptocurrencies and stock market.
Besides, the US themselves make situation worse with the chain of domestic political scandals. Why we've mentioned OPEC+ decision? Currently, both OPEC+ and the whole of Asia are shifting away from the US in their coalition agreements. And the main idea: you cannot keep your reserves in a currency that you do not control, do not issue, and you have big risks in this regard. As a result, US starts selling oil from SPR again. And now is a big problem to export inflation out to support the US Dollar, because new contracts are not in dollar.
Crude oil price seasonally starts to grow in the 2nd half of summer, and there we will see what consequences will be. The housing boom in G10 countries is over, problems with commercial real estate are already become visible. Until they form a critical point, and then one-two-three-four banks lay down. And so again another wave of negativity accumulates, and then a blow that will be more powerful.
And in this paradigm, they have no other choice but to start all support programs again, because without them the market will simply collapse. The Fed is the last resort, there will be no one in the United States to keep this system. Actually, the Fed is the whole system. The time of commercial banks is running out, they are not mobile. The model was brought money, placed it - it stops working in the digital world. The hostages of this system are commercial banks. And it turns out that the whole country of the USA is under attack, where commercial banks are the basis of the entire system.
Still, in short term perspective, at least until the May-June, July maybe (then there will be pause in August) market should keep driven by short-term factors - coming inflation reports and Fed meetings results. The turning point could come in June. As we've said - now majority is sure that May rate change will be the last one. We think that market is wrong and Fed will keep rate hike for 0.25% on every meeting.
It means that until May, EUR/USD could keep upside trend on disparity of expectations. Markets expect 0.5 rate change from ECB (and maybe more later) while are waiting "the last" 0.25% rate change from the Fed. Trend could change drastically and with a big screams on June, when these expectations will be broken. That's why we think that it is early totally deny long-term bearish scenario on EUR/USD.
Another risk factor for EUR is the same banking crisis. Hardly EU and the US banking system is significantly different. But it is totally uncertain by far in what way this crisis will reach EU and when. EU processes are the same - high inflation, drop of consumption, production etc. That's approximately what we think on nearest 1-3 months.
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