The summer is coming, well, at least for us in the north. Summers, can be a grind in markets, or at key macro inflection points have come with some of the most volatile trading periods in history (think GFC, ‘11 US credit downgrade/EU crisis, Brexit etc). So, are we on a highway to vol? Likely… There’re too many risks to list (but liquidity draining being a big one, peak tightening another) and of course unknown risks too.
It’s AI-euphoria and belief US labor will never cool (not our view) that are the factors holdings things up, take a broader look. We’ve been skeptical of “no or soft landing” since Q1, because US manufacturing is still contracting and look, even Germany is in a “technical recession,” btw China hasn’t benefited much from re-opening too. We fear debt ceiling may be distracting us from what could be a stalling global economy.
Fiscal policy will fade post a debt ceiling raise, meets a US consumer now strapped (and facing the potential for student loan forgiveness to fail) against a tight monetary policy backdrop, all this will add to more bumps along the vol highway. Buckle-up!
- The Debt Ceiling Dance: Markets have been behaving differently this time as we head into X-date (minor risk-off, rates on edge, big CDS premium etc). We think some sort of resolution occurs, the concern will be t-bill/bond issuance that follows.
- The Money Markets: The high rate environment continues to draw cash out of banks and into MMFs. Our analysis shows when institutional accounts move money into MMFs, esp. in/out of debt ceiling periods, we get a liquidity draining and risk-off.
- The Curve: Each Fed hiking cycle has seen markets skeptical of the Fed’s ability to maintain rates “higher for longer”, but this latest one takes the cake. But we did find a macro metric that strengthens the curve’s recession call as a legit signal.
- Banking System: We believe risk aversion (less credit availability as a result) is setting in across US depository institutions (esp. at smaller banks). And as CRE gets “marked-to-market” how will that translate to collateral values and capital hits?
- Exploring Narratives: We narrow down four regimes and associated macro views and market implications. Our long-standing view has been that the current regime will end up as a “boom turned bust” cycle (similar to what the US would see in post-war disruptions/fiscal spending followed by Fed tightening). In many ways, it’s also an extension to the prior cycle, where the economy was already slowing into 2020, but the mal-investment adjustments were postponed by epic stimulus efforts
US RATES FORECASTS
We think the Fed will be on a short-lived pause. In addition, our rates path is driven by two scenarios, where both paths see cuts, but the difference is by how much and what will be the catalyst to see them start to ease. If inflation declines continue, real rates (r-star) will turn very positive versus a Fed on hold at 5 plus percent rates. An “immaculate disinflation” along with clearer signs of economic weakness (job losses) could see the Fed cut by 50bps in late 2H23. If macro conditions worsen in tandem with FCI tightening/more credit accidents (base case), they could cut by 100bps or more. Timing of cuts also matters versus just the magnitude. To capture this we split the difference, expecting the Fed to end the year anywhere between 4.25-4.75%.