Banks, The Fed, Rates, Inflation = A Stagflationary Bust?

Blain’s Morning Porridge – 23^rd March 2023: Banks, The Fed, Rates, Inflation = A Stagflationary Bust?

“How do you know there is about to be a bank crash? Because one isn’t crashing at the moment.”

This morning – The Fed tries to be dovish to calm market fears, but banking fears and inflationary threats on the economy may lead us somewhere new: A Stagflationary Bust!

Apologies for very late Porridge this morning – all I have to say is trains, failure at Weymouth, thus no carriages available to go to London. Welcome to Britain in 2023.

Relax. Calm. Calm.

Nope. I am worried. Things feel angsty… change, and not of the good kind, is coming. Last night ex Merrill economist David Rosenberg said the changing guidance from the Fed means… “Peak Growth. Peak Inflation. Peak Credit Cycle. Peak Rates. Buy Bonds!” I don’t necessarily agree.. Why?

Something wicked this way comes – and it might just be a monumental Stagflationary Bust and a complete rebuild of the whole financial system… again… That’s bad for bonds as well… my answer? Stay long gold.

Bank crashes are like London Buses. None arrive for ages, then suddenly a whole bunch of them arrive together…

While there is a sort of tedious inevitability to bank failures there are very good reasons why they come in groups. Financial regulators and central banks expended loads of mental energy to ensure banks don’t go bust like they did in 2008 – through regulation and messing with fundamentals of capital and debt subordination by allowing the bad compromise of the now discredited AT1/CoCo capital bonds. Meanwhile, banking management cadres have been industriously innovating whole new ways to break their banks and destroy confidence in the institutions of the finance system – at which point we really must acknowledge and applaud the skill sets displayed by Credit Suisse’s series of progressively less and less competent idiots-in-chief to destroy value.

My own simple theory on banks is worth remembering: All good banks are alike; but each bad bank is bad in its own way, as Leo Tolstoy did not say… Understand the multiple ways banks can disappoint, and you are half-way there to understanding them….

It came as no surprise the current crop of banking failures– 3 so far largely on the back of managerial incompetence – have triggered massive fears others may also tumble. Excellent – or so I thought: be greedy while others are fearful. Monday morning I was out trying to scoop deeply discounted AT1 / CoCo bonds, quietly. Unfortunately, so were a number of other smarter investors who understand banking, sharing my view the idiosyncratic pressures and mistakes that slew Credit Suisse won’t necessarily apply to other banks.

Yesterday I was listening to the CEO of Algebris – apparently one of the largest investors in AT1 – bleating about why they remain a great investment that can only improve. Listen to it: ATI are Absolutely Not Dead. I must be very thick – because I did not understand his arguments at all. They sounded like a man talking his own broken book. I have a very simple understanding of how banks work. (You can read all about my simple CAMEL-L analytical approach in last week’s porridge: Credit Suisse – How Bad and What Next.)

Although a coven of investors are trying to put a claim together against the Swiss Regulator, Finma, I doubt they will succeed. That said, if anyone wants to quietly exist their Credit Suisse AT1 CoCo bonds, give me a shout and I have a bid.

I recently read a note on the current banking unpleasantness: “The Fed has been unlucky to find itself fighting a series of bank runs even as it tries to balance inflation against inflation risk.” Again, I disagree. The Fed is very aware that in these days of financial perma-crisis their job is to anticipate what will hit next, aware that financial crises are consequential – each little crisis spinning and altering the expectations that will trigger the next. Central Banks have evolved to deal with these crisis outbreaks – last week they were swift and decisive with deposits and backstop funding.

However, yesterday Jay Powell’s decision to hike rates by 25 basis points, and then give forward guidance there may be limited further hikes to come sounded like a bit of compromising twaddle – was a “Parsons Egg”: good in parts, too runny, but not runny enough. Just listen to the analysts agreeing on nothing. In recent days Central Banks have been getting it in the ear for being too slow to address inflation, and for being too aggressive hiking rates with the risk of triggering a deeper banking stramash. Central Bankers really can’t win.

US rates now stand at 5%, which would be getting back into the normalisation zone, if it wasn’t for the fact these are still negative real yields, with US inflation stubbornly around 6%. Its been that way for a decade! US inflation will fall, and fall faster than in Europe, but rates are still negative now.. and that distorts investment and is never a good reason to buy long bonds, which partially explains the inverse steep curve, fuelled by the $360 bln US depositors have pulled from banks and directed into Money Market ETFs over the last few weeks! (Which incidentally, is another reason for banks to wobble!)

The fact Powell now says further hikes are limited panders to the inflation doves and recession spooks, but keeps me fearful of long-term bond valuations. As long as the bond market (the risk-free-rate) is broken – then the value of every single other relative asset is equally broken… just saying…

There are two other factors that make this even more troubling:

The first is liquidity and valuations – I have never seen such wild swings in prices, reflecting wide bid-offers, hinting at just how illiquid markets are. Hi-yield and even investment grade credit feels set in concrete. When crisis hits, the markets will lock shut. Even treasuries are causing concern in terms of being difficult to trade. Even stocks look wrong, with moves in the mega stocks like Apple and Microsoft swamping trades in the rest of the market.

The second is mindset – it amazes me how many market commentators seem to have no idea just how distorted markets have been these last 14 years of monetary distortion.  Immediately discount and ignore any investment banking analyst telling you about spreads and relationships within normal market averages – like this: “Firstly, when we look at credit yields vs 3m bills, spreads are still in line with 10-year averages. Secondly, when we look at credit yields vs market expectations for the cash rate (proxied by the 2Yr bund) on a forward looking basis (in 2 years time), EU IG/HY spreads are 3.2/1.6 s.d. cheap.” Wow.. that all assumes we were in normal markets during the observation periods.. no we were not!!! There is a lot of Mispriced Nonsense thinking going on among financial analysts who have never figured what normalisation means.

The next few months are going to be interesting – geopolitics, domestic politics, how sticky wage inflation proves, potential dollar weakness, yield curve steepening, further banking wobbles, plus an increasingly negative macro overlay of declining consumer activity as inflation beats wages, rising corporate defaults, declining confidence, and the possibility of further no see-um-shocks creating a cataclysm of supply-chain shocks to reignite the smouldering inflation bonfire.. And, an illiquidity shock will just magnify crisis..

Hence my fears we are not just in for recession on the back of stressed corporates and consumers, but sticky, threatening long-term inflation above 5%, creating not just a deflationary shock but a long-term Stagflationary Bust… crashing minor chords..

Meanwhile, I do think there is value in the bank capital bonds – it’s a matter of being very selective in terms of which ones you attempt to buy.  But, I’m also taking a step back and wondering if I really want to be buying banks at all…? They do seem to experience crisis on a rolling basis, and I wonder what they really contribute to the economy. Banking services is basically handling accounts, processing payments, loans, mortgages, and whatevers… all things that can readily be done better by Fintechs and AI. I suspect our grandkids will wonder what the Grossbanken were..

Out of time, and back to the day job…

Bill Blain

Strategist – Shard Capital