On May 3, the Federal Reserve once again raised its policy rate, this time by 0.25% as widely expected. The policy rate now ranges from 5% –5.25%, up from 0%–0.25% slightly over a year ago. Inflation remains significantly above the Fed’s 2% target.

The Consumer Price Index (“CPI”), the measure Congress mandates the Fed to influence, reported at 4.9% year over year for April, 5.5% after stripping out the volatile food and energy components. The Personal Consumption Expenditures Index (“PCE”), the Fed’s favored version of inflation measurement, came in at 4.2% for March year over year. Both measures offer a significant decline from peak inflation readings of 9.1% for the CPI-U and 12.0% for the PCE.

But neither measure is 2%. The trimmed mean 12-month PCE inflation, which is Federal Reserve Chair Powell’s stated preference, has barely budged:

Source: The Dallas Federal Reserve

While the overall trend appears friendly to the Fed’s campaign to bring inflation back to earth, the persistence of the trimmed mean figures underscores our belief that this campaign will take a lot longer to be successful than most market participants think. Inflation seems to us rather like Fleetwood Mac—it refuses to go away.

What’s changed in the early part of 2023 is that the cohort causing the highest level of price growth—more than 10% (green in the preceding graph)—has significantly shrunk. But what’s driving the persistence of inflation, and likely will continue to do so, are the two middle cohorts 5–10% (dark blue) and 3–5% (red orange). As you can see here, the dark blue area has expanded since the end of 2022. And again, neither 5–10% nor 3–5% are 2%. As Chair Powell put it during his prepared remarks after the rate announcement May 3, “Inflation pressures continue to run high and the process of getting inflation back down to 2 percent has a long way to go.” Fleetwood Mac, indeed.

A snapshot of US Treasury yields from the week before, the day of, and the day after the  Fed rate meeting shows how oddly the bond markets interpret that remark from Powell. The gold line yield of 5.06% for the overnight rate on the day after the rate announcement certainly fits into the policy range of 5–5.25%. But the 1-month Treasury Bill jumps to 5.76%—from 4.70% only the day before. 2-month to 6-month bills drift a bit higher from rates the week before holding above 5%. Meanwhile, 3-year to 30-year maturities offer well below 4%. The 5-year note minus the 1-month T-Bill (highest yield 5.76% to lowest yield 3.29% on the curve) stood at a remarkable -2.47%.

Normal yield curves exhibit “term premium”. Term premium means that the longer you are willing to lend money, the higher your yield should be to compensate for future inflation and credit risks. A significant “inversion” in the yield curve where short term interest rates are higher than longer term rates have happened just before every recession since World War II.

The week before the Fed bumped rates again, the 1-month T-Bill yield was 4.35%. The day of the rate announcement, that rate jumps to 4.70% and the following day to 5.76%. Huge amount of rate volatility. Meanwhile 10-years to 30-years, rates barely budge.

This volatility highlights underlying stress in the markets. We believe the fall in yield of the 1-Month T-Bill so significantly below the overnight rate at the end of April was likely caused by the continued rush of investors moving cash from banks to money market mutual funds, specifically those funds that invest only in US Government short term debt. The flows over the last 10 weeks from banks to money markets is well over half a trillion dollars¹.

That “disintermediation” of money flowing out of banks and into money markets creates further stress on banks and is significant enough to cause these wild gyrations in the 1-month bill.

The three bank failures we have seen are further signs of stress within the capital markets. As we have noted before, stock and bond markets are not the real economy. Capital markets tend to be leading indicators or predictors of what the real economy might do in the future. 

The swift rise in short term interest rates over the last year caught at least three banks wrong-footed—so far. You deposit cash in a bank. The bank then lends that cash into the real economy by offering credit for mortgages, car loans, credit cards, business lines of credit, etc. Your deposit is known as a “demand deposit”. That means that you are entitled to your cash back on demand. But the bank has loaned your cash to borrowers who generally do not have to pay the bank back “on demand”. Rather the borrower has a term over which the loan is repaid. 

Banks who do not have sufficient cash on hand AND the confidence of their depositors find themselves exposed to “runs on the bank”. That is exactly what happened to Silicon Valley and to Signature banks, and was in the process of happening to First Republic when the FDIC stepped in.

The FDIC made all depositors whole in the three failed banks, even those with accounts larger than the $250,000 limit ordinarily in place. The FDIC took this action to stop contagion, and additional bank runs. The losses from the three failed banks as their assets are recovered will be made up by future hikes and assessments of FDIC insurance on the entire Federal banking system.

Meanwhile, the Federal Reserve offered a new temporary facility, open for about a month. It allowed banks to exchange US government debt whose market price had declined significantly for cash at nominal maturity value. But the term of the exchange is only for one year at the present time. This action represented an expansion of the Fed’s balance sheet again, which had been shrinking until the March banking crisis. The Fed’s action here can be looked on as mildly stimulative.

We find it instructive that the Fed wants to be paid back on this facility within a year. The Fed has the ability to hold those exchanged securities until they mature and pay themselves back in full. We believe that the Fed’s current posture not only underscores the overall general good health of the banking system, but also that the payback represents a marker of credit tightening down the road.

Will more banks fail? Certainly—happens all the time. That’s what the FDIC lives for: to wind down failures and secure depositors into new, stronger hands.

Will the banks that fail in the future be as big as #14, #16 and #25? The capital base of USA banks was greatly strengthened after the Great Financial Crisis of 2008-2009. But… banks this big failing points a finger at the Federal Reserve and the Office of the Comptroller of the Currency (OCC) whose job it is to oversee them. We suspect COVID allowed laxity in regulation that should not have occurred.

Here’s why you should be confident that your funds we manage are safe:

If Fidelity Investments holds your account, your cash and investments are held separately from every other of the 40.9 million individual investors at Fidelity. Unlike a bank, Fidelity cannot lend your cash, and can only lend your security holdings with your permission. Above and beyond, each account has cash insured up to$500,000 by SIPC, which is similar to the FDIC, and $1.9 million in additional coverage on cash by Lloyds. But the point here is that the plumbing is different from a bank: accounts are held separately. We have an independent accountant conduct a surprise audit that Fidelity does what they say they do every year.

If Advocacy Trust holds your account, the custodian is Reliance Trust, a unit of FIS Global. The important points here are two: Advocacy Trust does NOT accept deposits like a bank, NOR does Advocacy Trust lend. There are no deposits to lend in the first place. Advocacy Trust undergoes an independent audit every year and gets visited by the Tennessee Banking Commission on a regular cycle. Again, your cash and security holdings are held in separate accounts and cannot be lent. That same surprise audit covers Advocacy Trust as well.

We chose who custodies your wealth thoughtfully: first, not us, but independent third parties; and second, rock solid institutions who sailed through 2008-2009 without issues. Fidelity Investments and Reliance Trust fit both restrictions.

So let’s return to talking about your investments and your cash.

We classify these three bank failures as capital market stresses. Market stresses have a way of finding their way into the real economy. As a result, a meaningful drop in lending has happened as banks reassess their risk. 

This drop in lending causes further tightening within the financial system, a drag on the real economy.

We characterize inflation as a stress on the real economy. Bringing price stability—fighting inflation—is one of the Fed’s two mandates. The Fed has three main tools with which to fight inflation:

Raising short term interest rates above the neutral rate;

Quantitative tightening; and

Forward guidance.

The Fed can also loosen or tighten reserves backing lending by banks, but has not used that tool in decades since it can cause uncertainty within bank risk models. Finally, the Federal Reserve has responsibility for ensuring that the banking system is and remains sound. Let’s look at each of these items bulleted.

As we have written here before, we define the neutral rate as the Federal Funds rate which neither stimulates nor restricts the real economy. The Federal Reserve controls the Federal Funds rate as well as the Secured Overnight Financing Rate (“SOFR”). For the years between the Great Financial Crisis of 2008-2009 and the arrival of the Pandemic in 2020, inflation rarely topped 2% and the real economy expanded at a moderate rate overall. Nirvana for the Fed. During those years, the neutral rate was judged to be about 2.5%. The Fed Funds rate averaged 0.61325% from 2010–2019².

What the neutral rate is right now is really anybody’s guess. We won’t know until the current economic cycle ends and the next begins. The economy, at least as measured by Gross Domestic Product (“GDP”, a measure of output of goods and services), has been slowing. But, importantly, for now it continues to grow above 0%.

Quantitative Tightening can occur in two ways. The Fed can sell securities it owns into the open market and drain cash out. Or, it can just not reinvest principal or interest as it is collected. The lack of reinvestment in effect also drains cash by forcing other market participants to purchase securities instead of the Fed. Both have the effect of pushing interest rates up. Unlike controlling the Fed Funds or SOFR rates, Quantitative Tightening can affect the entire yield curve from 1-month to 30 years depending upon what maturities the Fed is targeting.

The Fed has been allowing securities to mature and collecting interest without reinvesting since announcing the balance sheet runoff program a year ago⁴. Over the last month, however, that runoff has been offset by the temporary lending facility lending to banks at face (maturity) value of debt securities rather than fair market value. That spike up you see in March below coincides with the new temporary facility.

“Forward guidance” represents the last tool the Fed currently uses to fight inflation. The Fed tells the capital markets and the rest of us what it intends to do. This transparency tends to become self-fulfilling. After last July’s Fed meeting, Powell announced there would be no further forward guidance due to the uncertainty around all the data they were seeing.

Then Powell said just this May, “I think real rates are probably—that you can calculate in many different ways. But one way is to look at the nominal rate and then subtract a reasonable estimate of let’s say one-year inflation, which might be 3 percent. So you’ve got 2 percent real rates. That’s meaningfully above what most people would—many people, anyway, would assess, as, you know, the neutral rate. So, policy is tight… And if you put the—you put the credit tightening on top of that, and the QT that’s ongoing, I think—I think you feel like, you know, we’re—we may not be far off ... We’re possibly even at that [sufficiently restrictive] level.”⁵

That’s not forward guidance itself but rather an assessment of where Powell thinks we are right now. The combination of rate rises, banks (“credit”) tightening lending, and Quantitative Tightening (“QT”) might just be enough to get the job done—inflation back to 2%. Then Powell went on to say, ”But ultimately, we’re not looking to get to 3 percent and then drop our tools. We have a goal of getting to 2 percent. We think it’s going to take some time. We don’t think it’ll be a smooth process. And, you know, I think we’re going to—we’re going to need to stay at this for a while.” 

That’s forward guidance: the Fed will keep conditions tight enough, long enough to bring inflation down to 2%.

The capital markets seem to be listening to a different tale.

The significant inversion in the yield curve which has now crept closer to the short end of the curve speaks to the belief that the Fed will move rates down, starting as early as later in 2023. That’s what the participants in the debt markets appear to believe.

By way of contrast, participants in the stock market, the other side of the capital markets, appear to believe a soft landing as the most likely outcome.

At the end of April, stocks in the United States had gained 9.17% as measured by the S&P 500® Index and 8.79% by the broader Russell 1000 Index. In these broad indices are either productivity or margin of profit expanding in the face of shrinking revenues? Broadly the answer is resoundingly, “NO”.

How do these gains in these indexes make sense, then? First, the gains have been powered by the top 8 stocks in the two indices. In the case of the S&P 500®, 492 of the 500 in the index have lost value in 2023. Without the “Great Eight”, 2023 is a loser so far.

Second, if a recession arrives in the second half of 2023, the betting in both stock and bond markets seems to be that the Fed would ease conditions dramatically. The first step in this playbook cuts short term interest rates significantly.

For this scenario to play out, demand destruction must clear, universal, and swift.

From the armchair where we sit, this quarterback sees only a Pick-6 as a trigger for that kind of demand destruction. An event such as:

• Congress fails to raise the debt ceiling, causing default.
• Dollar no longer the reserve currency.
• Continued runs on banks.
• China invades Taiwan.
• Russia nukes Kyiv and NATO retaliates.
• A new pandemic arrives.

Are any of these events possible? Certainly. Are any of these events probable? That brings us to the concept of fat tails.

Over long periods of time, stocks gain 11.5% annually⁶ depending on which time slice you’re looking at. Given that expectation, in a normal distribution over sufficient time, you’d expect to see the total return for stocks to average 11.5%. Data point #1, stocks have gained around +9% already in 2023.

This observation does not imply that we should expect stocks to gain 11.5% every single year, just that stocks average a return near that number.

Some years, stocks may be up +31% (2019), others down -24% (2022) —data points #2 and #3. A measurement of historical volatility – what is the range of returns distributed over the period under consideration—becomes key to understanding the range of return outcomes. The higher that historical volatility, the larger the swings within returns we should expect.

A “fat tail” can be observed when the return lays outside the range of returns predicted by historical volatility. A fat tail on the right side of the curve indicates an outsized gain; the left, an outsized loss.

We live in particularly uncertain times. That uncertainty lends weight to the probability of “tail” risk— particularly “left tail” risk of outsized loss.

Facts inform probabilities of risk. Facts we consider important:

• The economy in the USA continues to grow. Most of the global economy also continues to grow.
• The employment rate in the USA stands at a 50-year low. There are 1.6 jobs open for every 1 unemployed.⁷
• Inflation in the USA has peaked but not disappeared.
• The Federal Reserve has either reached the terminal rate of raises or is close to it.

The Federal Reserve during the 1970s under Arthur Burns played whack-a-mole with interest rates by raising rates when inflation rose, then once inflation cooled a bit, cutting rates nearly immediately. As a result, inflation averaged 7.09% during the 1970s. Nobel Prize winner Milton Friedman lambasted the actions of the Fed during the Burns era⁸. His monetarist approach held that actions taken by the Federal Reserve have a “long and variable lag” before the effects on the economy are seen. Here’s another fact:

• The Fed raised the funds rate from 0% - 0.25% to 0.25% - 0.50% on March 16, 2022.

If Friedman is right, we might only just now see the effects of what the Fed did last year. Arguably, to be effective, we’d have to look back to where the Fed finally got above the neutral rate, and policy turned restrictive. Maybe we’re looking at November 2022 when Fed Funds got to 3.75% - 4%. The point here is that as Powell said, “We think it’s going to take some time. We don’t think it’ll be a smooth process. And, you know, I think… we’re going to need to stay at this for a while.”

So with no recession here now, inflation remains persistent, at least so long as employment remains robust.

Which gets us back to those “fat tails” at least on the left of the curve.

• Congress fails to raise the debt ceiling, causing default. Dollar no longer the world’s reserve currency.

Could Congress fail to act rationally? Failure to raise the debt ceiling would certainly increase the cost of government borrowing. Total public debt exceeded GDP occasionally before 2016, but has done so persistently since. As you might imagine, it spiked during the pandemic reaching a peak of 134.83% of GDP. But it still remains elevated at 120.21% as of the end of last year. Owing more than you produce is a prescription for bankruptcy. Causing higher interest due on government debt only hastens that day of reckoning, especially were the USA to experience a recession.

So long as goofballs from the extreme wings of either party get elected, we suppose anything can happen. But we think there remain enough adults in Congress to do the right thing - eventually. A technical default where the USA delays payments for a few days is far more probable than actually walking away from making any payment at all. But even that probability should be small.

The dollar losing its position as the world’s reserve currency seems to us less dire. In fact, it has already happened to some degree. Russian oil settles in currencies other than the dollar. Were the dollar reserves among foreign nations to be significantly less, our interest rates likely would rise while at the same time the value of the dollar would decline. This argument pops up every time the dollar experiences significant weakness against other currencies. It did not happen in the 1970s, and is unlikely to happen now.

Continued runs on banks.

Of all of these “fat tails”, this one seems to us the most likely to be ongoing. Commercial real estate has the known problems of office vacancy or underutilization, though it varies widely from geography to geography. We expect the FDIC will be busy over the next year as the facility the Fed provided March-April comes due for repayment. But, importantly, banks are overall in far better shape than when we entered the Great Financial Crisis in 2008. Commercial Real Estate has far more diverse funding sources than existed in 2008⁹. We expect this event to continue to provide additional monetary tightness as banks reevaluate their risks and do not lend so readily and generously. But it will likely be episodic rather than systemic and quite localized like we have seen so far.

China invades Taiwan.

We can look at Tibet and Hong Kong for guidance. China considers both geographies, as well as Taiwan, part of China. Tibet was annexed by invasion in 1951. Hong Kong was annexed by treaty in 1997. China has had a history of border clashes with India, Viet Nam and others that did not result in invasion. China’s relationship with Korea is more complicated, dating back to the Mao era like Tibet.

An inflection point may have already passed. China has been quite aggressive in acquiring the ability to manufacture advanced semiconductor chips. The Taiwanese are shifting some of their manufacturing capacity in advanced chips to two new plants in Arizona. One will be online in 2024; the other 2026. Apple and NVIDIA are reportedly signed on as first customers. The hollowing out of Taiwanese intellectual property makes them less a prize. One consequence of invasion would almost certainly be the withdrawal of most Western capital, forcing China to rely further on its own resources.

We expect assimilation over conquest as the most likely path for China to annex Taiwan.

Russia nukes Kyiv and NATO retaliates.

Why has this event not already happened? Likely for a couple of reasons. First, Putin sees Ukraine and the Ukrainians as part of Mother Russia. Nuking one’s own people would scarcely “liberate” them, except permanently. Second, command and control is widely dispersed in Ukraine: there’s no real massed target of military value.

As long as it has taken to provide Ukraine with tanks to fight its own war, how long do you think it would take Western allies to authorize a retaliatory nuclear strike on Russia? This worry remains possible, but not probable.

A new pandemic arrives.

Unfortunately, the probability on this one is not if but when. But there have only been three in the last 50 years that killed more than 1000 people worldwide other than seasonal influenza. HIV was first detected in 1981. Swine flu in 2009. COVID-19 in 2019. mRNA techniques now allow for a rapid response, and we all know the drill of masks and isolation. It will probably be another generation at least before we see something as serious as COVID-19.

To summarize, “fat tails” exist not because they are probable. Rather the opposite.

Without an apocryphal event to trigger a sharp recession then, the highest probability remains that the Fed will “need to stay at this for a while.”

Powell stated his own beliefs about the outcome of such a policy. “The case of avoiding a recession is, in my view, more likely than that of having a recession. But it’s not—it’s not that the case of having a recession is—I don’t rule that out, either. It’s possible that we will have what I hope would be a mild recession.”

NOTE: The Federal Reserve has never avoided a recession after raising interest rates 5%. It’s sort of like the outcome of a Taylor Swift song on any former paramour—you know he’s going down.

We have positioned you for a mild recession, arriving sometime in 2023. The probability of when has to do with the Friedman maxim of a “long and variable lag”. Banks tightening lending standards acts as an event external to but also as a multiplier of tighter monetary policy. The Fed raises overnight rates and shrinks their balance sheet (“QT”) to tighten monetary policy. Banks curtailing lending has a similar effect.

When recession hits, without an apocryphal event happening at the same time, we believe the Fed will continue to hold rates where they are now or higher until we see an inflation number below 3%. This Fed will not play “whack-a-mole” with interest rates.

We made several significant shifts at the end of January to reflect these probabilities. We added more defensive positioning within the stock markets:

• Quality Factor
• Minimum Volatility Factor
• Value Factor based on Russell 1000
• Neutral allocation to developed Europe
• Exit allocation to Japan

We weighted the Quality, Minimum Volatility, and Value factors, and the Standard & Poor’s 500 Index exposure equally. That exposure to the S&P 500® has now been hedged against drawdowns. Developed Europe has better valuations than the USA, the dollar has weakened about 10% from its peak over the first part of 2023, and we can benefit from Europe benefiting from China reopening. We still have almost no direct exposure to Chinese companies. Japan has meaningful inflation and will at some point be forced to raise rates.

Reviewing the debt side of your holdings, we increased credit quality by selling half of the senior loan allocation, replacing it with a merger arbitrage strategy. Interest rate risk remains controlled by overall short duration. (Duration measures the sensitivity the fair market value of a debt has to interest rate changes.)

But… you should also know that we have two other versions of our models ready to deploy. If Powell’s favored horse pays off, and recession is avoided, we have models at the gates to express that outcome. These series of models were developed in collaboration with BlackRock, the world’s largest money manager. The third version of our models covers a hard recession as opposed to a mild one.

In a recession, you can count these things to happen with some certainty:

• Most stocks will decline. The more economically sensitive will decline most.
• The cost of borrowing for the least worthy of credit will go sharply higher. A rise in bankruptcies and defaults follow.

Should inflation persist even after recession arrives, owning gold becomes more interesting than it appears currently trading near its all-time high above $2000 an ounce. We might add gold exposure in that circumstance temporarily, though we would not at present hold it as a core position.

After a further period of that long and variable lag, inflation should come down below 3%, which is indeed 2%. Depending on how long it takes for that to happen, do not necessarily expect the Fed to go to neutral. Which means for lenders – bond holders – a return to a time when the primary objective in owning bonds was to collect a goodly amount of interest. When we get to that point, growth stocks and the economically sensitive come into play again.

Finally, we’d be remiss if we did not spend a moment talking about Artificial Intelligence (“AI”—we wonder if it talks to itself?). The subject seems to us in some very important ways not dissimilar from bitcoin, or, more particularly, blockchain technology. We’d observe that as the utility of bitcoin was overhyped, so likely is AI, particularly within the more commonly perceived utilities. Both of these technologies are tools: but for what? Defining uses that benefit mankind could improve all of our lives. But, as we pointed out with bitcoin, the easy, early utility is criminality. 

We should take great care here to get this right—in so many areas. Binance, gene modification, now machine learning, to name but a few.

We reflect on elders we knew when we ourselves were youths. A person born in 1900 who lived 90 years saw horses give way to automobiles, trains to airplanes, antibiotics cure and vaccines prevent horrible diseases, organ transplants give new life, and a computer in the form of the cellphone more powerful than the slide rules that put men on the moon.

What marvels yet to come will we witness?

1. Office of Financial Research: https://www.financialresearch.gov/money-market-funds/us-mmfs-investments-by-fund-category/
2. Federal Reserve Bank of St. Louis: https://fred.stlouisfed.org/series/FEDFUNDS
3. https://www.bea.gov/sites/default/files/2023-04/gdp1q23_adv.pdf
4. New York Fed: https://www.newyorkfed.org/markets/treasury-rollover-faq
5. https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20230503.pdf
6. Returns, Values, and Outcomes: A Counterfactual History, https://www.spglobal.com/spdji/en/documents/research/research-returns-values-and-outcomes-a-counterfactual-history.pdf
7. JOLTS report for March 2023. May 2, 2023 https://www.bls.gov/jlt/
8. One such example: Letter, Milton Friedman to Arthur Burns. April 26, 1971. https://fraser.stlouisfed.org/archival-collection/papers-arthur-burns-1193/letter-milton-friedman-arthur-burns-3547
9. “The 135 US regional banks (generally considered as those with about $10 billion to $160 billion in assets) hold just 13.8% of debt on income-producing properties. The top 25 largest banks, which the Federal Reserve (Fed) considers “large”, hold 12.1%. The 829 community banks (with $1 billion to $10 billion of assets) hold 9.6%, and the remaining 3.2% is spread among the 3,726 very small local banks with less than $1 billion in assets.” Moody’s Analytics, What’s the Real Situation with CR and Banks: Doom Loop or Headline Hype? April 4, 2023.