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Monthly Cash Review – April 2023 (USD)

Fed Hike Cycle Nearing the End?

Market indicators predict the Fed might soon be done with rate hikes. Meanwhile, PCE and CPI inflation show moderation, and the credit market has recovered from the spread shock of March.

Portfolio Strategist

The US Federal Reserve (Fed) might be done with its rate hike cycle after the May meeting. The 5%–5.25% range puts it right on its Dot Plot forecast. Of course, time will tell and risks remain. Inflationary pressures could persist in the economy unless there is additional “breakage” (bank failures, etc.).

Market indicators also show that the Fed might begin easing as soon as the third quarter. This seems unlikely given what we are hearing from various Fed officials, but things can happen fast as witnessed during the failure of three banks in March. The Fed Funds futures contracts, at the time of writing, show expectations for a Fed funds effective rate of 4.38% by December. The 3-month (3M) Treasury Bill (T-Bill) 2-year forwards are indicating yields of 3.62%, 135 bp below the current 3-month T-Bill yield. However, things could change quickly, as we witnessed in Q1 2023.

Is the Banking Crisis Over?

The failure of three US banks and Credit Suisse signaled a crisis in the markets. The Fed released over USD 400 bn of liquidity to support banks due to deposit outflows of USD 240 bn from smaller banks. Money market mutual funds have grown by ~USD 450 bn since the end of February.

Given the crisis, it is interesting that all three major central banks (the Fed, European Central Bank [ECB] and the Bank of England [BoE]) raised their policy rates in March, just days after the height of the crisis. After unleashing massive amounts of liquidity into the banking system, the Fed went ahead and raised rates showing that the fight against inflation would remain the priority.

Inflation Is Moderating

The data shows it. But is it enough? Some of the key measures of that moderation are the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE). Wages are mixed. Hourly earnings data show a decline but the Employment Cost Index (ECI) has not budged. This is a challenge for the Fed as upward wage pressure can fuel consumer spending.

However, some consumer data are showing signs of strain. Outstanding nominal revolving credit hit a new high and 30+day credit card delinquencies have also been ticking higher since the middle of last year. Perhaps the consumer is reaching a point where he or she must pull back. Perhaps the 20-dollar glass of wine at the local eatery is starting to bite. Other labor market indicators are showing signs of decline as well. The quit rate is on the decline and there has been a reduction in job postings. We are also seeing an uptick in both the labor force participation rate and continuing unemployment claims. It might be getting harder to find a job.

Credit Market Recovers

The credit market has recovered from the spread shock of March. Investment grade credit spreads were as wide as 163 bp and now are at 137 bp, and the spread between 3-month commercial paper and 3-month T-Bills was as wide as 47 bp and now sits at 9 bp at month end (Source: Bloomberg, as of April 30, 2023).

Overall, we remain patient on credit. Our conservative approach has served us well over various cycles and the end of this cycle remains a mystery. Conditions look favorable for a soft economic landing but other shocks could derail that landing. The highly leveraged real estate sector is of particular focus. Commercial office space has particularly high vacancy rates. As loans come due and the cost to refinance is notably higher, it might make economic sense for an owner to walk away. This could force banks to sell and reprice this sector of the market. It is unclear if this could create a systemic issue in banking, but it is unlikely that all banks will remain unscathed.

Watching the money supply as a leading indicator had been something of an anachronism. The days of monitoring M2 were last seen in the 1970s. But we are back! The rate at which the Fed is reducing the money supply is almost as fast as it increased it during the ’08 and ’20 crisis.

With its quantitative tightening program allowing for the maturity of up to USD 95 bn of mortgage-backed securities and US Treasuries per month, we are now seeing negative levels of money supply. This contraction in liquidity should indicate tighter monetary conditions, but there is still quite a way to go. The Fed’s Reverse Repurchase Facility is still absorbing over USD 2 trillion of excess liquidity each day and the Fed still owns ~34% of all US Treasury debt outstanding. Expectations remain that it will allow quantitative tightening to “run in the background” for as long as inflation remains a threat to the US economy, or maybe even longer.

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