by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a word on global oil supplies and prices, where a new tanker seizure by Iran would seemingly boost crude oil prices but growing concerns over recession have pushed those prices sharply lower so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an apparent Ukrainian drone strike against the Kremlin and a preview of today’s Federal Reserve decision on U.S. interest rates.

Global Oil Market – Iran:  The U.S. Navy announced that Iran has again seized an oil tanker in the Persian Gulf region, marking the second such incident in a week.  Tehran has justified the harassment by saying the tankers violated maritime regulations, but the real reason is likely to retaliate for the ongoing U.S. sanctions against Iran and to undermine the U.S. security presence.

• If they continue, the tanker seizures could boost crude oil prices beyond what they otherwise would be.
• All the same, global prices for oil and other key commodities are trading sharply lower today on increasing concerns about the impending recession in the U.S. Front-month futures prices for WTI are currently down 3.0% to $69.57, while prices for Brent are down 2.7% to $73.29.

Russia-Ukraine War:  Russia is dealing with another wave of what appear to be Ukrainian drone attacks today.  In one key incident, two Ukrainian drones were downed by Russian electronic warfare systems and crashed into the Kremlin in central Moscow, prompting Russian accusations that Ukraine was trying to assassinate President Putin.  The Russians also threatened to retaliate in kind against the Ukrainian government, but we would note that Ukraine may have been emboldened to launch the strike against the Kremlin because the capital of Kyiv is now protected by sophisticated air defense systems like U.S. Patriot missiles.  Other attacks apparently made by Ukraine today included a strike against a major fuel depot, a strike on an airport, and the derailment of a fuel train in southern Russia.  By disrupting Russian logistics, these attacks could signal that Ukraine is nearly finished preparing for its expected counteroffensive.

• Separately, the Turkish government announced that the deputy defense ministers of Turkey, Russia, and Ukraine will meet on Friday to discuss extending the agreement that unblocked some of Ukraine’s Black Sea grain exports last year.
  • Russia has signaled that it expects sanctions relief before it would agree to extend the deal.
  • If the deal isn’t extended and Ukrainian grain exports are again shut in, it could lead to another round of higher global food inflation.
• There is also new information on the explosions last September that damaged the Nord Stream 1 and 2 natural gas pipelines that run from Russia to Western Europe. Four Nordic media outlets have discovered that several Russian military ships, including a tug capable of launching mini-submarines, were spotted in the area just days before the explosions.  Indeed, the Russians could have had several motives for the attack. They may have meant to punish the European countries for lending support to Ukraine or to test the West’s security for undersea infrastructure in the region.

European Union:  The EU’s single-market commissioner, Thierry Breton, will announce his plan to ramp up the bloc’s production of ammunition and missiles in response to Russia’s aggression against Ukraine.  Breton’s “Act in Support of Ammunition Production” (ASAP) would pour some €500 million from the EU budget into European defense industry factories to boost weapons manufacturing.  The plan is the third leg of the EU’s program to boost its defense capabilities after many years of muted efforts.

Chile:  Leftist President Gabriel Boric is making good on his plan for the government to take at least a 51% stake in key lithium-mining operations.  In an interview with the Financial Times, the official charged with negotiating for the stakes revealed that he wants to complete the purchases by the end of this year.  The process has spooked investors and driven down the value of Chilean mining firms.  The move is also expected to shift investment toward other producers such as Australia, Argentina, and Africa.

U.S. Monetary Policy:  The Fed’s policy making committee will wrap up its latest meeting today, with its decision due to be announced at 2:00 PM EDT.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, the focus for investors will likely be the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.  Given the damage inflicted on the economy from the current rate-hiking cycle, we continue to believe that any hint of a pause could give a boost to equities.

U.S. Fiscal Policy:  Democrats in the House of Representatives launched a “discharge petition” aimed at bringing a vote to the floor for a “clean” bill which would raise the federal debt limit with no associated spending cuts.  The discharge petition would require the support of five Republicans, so it’s considered a longshot, but it does suggest at least some in Congress are increasingly concerned about the economic damage that could be caused by brinksmanship around the debt limit or an outright default.

U.S. Artificial Intelligence:  Arvind Krishna, the chief executive of IBM (IBM, $125.16), said in an interview that his company will pause all hiring of back-office positions that could be done with artificial intelligence.  Going forward, Krishna suggested that about 7,800 positions at the company could eventually be replaced by AI and automation.  The statement will likely fuel concerns that the rapid rollout of AI could boost unemployment.

• In another example of AI disruption, education technology firm Chegg (CHGG, $9.08) yesterday warned that popular AI chatbot ChatGPT is already starting to hurt its sales of on-line study guides.
• Chegg’s stock plunged 48.4% on the news.

U.S. Labor Market:  In yesterday’s JOLTS report on the labor market, total job openings fell in March to a seasonally adjusted 9.59 million, marking their lowest level in almost two years.  In addition, March layoffs rose to 1.81 million, reaching their highest level in over two years.  The figures point to a worse-than-expected softening in labor demand and add to other recent evidence that the economy could be slipping into recession even now, although we still think the recession will hit a bit later in the year.  In any case, the weak JOLTS report helped push equities and other risk assets sharply lower yesterday.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a report showing an acceleration in the Eurozone’s consumer price inflation.  While the acceleration was modest, it could still encourage a more aggressive interest-rate hike by the European Central Bank at its policy meeting on Thursday.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an unexpected resumption of rate hikes in Australia and a warning by U.S. Treasury Secretary Yellen that the federal government could be unable to pay its bills by June 1 if Congress doesn’t act to raise the federal debt limit.

Eurozone:  The April consumer price index was up 7.0% from the same month one year earlier, dashing expectations that annual inflation would be unchanged at 6.9%.  The acceleration in headline price growth could encourage the European Central Bank to again hike its benchmark short-term interest rate aggressively at its policy meeting on Thursday.  That’s especially the case given that a separate key measure of inflation also remains worrying.  Excluding the volatile components of food and energy and the government-influenced prices for alcohol and tobacco, the April core CPI was up 5.6% on the year.  That marks somewhat cooler core inflation than in March, when the core CPI was up 5.7%, but it was no cooler than the 5.6% increase in the year to February.

Italy:  The right-wing populist government of Prime Minister Meloni has issued a decree aimed at making it easier for companies to hire new workers.  The decree will reduce the country’s “basic income” support for people who can work and ease regulations to make it easier to hire short-term workers.  In a modest effort to encourage more births, the policy also includes a cut in payroll and benefit taxes for workers with children.  None of the changes are revolutionary, but they could have a small impact on Italy’s labor market, and they could signal further, more substantial moves by Meloni later, despite opposition by labor groups.

Russia-Ukraine War:  The U.S. released a new, unclassified estimate that Russian forces fighting in Ukraine have suffered approximately 100,000 total casualties since December, including about 20,000 killed in action.  According to the report, about half the fatalities were members of the Wagner mercenary group with half of those being prisoners who had been enticed to join up in return for their freedom if they survived a six-month tour of duty.  The enormous losses show how the Russians’ strategy has caused a depletion in their combat strength just as the Ukrainians look set to launch a new counteroffensive.

Australia:  The Reserve Bank of Australia (RBA) unexpectedly resumed its monetary tightening cycle by boosting its benchmark short-term rate 0.25% to 3.85% to help bring consumer price inflation back down to target.  The hike by the RBA was its first since a similarly sized increase in March.

• The RBA’s rate hike underscores that many major central banks remain committed to monetary tightening despite nascent signs that inflation is cooling. The rate hike is a signal that investors should be prepared for the possibility that rates could go higher than anticipated, and possibly stay there, in key countries around the world.
• As a result of the RBA hike today, Australian bonds have sold off, boosting the yield on 10-year government obligations to 3.456%. In contrast, the Australian dollar (AUD) has jumped 1.01% to $0.6697.

Canada:  The Canadian government and its main public-employee union yesterday reached an agreement on a new labor contract that will end the workers’ strike.  Under the deal, the government will boost wage rates by 12% over four years and provide a one-time, lump-sum payment equal to 3.7% of annual pay.  The agreement hewed close to what the unions initially demanded, reflecting the bargaining power they had amid the country’s tight labor market.

U.S. Labor Market:  As we warned in our Comment yesterday, Hollywood screen writers failed to strike a deal for a new labor contract last night with the major networks and studios, prompting them to announce a strike.  As the 11,500 members of the Writers Guild of America walk off the job, late-night and variety shows are likely to be the first affected.  The strike reflects both concerns about the impact of streaming technology on writers, and the increased bargaining power workers have in today’s tight labor market.

U.S. Monetary Policy:  The Fed’s policy making committee will begin its latest meeting today, with its decision due tomorrow afternoon at 2:00 pm ET.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, as we mentioned in our Comment yesterday, the focus for investors will likely be on the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.

• Given the damage inflicted on the economy from the current rate-hiking cycle, any hint of a pause could give a boost to equities.
• Also, any strong signal of a pause in U.S. interest rates would likely be a further negative for the dollar. Factors such as slowing U.S. economic growth and the prospect of continued interest-rate hikes abroad have now pushed the greenback lower by 8.6% from its most recent peak last September.

U.S. Fiscal Policy:  Yesterday, Treasury Secretary Yellen warned that the federal government could be unable to pay all its obligations, including Treasury debt service, as early as June 1 if Congress doesn’t raise the debt limit.  In addition, the bipartisan Congressional Budget Office brought forward its deadline of when the government could default, saying lower-than-expected tax receipts this spring could leave the government unable to pay its bills by early June.

• The new forecasts raise the risk of a near-term default on government debt, which would likely be a significant negative for U.S. asset values.
• President Biden later invited the Republican and Democratic leaders of Congress to meet next week to discuss a way forward.

U.S. Bank Regulation:  Responding to the recent U.S. bank failures, the Federal Deposit Insurance Corporation yesterday recommended a boost in the business deposit amount that would be insured as one way to help prevent bank runs.  According to the FDIC, a targeted rise in deposit insurance for businesses’ everyday operating accounts would be more cost-effective and less likely to promote risky behavior by bank bosses than just eliminating the $250,000 cap in place on deposit insurance.

• The FDIC didn’t specify how much the coverage cap should be raised for business transaction accounts.
• However, it did calculate that raising the insurance cap to $2.5 million would likely cover what most small and medium-sized companies need to keep in their accounts to cover payroll.
• In any case, any such change in the deposit amount covered by insurance would require approval by Congress.

U.S. Defense Industry:  As major U.S. defense contractors released their quarterly reports over the last couple of weeks, some company officials said on their earnings calls that they are facing far fewer supply chain problems than they did over the last two years.  Greg Hayes, the CEO of Raytheon (RTX, $100.33), even gushed that, “It’s getting a hell of a lot better.”

• The officials noted that defense supply chains are still not back to normal, but the situation is far better than it was, and revenue growth now looks set to accelerate sharply.
• We continue to believe that increasing geopolitical tensions will drive military budgets higher around the world. Due to issues like bureaucratic lethargy, labor shortages, and supply chain disruptions, the expected growth in revenues and profits will probably only become notable in the next couple of years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several notes on the U.S. economy, including a new federal bank seizure and sale, and the risk of a writer’s strike in Hollywood.  We next review a wide range of other U.S. and international developments with the potential to affect the financial markets today, including big new labor union actions in France and Belgium, and important purchasing managers’ indexes in China.

U.S. Banking Industry:  Over the weekend, major banks including JPMorgan (JPM, $138.24) and PNC (PNC, $130.25) placed bids to take over ailing First Republic (FRC, $3.51), the latest mid-sized bank to face falling asset values and deposit flight connected to the Federal Reserve’s interest-rate hikes.  JPMorgan ultimately won the day, giving it control of about $200 billion of First Republic’s assets and all of the bank’s $100 billion in deposits.  As part of the deal, the FDIC will provide JPMorgan with about $50 billion in fixed-rate term financing and share potential losses on First Republic’s loans.

• At least so far, it appears that the First Republic takeover could close the chapter on this spring’s bank crisis. As of right now, we’ve seen no major ripple effects elsewhere in the financial markets, which suggests the federal regulators have managed to contain the idiosyncratic problems at Silicon Valley Bank, Signature Bank, and now First Republic.
• However, we continue to be concerned about longer-term “disintermediation” risks in the banking sector, as high short-term interest rates prompt savers to move deposits out of banks and into investments such as mutual funds and Treasury bills. The loss of deposits could force banks to pull back further on lending and make the impending recession worse than it otherwise would be.

U.S. Construction Industry:  Investors continue to look for signs the economy is cooling enough to bring down inflation and allow the Fed to stop hiking interest rates, but we’re starting to focus more on a factor that could delay the slowdown:  construction spending.  Non-residential commercial construction has grown smartly over the last year and looks set to continue growing in the very near term, in part because of federal fiscal stimulus.  Indeed, spending on new factories has recently reached a record high, more than offsetting the decline in residential building.  We still think the economy is likely to slip into recession soon, but the momentum in construction spending could be one reason it’s taking so long for the data to show it.

• Even as some firms get cautious about underlying demand and pull back on investment, and even as the ongoing bank crisis threatens to prompt a sharper pullback in lending, those forces will be at least partially offset by:
  • Increased investment in defense industry facilities as the military budget rises;
  • Higher investment in semiconductor factories because of the subsidies in last year’s CHIPS Act; and,
  • New investment in battery plants and other green-technology factories because of the subsidies in last year’s Inflation Reduction Act.
• Although the Fed’s rate hikes pushed residential construction sharply lower over the last year or so, the decline came entirely in the single-family sector. Construction in the multi-family sector has held up well as residential firms try to meet the increased demand for apartments.

U.S. Labor Market:  Hollywood screenwriters are expected to go out on strike if they can’t agree on a new contract with the major networks and studios by their deadline later today.  In part, the potential walkout reflects the country’s current tight employment market, which has given workers increased bargaining power.  However, it also reflects the concern among writers that they’re being shortchanged by new streaming models.

U.S. Monetary Policy:  The Fed’s policy making committee will begin its latest meeting tomorrow, with its decision due on Wednesday afternoon at 2:00 pm ET.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, the focus for investors will likely be the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.

• Given the damage inflicted on the economy from the current rate-hiking cycle, any hint of a pause could give a boost to equities.
• Any strong signal of a pause in U.S. interest rates would likely be a further negative for the dollar. Factors such as slowing U.S. economic growth and the prospect of continued interest-rate hikes abroad have now pushed the greenback lower by 8.6% from its most recent peak last September.

European Union:  Today, May 1, is the Labor Day holiday in much of the world, including the EU.  In addition to the holiday festivities, however, the day will be marked by a number of labor protests, including yet another round of demonstrations against President Macron’s pension reform in France and even a wide-ranging set of labor protests in Belgium.

Russia-Ukraine War:  The Ukrainian defense minister said his country is close to completing its preparations for a spring counteroffensive, and that it is generally ready to launch the operation.  The statement is consistent with a range of signs that the Ukrainians will soon launch a high-stakes attack to push the Russian occupiers back.  If successful, the counteroffensive could help shore up Western support for the Ukrainians and reduce political pressure for negotiations.

• Meanwhile, NATO’s top commander, Army Gen. Christopher Cavoli, has told the House and Senate armed services committees that the number of Russian forces in Ukraine has now surpassed the number from when Russia first invaded last year.
• While Russia has the resources to keep fighting in Ukraine for another year, Cavoli said the country’s forces remain vulnerable to Ukrainian weapons, ingenuity, and resolve.

China:  The official purchasing managers’ index for manufacturing fell to a seasonally adjusted 49.2 in April, short of expectations and far below the 51.9 reading in March.  The April PMI for the service sector also fell, but only to 56.4 from 58.2 in the previous month.  Like most PMIs, China’s are designed so that readings above 50 indicate expanding activity.  The figures suggest the Chinese service sector continues to recover from the government’s strict pandemic lockdowns, but the factory sector still faces challenges, in part because of weak demand overseas.

Iran:  The government’s statistical bureau has now failed to publish any data on consumer prices for two straight months, leading to speculation that the annual inflation rate has surged to a new record high of more than 49%.  Driven in part by U.S. sanctions on Iran because of its nuclear program, the inflation surge risks undermining political stability in the country.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a deep dive into the GDP data and why we believe that the economy may still be headed for a recession. Next, we give our thoughts on the Bank of Japan’s recent policy decision. Lastly, we discuss the yuan’s (CNY) rising prominence on the global stage.

Growth Moderation: The U.S. economy skirted recession in the first quarter of 2023; however, problems remain under the surface

• Strong spending from households helped prevent the economy from contracting. According to the Bureau of Economic Analysis, U.S. GDP grew 1.1% at an annual rate in the first three months of the year. The most significant gains came from consumption which accelerated from 1.0% in Q4 2022 to 3.7% in the following quarter. The improvement in the level of spending was related to a sharp pick-up in demand for motor vehicles, which expanded at a pace not seen in the pre-pandemic era.
• Although it is never good to bet against the U.S. consumer, it is unclear how long spending can continue to save the day. Last week, earnings reports from the four major banks reported an increase in customer delinquencies. At the same time, the Bank of America Institute stated that credit card spending slowed to its weakest pace in two years. The increase in defaults and the decrease in spending will likely worsen throughout the year as the Federal Reserve keeps interest rates elevated to combat inflation. Additionally, the slow rise in jobless benefits suggests that the labor market is finally starting to loosen up.

• The major unknown is how the Federal Reserve will react once the economy enters recession. The market is accustomed to the Fed cutting rates aggressively during a downturn, but with inflation still elevated, policymakers may instead decide to hold rates steady. The central bank has cut rates below 2% in response to the previous three recessions. As the chart above shows, this aggressive easing has helped fuel market rallies in each of those cycles. The expectation of possible rate cuts helps explain why NASDAQ has gotten off to a solid start for the year. However, the Fed’s failure to repeat this trend could lead investors to readjust their portfolios to reflect the elevated risk associated with tighter-than-normal policy.

No Rush: The Bank of Japan is not close to ending yield curve control (YCC) even as data shows that price pressures are building in the economy.

• In his first meeting, newly appointed BOJ Governor Kazuo Ueda didn’t surprise markets but paved the way for an eventual pivot. The BOJ left its ultra-accommodative monetary policy unchanged, removed guidance on the future path of policy, and included plans to conduct a long-term policy review. The market widely expected the decision to keep rates intact as investors assumed Ueda would not want to make significant changes to interest rates given the ongoing market turmoil. However, his plan to release the findings on the review of the central bank’s ultra-accommodative policy sometime in 2024 has added to speculation that he is not ready to pivot toward more hawkish policy.
• That said, the central bank’s lack of guidance on future policy suggests that it has not fully committed to maintaining YCC. Its latest statement scrapped references to keeping rates at “current or lower levels,” indicating that it seeks policy flexibility. The softening of its stance comes amidst mounting evidence that price pressures are becoming sticky. Consumer prices, excluding fresh food in the country’s largest city, accelerated from 3.2% to 3.5% in April. Investor concerns about rising inflation and easy monetary policy led to JPY depreciation against other peer currencies following the BOJ’s announcement.

• Keeping rates low prevents disruption to the international financial system but incentivizes speculative attacks on the 10-year JGB. The popularity of the yen-carry trade, in which traders try to earn arbitrage profits by borrowing at low rates in one country to invest in higher yielding assets in another, has meant that many traders are exposed to exchange rate risk. The International Monetary Fund has warned that an abrupt end to YCC may have spillover effects on global financial markets. However, doubts about whether the BOJ can credibly maintain its peg may lead to central bank intervention. As a result, the JPY may have less upside now than we thought at the beginning of the year.

Renminbi Rising: In a sign that China is looking to set up a parallel trading system, its currency has increased in popularity.

• Beijing is encouraging more countries to use the yuan (CNY) to pay for Chinese goods. On Wednesday, the Argentine Prime Minister announced that his government would use CNY instead of USD for transactions with China. The switch in currency preferences was designed to prevent a drain on Argentinian foreign reserves which have been strained by high debt servicing costs and rising import prices. The CNY is already the most popular traded currency in Russia and is now being considered by Saudi Arabia to price oil sales.
• The war in Ukraine has fueled Beijing’s ambition to make CNY a global currency. According to the Standard Charter’s Renminbi Globalization Index (RGI), usage of the Chinese currency increased by 26.6% in 2022. Although cross-border CNY payments have increased for five consecutive years, transactions in this currency have more than doubled their pre-pandemic level. In March of this year, local cross-border payments surpassed the greenback for the first time on record. These statistics suggest that China is becoming more aggressive in reducing its dependency on the U.S. dollar as it fears possible isolation.

(Source: The National News)

• The rising demand for CNY reinforces our view that the U.S. dollar is headed for a secular decline. As regional blocs begin to form worldwide, countries may be forced to hold on to both Chinese and American currencies. We suspect that dual holdings will be most prevalent in countries that find themselves on the wrong side of U.S. sanctions. Thus, the CNY should be popular in authoritarian states. That said, China’s unwillingness to open its capital account will prevent its currency from emerging as a true challenger to the greenback. As a result, we still believe that concerns about the dollar losing its hegemonic status are overblown.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts about the positive news regarding Big Tech and why it may not relieve concerns about a possible downturn. Next, we discuss the controversy regarding regional banks and the Federal Reserve’s new lending facility. Lastly, the report provides an overview of the ongoing debt ceiling debate and its impact on bond volatility.

Why the Gloom? Earnings are better than expected, but recession fears weigh on investor sentiment.

• The Tech-heavy NASDAQ Composite rose 0.5% Wednesday after Microsoft (MSFT, $295.36), Alphabet (GOOGL, $103.67), and Meta (META, $209.40) reported earnings and revenue that beat expectations. Microsoft’s fiscal Q3 2023 results showed that the company’s cloud service business slowed but not as much as investors had feared. Alphabet’s Google search engine was able to generate solid ad sales. Meanwhile, Meta added 37 million daily users to its flagship Facebook app. The tech behemoths’ strong performances have boosted confidence in the sector as layoffs and restructuring have helped make the companies leaner and more efficient. That said, market participants are not convinced that the worst has already come to pass.
• Despite the strong performance by Big Tech companies, there are concerns from the market of further trouble ahead. The S&P 500 closed down 0.4% on Wednesday on investors fear that quarterly earnings are reinforcing views that consumers are reining in their spending. Dutch Semiconductor equipment maker ASM International (ASMIY, $347.99) reported a drop in first-quarter earnings and stated that the company expected sales to decline in the second half of 2023. Similarly, South Korean company Samsung Electronics (SSNLF, $40.60) posted a record $3.4 billion loss in chip sales in Q1 2023. The decline in semiconductor sales is related to a slump in demand for consumer electronics, which has been associated with changes in the business cycle.

• Although the S&P 500 is up 6% this year, a few stocks have driven much of the gain. Microsoft and Apple (AAPL, $163.76) accounted for 40% of the increase and now account for a record 13.3% of the index. The lack of market breadth has led to concerns that this year’s rally may not be sustainable. The recent banking turmoil has worsened those concerns. That said, investors should remember that much of the recession fears have already been priced into the market, suggesting that equities remain fertile for long-term investment growth.

Now the Zombies! First Republic’s deposit exodus has put the Federal Reserve’s new emergency lending facility into focus.

• First Republic Bank’s (FRC, $5.45) troubles are still weighing on investor sentiment. On Monday, the bank disclosed that it had lost $100 billion in deposits last quarter. Although in March First Republic Bank was able to replace some of the lost holdings with $30 billion in deposits from major banks, the new injections were not enough. In order to shore up its cash position, First Republic has now decided to sell assets, likely at a discount. Its precarious situation has led regulators to consider downgrading their assessment of the bank, which would limit the firms’ access to the Federal Reserve’s lending facilities, if it can’t find a quick solution to its woes.
• The struggles of First Republic Bank are a reminder of the tensions caused by fractional reserve banking. Banks convert deposits, which depositors view as “money,” into loans and securities, which pay a higher interest rate. This model relies on a normally sloped yield curve. When central banks tighten policy, yield curves tend to invert, meaning that funding costs for banks (those short-term deposits) may now be paying a higher rate than the loans and securities held by the bank. What we have seen recently is that a few banks have held long-duration risk on the asset side (loans and securities) as policy tightening has threatened their solvency. As long as deposits “stay put,” the bank can continue to operate, however, if depositors withdraw their funds, the bank is in trouble. As we mentioned in yesterday’s report, unlike Silicon Valley Bank, most regional banks don’t have a high level of exposure to long-term Treasuries, but deposit outflows remain a problem. So far, the smaller financial institutions have been able to depend on Federal Reserve backstops for relief, but even that solution has its flaws.

• The new lending facilities give the banks funding by offering cash for their securities at par. This feature allows them to meet deposit withdrawals without selling the securities at a loss, but it doesn’t solve the disintermediation problem. If banks keep deposit rates low, then those deposits are still at risk of leaving for better yielding alternatives. The long-term solution is lower short term interest rates, which discourages disintermediation. However, that solution conflicts with the Fed’s goal of raising rates to contain inflation.
  • As a disclaimer, we note that the regional banking system is relatively stable today, and thus zombie banks are a worst-case scenario that is very unlikely to materialize.

McCarthy’s Opening Salvo:  Republicans raised the stakes in their stand-off with President Joe Biden after narrowly passing their debt ceiling bill through the House of Representatives on Wednesday.

• The bill will not be made into law but suggests that debt talks will likely extend into the summer. Voted primarily on partisan grounds, the bill passed 217 to 215, with four Republicans refusing to back it. The legislation would increase the U.S. debt ceiling by $1.5 trillion in exchange for $4.8 trillion in budget cuts. Additionally, the bill would push back the potential default date to March 31, 2024, at the latest, setting up a potential battle during the election year. President Biden has vowed to veto the bill if it comes to his desk.
• The Biden administration has made it clear that they prefer a “clean” increase in the government’s borrowing authority. As a result, President Biden has refused to hold negotiations with his Republican counterparts. White House officials argue that it is the responsibility of Congress to raise the debt ceiling, and thus, should come with no conditions.  The president had released his own budget proposal in March. His plan would cut the deficit by $2.9 billion over a decade and raise $4.7 trillion primarily from higher taxes on corporations and wealthy households.

• There is unlikely to be much incentive to come to an agreement now. Typically, the stand-off over raising the debt ceiling comes down to the wire, and that is when both sides eventually start making concessions. The focus on the debt ceiling has taken on increased importance due to the impact it may be having on Treasury bills. The yield on one-month Treasuries jumped 26 bps on Wednesday; meanwhile, the spread between three- and one-month treasuries continues to widen. The sudden interest rate change is possibly indicating that investors are worried about not being repaid. Although we think the risk of a government default remains relatively low, uncertainty over the debt ceiling could lead to increased volatility within the financial markets.

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