Daily Comment (March 10, 2023)
by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EST] | PDF
Good morning! Today’s Comment begins with our thoughts on the sudden sell-off in equities yesterday. Next, we go over the latest developments in the Middle East and Asia. Finally, we discuss why we are not confident that Haruhiko Kuroda’s exit from the Bank of Japan will lead to a quick end to yield curve control.
Trouble Lurking: Huge sell-offs in major banks yesterday have led to concerns that the Fed may be unable to maintain rates at its current level.
- The four largest U.S. banks lost a combined $52.4 billion in market value on Thursday. The sell-off was related to concerns that banks may be sitting on unrealized losses in their security portfolios. The fear was sparked after Silicon Valley Bank (SIVB, $106.04), a small technology focused lender, revealed that it had lost $1.8 billion following the sale of portfolio securities completed to address a decline in customer deposits. The sale of the company’s stock was halted after it fell 68% following the report. The company is now scrambling to raise new capital elsewhere.
- This current problem within the financial system is related to bank bond portfolios. During the pandemic, these banks invested the influx of deposits, mostly from pandemic stimulus, into long-dated securities such as Treasuries. The value of the holdings has plummeted as the Fed rate hikes have encouraged investors to reallocate their portfolios toward shorter-duration assets. Meanwhile, depositors have responded to higher rates by moving their holdings into higher yield money market funds. Equity holders of bank stocks are unsure as to whether these institutions have reflected the bond losses on their balance sheets.
- Although the Fed’s mandate of maintaining price stability and full employment is well publicized, it is frequently forgotten that the central bank was originally established to stabilize the banking system. Thus, the Fed’s 2% target may take a back seat if the Fed believes the banks are in trouble. Movements within the swaps market reinforced this view. The latest CME FedWatch Tool shows that investors expect the markets’ reactions to impact Fed policy. Thirty-day fed futures contracts now signal that the Fed may be less inclined to raise rates by 50 bps in its March meeting, with some contracts showing that the Fed could end the year with rates lower than they are today. We will continue to monitor this situation closely.
Major Power Games: While the U.S. is building closer ties to the Middle East and Indo-Pacific, Russia is working to maintain influence within Eastern Europe.
- Saudi Arabia is playing the U.S. and China against each other as the two look to reshape the Middle East. On Thursday, Saudi Arabia requested several items from Washington including security guarantees, support for building its civilian nuclear program, and fewer restrictions on arms sales in exchange for normalizing relations with Israel. At the same time, China brokered an agreement to restore diplomatic relations between Saudi Arabia and Iran. Since Iran and Israel are bitter rivals, we suspect that the OPEC leader could use the arrangement to promote itself as the dominant powerbroker within the region.
- The U.S. and India’s economies are becoming more integrated. White House representatives traveled to India this week to work out the details of supply chain coordination for semiconductors. This effort reflects the U.S.’s broader goal of decoupling from China. The growing population and improving infrastructure in India have made it a target of American foreign direct investment. Apple’s (AAPL,$150.04 ) decision to set up a production plant in India exemplifies this trend. The decoupling from China will force many companies to reshore their factories in other countries as the world breaks into regional blocs. India is one country that will gain from this shift while other possible beneficiaries include Indonesia, Mexico, and Brazil.
- Russia is losing its grip on allied countries within Eastern Europe. Protests forced the Georgian government to withdraw a bill that would have limited outside media influence in its politics. Meanwhile, Hungarian President and Putin ally Viktor Orbán warned that his country might have to distance itself from Russia due to its conflict in Ukraine. The souring of relations between Russia and some of its allies comes amidst concerns that Moscow may look to expand the conflict into other countries to turn the tides of the war. So far, the Georgian and Hungarian people seem uninterested in participating in the conflict.
The New BOJ: Outgoing Bank of Japan Governor Haruhiko kept policy unchanged at his last meeting; however, his successor is slated to welcome in a new period of Japanese monetary policy.
- Kazuo Ueda will assume command the Bank of Japan in April and is expected to begin a new policy era. The new head of the BOJ will take over an economy replete with rising inflation and an eroding bond market. Japanese inflation has accelerated to a 41-year high, and the country’s yield curve is kinked. Ending yield curve control should alleviate these issues, although the country’s heavy debt burden will complicate the move. Even if the economy expands at a modest pace of 3% over the next 10 years, the country’s debt could climb to 1,100 trillion JPY ($8.5 trillion).
- The possible hawkish shift in Japan’s monetary policy could lead the JPY to outperform the dollar. According to Deutsche Bank, a combination of policy normalization and easing by the Fed could push the JPY up about 60% against the greenback. The analysis assumes that 10-year Japanese bond yields settle at around 1.5% to 1.6% once the BOJ ends its policy intervention. A stronger JPY should be supportive of Japanese equities for dollar-based investors since it has a strong reputation for being a hedge against dollar devaluation and U.S. recessions.
- That said, Ueda’s taking office is not a guarantee that yield curve control will immediately cease. The International Monetary Fund has warned the Bank of Japan that an abrupt end to its policy will have a “meaningful spillover” effect on global financial markets and could lead to a liquidity crunch for potential borrowers profiting from arbitrage trading. Additionally, the latest GDP figures showed that weak consumption and investment almost pushed the country into recession last year. In short, the decision to end yield curve control is not an easy choice and is not likely not be as smooth as many investors are anticipating.