It’s Always Darkest Just Before It Turns Pitch Black

By Kimberly D. Woody, Senior Portfolio Manager

The yield on the 10-year US treasury is up an astonishing 137 basis points from the lows in April following the Silicon Valley Bank debacle and subsequent downgrade of some regional banks by Moody’s. The Fed remains focused on inflation, and inflation has moderated. As such, the CME Fed watch probability of no change to rates at the next FOMC meeting is 90% as of October 17, 2023. But rates no longer simply reflect inflation expectations. We contend they embed a sense that the Fed has lost control. Higher rates are driven more now by the term premium and compensation for what we feel is rampant fiscal irresponsibility by those in Washington. The US has an almost two trillion-dollar budget deficit when we’ve had no recession since spring 2020. In fact, the deficit topped 2009’s level, a year in which GDP contracted -2.6%. Budget deficits are large and projected to remain that way even assuming the economy avoids falling into recession. This is not the behavior of a triple AAA-rated economy, and Moody’s is threatening to follow S&P’s move to downgrade following the Great Financial Crisis.

The crisis with Silicon Valley Bank should have been no surprise to the FOMC. We feel the interest rate transmission mechanism is currently considerably flawed and inadequate. After a decade of zero interest rates and massive injections of liquidity, even eight hikes didn’t curb inflation as quickly as initially hoped. At least so far. What the policy did do is create substantial unrealized losses in held-to-maturity bonds maintained as balance sheet collateral and expose a mismatch in assets and liabilities. While blame lies solely with Silicon Valley Bank, the interest rate risk faced by regional banks had literally not existed for more than a decade. Nor had the prospect of a 5-percentage point rise in the Federal Funds rate over a 12-month period. The urgency required to realign the balance sheet may not have been fully appreciated. Ultimately, that is the shared fear and inherent danger in the Federal Reserve meddling with the system. The stress to which a very warped financial system has been subjected will result in the Fed “breaking something.” In fact, it seems following a Fed hiking cycle something always breaks.

With the Fed no longer buying treasuries as it attempts to reverse quantitative easing, foreign countries buying fewer US treasuries and a need to issue massive amounts of treasuries to fund our budget deficit doesn’t bode well for rates and most likely accounts for the massive run-up in yields we’ve seen this year. With the cost of debt service now set to eclipse that of defense outlays in the national budget, it’s difficult to see a way through this without some sort of reset. And that could come in the form of massive technological innovation – something like AI or a drug ending obesity. It could also come from a concerted effort in Washington to embrace some semblance of fiscal responsibility. Or we could just continue with more of the same, the economy weakening under the weight of its own borrowing, and we return for more quantitative easing. I’m betting on a combination of the first two. The good news is that the Fed has, in our estimation, resolved to end hiking, and history would suggest that treasuries rally after the Fed’s final hike.

While politically and economically the environment is tenuous at best, we believe this is well understood by investors. Sentiment and valuations have now reached a level where even directional improvements may be incorporated into asset prices. The situation is not yet dire and there is room to pivot. Employment remains resilient and while the consumer is cooling, they are also seeing a better environment for shelter, gas and food. Core CPI continues to trend lower ex some anomalies related to timing. Based on this, we are sanguine on the outlook for the rest of 2023.

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