May 8, 2023
Another One Bites The Dust
A week packed with macro data was again dominated by a focus on the banking sector as First Republic Bank (FRC) became the second-largest bank failure in history. Having been taken into FDIC receivership, JP Morgan assumed the bank's $173bn customer loans and $92bn of deposits, whilst FRC’s equity and bondholders were wiped out. The FDIC will also provide loss share agreements covering acquired single-family residential mortgage loans and commercial loans.
Another crisis averted…or merely postponed. Perhaps ironically, whilst all uninsured deposits were taken into the “too big to fail” safety of JP Morgan, it leaves unanswered the question of the safety of uninsured deposits at other regional banks, for which there is still no explicit guarantee. In the meantime, the “deposit walk” continues with unadjusted deposit outflows of over $360bn in the 3 weeks leading into May. This past week, money market fund inflows accelerated to $47bn suggesting the drain continues 😬.
Regional bank stocks were hit hard as markets looked for the next shoe to drop. PacWest and Western Alliance are under significant pressure, with PacWest weighing strategic options, including a sale. Despite a sharp short squeeze on Friday, the KRE regional banks index was down 16% on the week. As we’ve stated frequently in The Macro Pulse, these banking issues are not going away when the driver is simply that Fed rates are too high for the banking system to handle. Either Fed rates will need to be aggressively cut, or the Fed’s balance sheet will explode as they ultimately become the lenders of last resort.
Back to the data and despite the Fed-induced bank stress, the Fed hiked 25bps on Wednesday as expected, although signaled a pause in dropping the phrase “some additional policy firming may be warranted.” In the press conference, JPow firmed up expectations for a pause in highlighting the extent to which they’ve already tightened, bringing them “closer, or maybe even there” to the terminal rate. He also re-emphasized the credit tightening from banking stress to be doing part of the job in bringing inflation back to target, although pushed back on expectations that the Fed will cut later this given how slowly inflation is falling and further, would be “prepared to do more” if the data so warranted.
TLDR: The pause is here. The bar to hike seems high, but also to cut given how slowly inflation is falling. So pause and hold, all things equal.
Of course, all things are not equal and the ongoing banking stress adds a huge downside risk to the outlook for the economy and Fed rates. JPow tried to play down the bank stress, somewhat strangely suggesting conditions in the banking sector had “broadly eased since March” (despite the KRE regional banks index selling off hard and the failure of First Republic Bank, the second largest bank failure in history.) Monday’s Senior Loan Officer Opinion Survey (SLOOS) will be closely watched to gauge just how quickly bank lending and credit is tightening 👀 .
The ECB was the other major Central Bank in action and slowed its pace of hikes to 25bps, lifting the refi rate to 3.25%, despite some calls for another 50bps. In a slightly more hawkish twist, however, they also announced an end to re-investments of the proceeds of bonds bought during QE, which will shrink the bond portfolio at a pace of EUR 25bn a month, up from 15bn. Lagarde was at pains to stress the plan to keep hiking - “We are not pausing, that is very clear” - although it remains significant that the pace of hikes is slowing, ultimately leading us to the pause.
Indeed, the ECB’s Bank Lending Survey released Tuesday showed that bank's credit standards “tightened substantially,” with net demand for loans from firms also declining. A disinflationary credit crunch is gaining traction on both sides of the Atlantic.
Labor market resilience…
US Non-Farm Payrolls was the other big release of the week and once again came in stronger than expected, rising 253k Vs. the 185k consensus. In addition, the unemployment rate fell to 3.4% from 3.5%, and average hourly earnings ticked up to 4.4% from 4.3%. Sizeable downward revisions, however, muddying the waters, with the March estimate revised down from 236k to 165k and Feb also lower from 326k to 248k. We know that employment is the most lagging of indicators of the economy and also, during downturns, are systematically overstated given the optimistic assumptions made when making adjustments.
On the face of it then, the labor market remains resilient, yet there’s a growing divergence with the lead economic indicators. These sizable downward revisions start to plant the seed of doubt on how healthy the labor market is. Frustratingly, from a narrative perspective, it’s failing to provide the clarity to trigger the all-clear for the next leg higher for crypto as the “peak rates, peak Fed” macro regime shift can’t yet be fully embraced and we’re forced to wait for the next data point. Over to CPI this coming week .
Overall, how has this left our markets?
With banking stress and the expected credit-driven slowdown, markets are still pricing 75bps of cuts from current levels by year-end, with a first cut getting priced for July. As a result, our favorite economist, 2yr US yields, ended the week 8bps lower (although, at one point were 35bps lower as regional banks hit their lows). The peak rates dynamic then continues to provide a supportive tailwind, and with the ongoing bank stress, it feels like we’re knocking at the door for the next leg lower in yields which can finally break us out of this range-bound lethargy for crypto majors.
Likewise, the broad dollar continues to tease a break to new lows and is something worth watching as a lead on this regime shift. DXY 100 is a psychological level to break, but I suspect when it does, it will trigger other cross-asset correlations, which can propel the digital asset complex higher.
Flows & Vols
The rangey price action in BTC and ETH continues to weigh on vols, with generally a lack of conviction as we await the aforementioned trigger to break the ranges. BTC put/call skew remains negative (Calls > Puts) across the term structure implying a still generally bullish outlook, helped no doubt by the ongoing bank stress, which continues to fuel a powerful BTC narrative as “digital gold” and a hedge against a failing fiat system. That BTC narrative dominance is reflected with ongoing ETH/BTC vol compression seeing ETH vols trade below BTC at times over the past week.
We continue to see a “buy the spot/vol dip” reflex, but it’s challenging to keep bleeding theta as we fail to break out of the range. Equally, given the underlying event risks, shorting vol at these levels doesn’t look attractive either. So we get stuck in this cat and mouse with short-term tactical trading rather than committing risk more significantly to conviction trades. For longer-term traders, however, these outright levels of vol remain attractive for putting on directional trades.
Having navigated a big week for macro data, it’s somewhat disappointing to have not gained enough “end of hike cycle” clarity to break us out of these ranges and drive the next leg higher for crypto. However, key macro drivers continue to evolve positively and test towards key levels that, once broken, look set to drive a “blow off top” type move for crypto. The Nasdaq threatens to break out to new-year highs; Gold reached new all-time highs on Thursday. The dollar and US yields are looking precariously at the year's lows. We’re finally awaiting that trigger to break us out of these cross-asset ranges. With the lagged macro data yet to roll over sufficiently, the banking sector stress looks set to be that catalyst. The pressure is building.
David Brickell 💜