The liquidity crisis that triggered bank failures in Europe and the US seems to have come to an end after the government and large banks joined forces. However, the impact of the small and medium-sized bank turmoil on the economy is greater than expected. With signs of capital flows, a slow return to a normal yield curve and layoffs at large corporations, the US economy is likely to fall into recession in the second half of the year, and investors should not be overly optimistic or aggressive.

 

The past two months have seen the arrival of the Black Swan in the US, which has caused an uproar in the banking sector. Silicon Valley Bank and Signature Bank were both taken over by the FDIC within two days of each other as they became insolvent.

 

The interesting thing is that investors seemed to ignore the crisis, and the stock market continued to rise as usual after just a little shakeup. This can be attributed to the swift response from the government. Before all was settled in the US, Credit Suisse, a century-old bank, was on the verge of bursting into flames, but it was only thanks to the Swiss government, the central bank, and UBS that, with the government's strong encouragement and guidance, UBS was able to acquire it, saving Credit Suisse and the European financial system.

 

As mentioned above, the European and US stock markets only fell a little and then rebounded. Even the bank stocks in Europe and the US, which were the main focus of the storm, were completely ignored by investors, even though they were overwhelmingly underwhelmed and recovered their losses soon after a slight fall. As for gold, which was seen as a haven for capital, the price of gold soared above $2,000 and then softened shortly afterwards.

 

The crisis was centred on the small and medium-sized banks, and the flow of capital from them to the large banks was evident after the incident. However, small and medium-sized enterprises (SMEs) are an important pillar of the economy, both in terms of employment and loans. In addition, small and medium-sized banks account for 75% to 80% of commercial mortgages in the US. If deposits from small and medium-sized banks were to drain away, it is conceivable that credit would shrink, and the commercial real estate sector would be affected as well. Large banks are more likely to serve large corporations and wealthy investors. Even if they are willing to lend to SMEs, they are always the first to "call back" when the wind blows. It is like "lending an umbrella when the sun is shining but wanting it when it starts to rain".

 

When the banking crisis broke out earlier, capital flowed into the safe havens of gold and US bonds, as it always does. 10-year US Treasury yields fell from as high as 4% to as low as 3.35%, and 2-year yields fell from 5% to 4%. As the storm subsided, capital should have returned to other investment sectors. However, the 10-year bond rate remained below 3.5%, and the 2-year rate remained close to the 4% level.

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Why is the hot money still in the bond market and not making any major moves? Perhaps it is because forward-looking investors have predicted that the US economy will head into recession in the second half of the year.

 

To fully understand the economy and the market situation, one should look beyond the stock market and pay more attention to developments and movements in the bond and foreign exchange markets. There is a wide range of opinions on the outlook for interest rates, including whether to continue to raise rates, slow down the pace of rate hikes, stop raising rates, or even cut rates. According to Barclays' analysisˆ, the chances of another rate hike of 0.25% in May are very high,  and we cannot rule out further increases after that. However, as the response to the rate hike lags and credit continues to contract, there is a chance that the US economy will move into recession in the second half of the year. According to Morgan Stanley*, the performance of the bond market seems to be reflecting a recession in the US economy, as the banking crisis has not been resolved. Fed Watch, which reflects the market's expectation of a Fed rate hike, shows that there is a 70% chance of a rate cut in July.

 

The inverted yield curve has been in place for three quarters, which means a certain possibility of a recession is approaching. The recent news of layoffs and cost-cutting by large corporations is also due to the fact that the executives in charge of these companies have also seen the uncertain economic outlook and are therefore taking precautions in advance.

 

The short-term federal funds rate has now risen to a range of 4.75% to 5%. Recently, inflation has continued to fall, while on the other hand, interest rates have continued to rise. A further increase of 0.25% at the next meeting would be sufficient to contain inflation for the time being. It would be good to pause and wonder if the rate could be raised to a level about half a percent above the core PCE.

 

Although there are no fixed rules on what measures contribute information to the process of recession, normally investors see recession if there are two quarters of negative GDP measure, and when the Federal Reserve starts to cut interest rates and the yield curve returns from inverted to normal, that's when the recession hits. 

 

Thus, if the Fed does cut rates in July, as expected by Fed Watch, this is a signal that the US economy is in trouble. But we don’t believe that the Fed will cut interest rates in 2023.

 

Based on these two assumptions, we believe that a recession is not going to come, at least not in 2023, although we see a downward sloping of the US economy. 

 

How should you position your portfolio in view of the situation? Speak to your dedicated WRISE Client Advisor now or connect with us at www.wrise.com

 

Source:

ˆFederal Reserve will likely hike interest rates again, signal a pause in inflation fight (yahoo.com)

*Bond Market Recession Signals: Flashing Red? | Morgan Stanley

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