It has been said that the Federal Reserve will continue to raise interest rates until “something breaks”. Recent bank rescues suggest that some cracks are occurring – the so-called canary in the coal mine. In fact, there may be multiple canaries in multiple coal mines, suggested by the international government intervention for British pension funds, Credit Suisse and Deutsche bank.

The Economy

The US economy remains in an overall growth mode supported by the services sector. Manufacturing is pulling back though, and leading economic indicators have dropped for eleven straight months. This is not an auspicious sign. It suggests that the Fed’s policy is beginning to bite. The labor market continues to hold up on balance despite layoffs by high-profile companies. Employment rose in February, but the unemployment rate also ticked up to 3.6%. GDP measures still reflect expansion with the Atlanta Fed’s most recent real-time GDP Now estimate registering 3.2%.

Interest rate sensitive parts of the economy are bearing the brunt of the restrictive monetary policy. Banks, real estate, and financial markets have been the economic canaries. Single family home sales dropped by 22% over the last year, while their prices declined -.7% nationally, led by the northeast and west, each showing a -6% drop. The housing affordability index has likewise dropped by 24%, due to increased interest rates. It is expected that the recent stress experienced by the banking system will cause lending standards to be tightened, further reducing economic activity.

The Markets

Despite the fact that the stock market has only managed to recover half of the 26% selloff that occurred in 2022, speculative juices are still flowing. Although the Fed’s stated resolve is to continue until inflation is beaten back, stock market players continue to expect the Fed to blink. The markets bid up prices from the low last October through February, expecting a policy ease. The uptrend was broken when the banks failed, but after that was resolved, prices continued higher again, reflecting an expectation that the bank failures will encourage the Fed to back down. Bitcoin, the ultimate speculation, while still well below its high, has risen 80% off its low. Other speculative favorites have traced the same pattern. The price of Tesla stock has doubled while still being less than ½ its high price. This discrepancy illustrates just how great the bear market damage has been for the previous high-flyers.

Long-term bonds have also rallied, albeit less exuberantly than stocks, only recovering 25% of their prior value. It was this Fed-induced loss of Treasury bond value that reduced Silicon Valley Bank’s capital and caused it to fail. The market may be right. Since the SVB failure, the Fed pumped $391 billion back into the banking system over the last two weeks, partially reversing a $623 billion reduction that was intended to fight inflation. That process had taken 10 months to execute. While the old adage “Don’t fight the Fed” remains true today, the markets are not sure whether the Fed can deliver on its stated intentions. It will be interesting to see how the drama plays out. The speculators are betting against the Fed and they may be right, because the Fed’s hands are tied by inflation on the one and economic failure on the other. If the Fed backs down, markets can be expected to rally strongly for a time, and we can expect to live with inflation for an even longer time. If the Fed does not waiver, more economic breakage is foreseeable and possibly also a noticeable recession, neither of which are good for the financial markets.

Canaries and Coal Mines

For the 12 years before the 2021 policy reversal, the government threw an easy money party - low interest rates, easy credit, and money handouts for everyone. It was a politician’s dream. During that time, the balance between spenders and fiscal conservatives shifted so that virtually all were standing on the same side of the fiscal ship of state. Modern Monetary Theory (MMT – a.k.a. the Magic Money Tree) provided the rational. It posited that the government can print as much money as it would like, as long as it does not become inflationary. Global competition and aging demographics provided a countervailing force, so inflation stayed in check. The canary was singing happily.

Under the surface though, forces were building for a comeuppance. Excessive fiscal and monetary stimulus resulted in what was said to have been the lowest interest rates in 5,000 years, and the accompanying financial leverage fueled the “everything bubble”. It drove high stock and bond market valuations. Real estate followed suit. Newly created cryptocurrencies became reminiscent of the Dutch tulip bulb mania of 1630’s. Eventually the financial inflation found its way into consumer prices. Excess money from pandemic handouts encountered supply restrictions from reductions in pandemic manufacturing. The canary's beak was starting to get itchy.

Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” When consumer prices became hostage to inflationary forces, the Federal Reserve belatedly decided to reverse their policies, hoping to quell the growth before it became embedded in people’s expectations as it had in the 1970s. They caused interest rates to climb and started removing some of the excess money that they had printed during four rounds of “quantitative easing".

Speculation is based on easy money, also known as excess liquidity. People justify high real estate prices and risky corporate decisions by access to low rates. As liquidity dried up, speculation in cryptocurrency and the stock market slowed and prices fell. As interest rates rose, bond and real estate prices fell from their lofty levels. As Warren Buffet famously said, “Only when the tide goes out do you discover who's been swimming naked”. As the water continues to drop, we discovered Silicon Valley Bank and First Republic Bank failing due to rising rates, falling bond prices and insufficient risk management. It takes time, a year or more, for Fed policy to work its way through the system. Companies and people remain relatively unaffected until it is necessary to refinance their prior borrowings and they find that rates are either higher or loans are not available. There is likely more to come. The canary is getting dizzy.

Chief bank regulator, Jerome Powell, of the Federal Reserve declared that bank depositors should "assume" that their deposits are safe. This seems like a potentially dangerous choice of words. The Fed intends to continue to tighten the financial screws but suggests that the recent failures will cause lending standards to tighten and help the Fed reach its goal of slowing the economy, possibly allowing a lower peak interest rate. Unfortunately, tightened lending standards will make it harder for the businesses that rely on cheap loans to finance their operations. Many of these "zombie" companies could fail. If businesses fail, workers are laid off. If workers are laid off, there is less consumer spending, lower company earnings, and more failures - a classic recession scenario. This is when the canary keels over.

If economic activity drops and businesses go under, it is not a good time for the stock market - especially when prices fall from an overvalued level, where they still are. It is not a good time to hold risk assets during difficult economic conditions - all the things that performed so well until recently. But based on recent history, the markets have come to expect that the Fed would reverse policy once the going got tough, and have almost continuously expected a "pivot" for the last year. Sooner or later policy will change. The upcoming election may encourage a more rapid change.

If the reversal comes too soon, the equity markets will take off again as the speculators are vindicated. Powell knows that the longer term effect of this will be to kick the inflation can further down the road, possibly repeating the 1970s experience, or moving closer to the point where excessive government debt threatens long-term economic stability and further hamstrings government fiscal and monetary policy. If the reversal comes too late, recession will take hold and market values could continue to decline to the point where investors throw in the towel. Given that the presidential election year is coming up, the odds likely favor an earlier reversal or pause, plus additional government spending. There could, however, be more damage in the interim. Until then we must be careful of risk, plan for our financial well-being, and keep listening carefully to the canary.