Despite Broadsides From New England Democrats And Southern RepublicansThe Fed Put Is Nothing To Bank On: The Geopolitical — Stock Market Connection

Echoes of 2007 reverberated yesterday as banks faced the possibility of a run on deposits, but yesterday’s news likely fades with this morning’s employment report. Since the report is unpredictable the market could easily trade in huge directions both ways, consequently the volatility risk premium points to a higher market over the next few days while my technical reading of key stocks in the S&P 500 is bearish. Yesterday's cross-asset action brought several positive factors for US stocks. The US yield curve is rising and in the current context that is bullish. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. Expect the S&P 500 to be range-bound over the next few days before making one last try at 4200.

Yesterday banks broke under the weight of portfolio losses in bonds and turned a morning rally into a rout. Should this continue the political pressures on the Fed from both parties will likely move the Fed to abandon its current stance. The Fed’s robust tightening has turned bonds into high risk bets and consequently a Fed-induced run on banks is one of the few things that can exercise a Fed put. But in the absence of a run the likely outcome is a deterioration of bank valuations, since not only is the maturity mismatch an issue but the willingness of consumers to accept low bank interest rates. The Fed could resist political pressure by pointing out a clear behavioral change among the American people.

S&P Global notes “As deposit competition intensifies, banks should consider slowing or even stopping growth to mitigate credit risk and threats to their net interest margins, according to South State Bank Director of Capital Markets Chris Nichols. Deposit costs rose more quickly in the fourth quarter as liquidity pressures grew across the banking industry, with the industry recording a quarter-over-quarter, interest-bearing deposit beta — the percentage of change in fed funds passed on to depositors holding interest-bearing accounts — of 44.6% in the fourth quarter, up from 32.8% in the third quarter and 17.7% in the second quarter.”

The Fed may tolerate a deep decline in bank valuations as long as no runs occur since banks have arguably taken on too much risk in the general atmosphere of irrational exuberance. RISK.net notes “The proportion of US banks’ exposures deemed safe enough to acquire a 0% risk-weighting has fallen yet again in the fourth quarter of 2022, reaching lows not seen since the early days of the Covid-19 pandemic, while 100% risk-weighted exposures have climbed. Riskless exposures dropped to 32.6%, a fall of 0.3 percentage points on the previous quarter and 2.5 points compared with Q4 2021. This reflects an absolute drop of 0.8% over the quarter and 10% over the year, to $4 trillion.”

Given the Fed’s need to tame inflation it’s possible the Fed’s first move isn’t to lower interest rates so much as signal an easing of capital requirements, in an effort to solidify the money markets and encourage banks participation in loans, repos and securities purchases. The effect would likely be to keep the financial markets from imploding as they did following Lehmans’s collapse, rather than to stop the downturn. The GOP signaled they want the Fed to ease capital and leverage requirements and the Democrats would accede to this.

But given liquidity concerns from the Fed’s QT program and the potential for the Bank of Japan to exit yield curve control, easing capital requirements might not be enough to help banks. A break below the October lows could send global confidence reeling and the dollar soaring against most currencies other than the Japanese Yen, forcing the Fed’s hand.

Yesterday I added to my short-term bullish position via the levered ETF UPRO. Consequently my current positions include a slightly smaller but still moderately large cash position, 3M (MMM), Pfizer (PFE), the levered ETF UPRO and a much smaller position in the inverse levered ETF SPXU.