In April, the S&P 500 index rallied 1.2 percent despite the Federal Deposit Insurance Corporation (FDIC) grappling with the third US bank failure in less than two months. First Republic Bank was the latest to fail, but the FDIC arranged for JP Morgan to acquire the majority of its assets under a “loss-sharing agreement,” with the FDIC providing $50 billion in financing to JP Morgan. This followed the failures of Silicon Valley Bank, Silvergate Bank, Signature Bank, and the Swiss National Bank’s orchestration of up to 100 billion Swiss francs in “liquidity assistance” to UBS for the takeover of Credit Suisse.

While the US Treasury Department’s spokesperson stated that “the banking system remains sound and resilient, and Americans should feel confident in the safety of their deposits and the ability of the banking system to fulfill its essential function of providing credit to businesses and families,” the reality is that the bank problem has not been entirely resolved. Many banks have invested heavily in bonds, which have depreciated in value due to the 20-fold increase in the federal funds rate within a year.

Consequently, many bank balance sheets are plagued with large unrealized losses, and as confidence erodes, insolvency becomes a real issue, with deposits leaving.

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In March, several banks failed or were in trouble, which prompted central banks to intervene with emergency liquidity injections to prevent further “bank runs.” As a result, interest rates on government bonds saw a significant decline, and some of the excess liquidity flowed into the stock market, which led to a 3.5 percent rally in the S&P 500 index for the month.

The yield on the 10-year Treasury note declined from over 4 percent in early March to 3.39 percent, and the 2-year Treasury yield fell from over 5 percent to 3.76 percent in eleven days.

In the previous report, it was noted that the surge in interest rates resulted in marked-to-market losses of nearly $1 trillion on the bonds held on the Federal Reserve’s balance sheet. However, given the Fed’s ability to create money, those losses were unlikely to have an immediate material impact. As regional banks lack the same capability, significant investment losses can create massive problems, as seen with Bear Stearns and Lehman Brothers in 2008.

Banks invest funds to generate interest to pay a small return on their deposit base, and they usually classify their bonds into two accounting categories: “available for sale” and “held to maturity.” Bonds in the “available for sale” category are marked-to-market, which means their value is based on current market prices. As interest rates increased, the prices of longer-dated bonds decreased in value, resulting in losses for banks holding such bonds.

Bonds categorized as “held to maturity” are not subject to the “marked-to-market” valuation requirements because they are not intended to be sold. However, a crucial exception to this is that if any of the “held to maturity” bonds are sold, the entire portfolio must then be valued at current market prices.

In early March, shares of Silicon Valley Bank (SVB) stock experienced a decline of over 60 percent in a single day following its announcement that it sold $21 billion in bonds and was in search of additional capital. This news indicated that the bank was either insolvent or close to it, which triggered a run on deposits.

According to reports, at year-end SVB had $91 billion in the “held to maturity” category that were worth just $76 billion. The $15 billion “unrealized loss” equated to almost all of SVB’s shareholders equity. This created stress on other banks such as First Republic Bank, PacWest, and Credit Suisse to name a few. Central banks flooded the markets with liquidity and other measures to stave off a panic.

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Following a 6.2 percent rally in January, the S&P 500 index fell 2.6 percent in February as the Federal Reserve raised interest rates for the eighth time since March 2022. By the end of the month, the yield on the 10-year Treasury Note increased to 3.92 percent from 3.52 percent, and crude oil prices (WTI) declined about $2 a barrel to just under $77, down from roughly $79 at the end of January.

As of February 28, 2023, the 3-month Treasury Bill yield was 4.88 percent while the 10-year Treasury yield was 3.92 percent. With short-term interest rates higher than long-term rates by 96 basis points (0.96%) – known as an inverted yield curve – the odds of an economic recession have increased materially as the “inversion” has persisted for the past 18 weeks.

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After a tumultuous year in the markets in 2022, when the Federal Reserve underwent an unprecedented interest rate hike cycle with an 18-fold increase in the federal funds rate over nine months and a war between Russia and Ukraine broke out, the S&P 500 index rebounded in January with a 6.2 percent rally. Interest rates on the 10-year Treasury Note fell from 3.88 percent at the end of 2022 to 3.52 percent on signs that inflation is decelerating.

In our last piece we highlighted the fact that despite the massive interest rate hikes in the second half of 2022, the S&P 500 index registered a 1.4 percent increase. While that was not something to cheer about, it was an indication that perhaps a good portion of the selling was behind us as stocks tend to bottom on bad news.

Another reason for the January rally is likely due to positioning. For example, net speculative S&P 500 futures contracts have been negative (net short positions) for 32 consecutive weeks, indicating a persistent bet that the S&P 500 index would decline. What’s more, a prominent Wall Street firm suggested that there was no reason for investors to take on risk, which is quite extreme. In addition, the fourth quarter saw equity fund allocations underweight by the most since 2005.

As a result, investor sentiment had gotten so negative, a small bit of good news had the potential to spark a rally.

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The financial markets had a challenging year in 2022 largely due to the Federal Reserve’s adoption and implementation of a radical, untested theory which allowed inflation to reach a 40-year high before the Fed changed course. As a result, the markets lost confidence in the Fed, which was reflected in lower stock, bond, and commodity prices, to name a few.

For the year, the S&P 500 index declined 19.4 percent and the yield on the 10-year U.S. Treasury Note more than doubled to 3.88 percent from 1.52 percent at the end of 2021. After dismissing inflation for more than a year, the Fed frantically tried to address the problem by increasing interest rates at a record pace.

At times, to be quite candid, the Jerome Powell-led Fed has been intellectually dishonest. In one instance, a former U.S. Treasury Secretary publicly called out Mr. Powell specifically for making statements that were “analytically indefensible.”

Another issue is that Chairman Powell often reads answers to questions at press conferences, which makes it look staged and gives the impression that he is not in command of the subject matter, followed by responses that seem to confirm it. As a result, the Fed’s credibility has taken a massive hit.

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Amid the ongoing war between Russia and Ukraine, the mid-term election drama in the U.S., and escalating tensions in China as a result of severe COVID lockdown policies, a number of markets experienced impressive moves in the month of November.

For example, the S&P 500 index rallied roughly 5.4 percent in November and closed the month up 13.8 percent from its mid-October low. In addition, the yield on the 10-year U.S. Treasury Note fell from 4.10 percent to 3.68 percent, with 30 basis points (0.30%) of that taking place on one day.

The catalyst for the large moves was an inflation report. After a 9.1 percent year-over-year increase in the Consumer Price Index (CPI) in June, the CPI increased “only” 7.7 percent year-over-year in October. While obviously still high, there is evidence that deflationary forces are having the desired effect. As a result, the U.S. dollar index has declined roughly 6 percent over the past four weeks.

Oil prices are well off their peak, trading around $80 a barrel compared to more than $122 a barrel in June. And many other commodities such as aluminum, lumber, steel, soybeans, and wheat, to name a few, are also down significantly since the summer. The price direction is a welcome sight.

Meanwhile, the cryptocurrency world was rattled by the bankruptcy of FTX, a company that was run by Samuel Bankman-Fried. Earlier this year FTX raised a funding round with a valuation of about $32 billion. One prominent Silicon Valley company invested $150 million and published an over-the top glowing article about FTX on its website on September 22, 2022.

Unbelievably, the article stated:

• “FTX will be the super-app. Banking will be disrupted and transformed by crypto.”
• “Crypto is money that can audit itself, no accountant or bookkeeper needed.”
• “The FTX competitive advantage? Ethical behavior.”

On November 11, 2022, FTX filed for bankruptcy. In front of a bankruptcy judge, John Ray, FTX’s new Chief Executive Officer and the person who was in charge of Enron following its bankruptcy scandal said, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”

Another attorney for FTX estimated the number of creditors to be “more than 1 million,” up from the previous estimate of 100,000, and told the judge a substantial amount of assets are either missing or stolen.

The Silicon Valley fund was forced to write down its $150 million investment to zero and issued an apology as details emerge about what appears to be massive fraud. Remarkably, Samuel BankmanFried testified in front of Congress twice in the past 12 months and was a very large donor, seemingly in an attempt to buy influence at the highest levels of government. Unfortunately, a lot of that money may have been stolen, but there is a lot we still do not know.

In his December 7, 2021 testimony in front of Congress, Samuel Bankman-Fried said, on FTX “there is complete transparency about the open interest, there is complete transparency of the positions that are held, there is a robust, consistent risk framework applied.” In contrast, it appears that up to $8 billion of FTX client assets are missing.

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U.S. stock markets rallied to begin the fourth quarter as the S&P 500 index gained almost 8 percent in the month of October despite the fact that the yield on 10-year U.S. Treasury Notes rose to 4.10 percent from 3.83 percent at the end of September and a barrel of West Texas Intermediate crude oil rose to about $86.50 from just below $80.

Volatility remained elevated and a case can be made that the Federal Reserve may have influenced the market in a way that could backfire. On Friday October 21, 2022, an article appeared in the online version of the Wall Street Journal (not the print version) just before 9:00 am. It was significant as that Friday happened to be an option-expiration Friday where hundreds of billions of dollars-worth of options, futures, and derivatives expire.

The article quoted several members of the Fed’s Federal Open Market Committee (FOMC), which also happened to be the last piece of public information prior to the “blackout” ahead of the official FOMC meeting. The article hinted that the Fed would debate the size of future hikes, giving some hope that the so-called “pivot” away from future interest rate hikes could be coming.

As a result, stock and bond markets staged a vigorously rally.

On November 2, 2022, Federal Reserve Chairman Jerome Powell seemed to pull the proverbial rug out from markets when he said “it’s very premature to be thinking about pausing” interest rate hikes as the Fed has “some ground to cover” in its attempt to restore low, stable inflation, “and we will cover it.”

For that reason, stock and bond markets sold off hard.

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The only thing worse than a hostile monetary policy is a Federal Reserve that does not know what it is doing. The markets are dealing with both.

As inflation hit a 40-year high in January 2022, Federal Reserve Chairman Jerome Powell said the Fed “decided to keep the target range for federal funds rate at 0 to ¼ percent.” In that same press conference Mr. Powell referred to inflation as a “high class” problem. Now, after high inflation has caused a rout in the currency, commodity, stock, and bond markets, Mr. Powell has found religion and wants everyone to know that low, stable inflation is the “bedrock” of the economy.

For well over a year, Chairman Powell has repeatedly said that the Fed is “guided by our mandate,” one of which is stable prices. As the Fed ignored inflation and did not begin to raise interest rates until the Consumer Price Index (CPI) was 7.5 percent – a 40-year high – markets are sending a message to the Powell-Fed that those type of statements are not credible.

Consequently, markets have lost confidence in the Fed and are acting accordingly.

September saw the S&P 500 index fell 9.3 percent, the yield on the 10-year U.S. Treasury Note rose 68 basis points (0.68%) to 3.83 percent (it was 2.60 percent on August 1, 2022), and a barrel of oil fell from just over $88 to roughly $79.70.

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Following a 9.1 percent gain in the month of July, the S&P 500 index fell 5.8 percent in the last four days of August following Federal Reserve Chairman Jerome Powell’s speech at Jackson Hole, WY. For the month of August, the S&P declined 4.2 percent.

 While we have been especially critical of the Powell-led Fed previously stating that “people who speculate on a radical, untested theory that has a damaging effect on the markets and the economy should not be in charge of monetary policy,” apparently, we were not harsh enough. To be blunt, the Powell-Fed has embarrassed itself.

 The same people who ignored rising inflation and kept interest rates at zero until inflation hit nearly 8 percent are now lecturing us about the importance of low inflation. Powell, who four weeks ago said “now that [interest rates] are at neutral” – the theoretical level that is neither accommodative nor restrictive – recently did a 180-degree turn saying “another unusually large increase [in rates] could be appropriate at our next meeting.” 

After the 1008 point decline in the Dow Jones Industrial Average on August 26, 2022, the day Powell gave his speech, Minneapolis Fed President Neel Kashkari said he was “happy.”

The yield on the 10-year Treasury Note rose from 2.60 percent in early August to nearly 3.25 percent at month end. Oil, meanwhile, was trading at roughly $87 a barrel, down from the mid-$90s in July.

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