For devotees of the (missing and suspected dead) Phillips Curve cargo cult, the Fed can’t stop raising rates until we see major unemployment.  I do not share their faith in the defunct Phillips Curve or an all-powerful Fed.  I agree the Fed can deliver that unemployment.  In this cycle, the Fed would do that by sacrificing a bunch of Regional Banks and the (huge) family/dynastic wealth tied up in Commercial Real Estate (CRE).

Is the Fed likely to make that sacrifice? 

“All animals are equal, but some animals are more equal than others.”  – George Orwell, Animal Farm.

Here is where messy politics complicates the tidy narrative…    If you only see the forest, you overlook that some trees are more important (and more vocal) than others.  Banking and Commercial Real Estate are VERY important trees – loved and protected by many in power.

Where will a wealthy mob carrying pitchforks and torches go when they look for retribution for their personal losses?  The path from higher rates to the Fed’s doorstep would be obvious.  Especially if that doorstep is littered with dead/dying regional banks clutching defaulted CRE loans.

• The Fed cares a LOT about the banks.  That is where Fed staffers go to get jobs.  The 48 Senators and 409 Congressmen who are NOT from New York also care a lot about “their” local banks run by their friends and donors.
• The top 10% cares a LOT about CRE as an asset class.  The Fed wouldn’t be blowing little people out of their homes in Vegas (like 2008).  The Fed would be blowing up dynastic wealth that underpins most “millionaire next door” fortunes outside of the major mega cities.  Commercial Real Estate underpins the fortunes of a lot of Congresspeople themselves, much less their donors and neighbors.  Real Estate underpins the fortune of a deeply selfish Orange-Haired demagogue who doesn’t play fair.  Look at how immediately effective (and comically pained) the SVB’s depositors howls were.  Now multiply those howls from that same class nationwide.
• The Fed cares MOST about its independence, prestige, and mystique.  Those will all come under attack if they end up blamed for “Blowing up my community’s regional bank and destroying MY family’s hard earned fortune.”  Congress is not full of people inclined to sacrifice for the greater good.  Payback would be brutal.  It might even be pre-emptive.  Facing this well-heeled mob, the Fed likely comes out a shadow of its former self.  The Fed knows that.  It will avoid that conflict.

So the tidy market narrative of “The Fed stays the course and we get a recession” decomposes into messy political reality of “If the Fed stays the course, it would be calling in an airstrike on its own position.” 

Maybe you genuinely believe that steely eyed Powell has the stones to do that.  From what I’ve seen so far, I don’t think he will.  They will cut rates before too many banks go under.

They are playing for time.  Hoping to get some economic softening, lower CPI numbers, and a bit of unemployment.  That gives them a fig leaf to justify the move.  The economic numbers will likely give them that.

But if they don’t get that fig-leaf, they do the rate cuts naked.  Because the path to a deep, unemployment-driving, Phillips Curve Cargo-Cult recession leads through too much pain in sectors that have too much political pull.  That is the messy reality.

The cult of the all-powerful Fed will paper over the (obvious) cracks in their narrative and declare this another great victory.  But the world will know this a little more in its heart;  Interest rates are a blunt-force instrument with wildly differential impacts across different economic sectors.  There are other, better tools for managing the economic cycle.  At some point, the fever dream will break and we’ll go back to a more balanced toolkit.

The lady doth protest too much, methinks. (“used in everyday speech to indicate doubt of someone’s sincerity, especially regarding the truth of a strong denial)”.  Fed quotes from Friday March 24…

• WASHINGTON, March 24 (Reuters) – St. Louis Federal Reserve president James Bullard said Friday the U.S. likely will need higher than expected interest rates to contain inflation as the economy remains strong and stress in the banking sector likely eases.  (how is stress in the banking system – caused by higher short term rates – going to ease if short term rates go higher than expected?)
• Federal Reserve Bank of Atlanta President Raphael Bostic acknowledged banking sector woes made the central bank’s interest rate hike call this week challenging, but he said the Fed’s main job must remain focused on getting inflation lower. Speaking in an interview Friday with National Public Radio, Bostic said “there was a lot of debate but this wasn’t a straightforward decision” to raise rates this week even as the banking sector is under stress. But, “we have to get inflation under control and back to our target,” Bostic said.

A lot of people expect the Fed to keep raising rates to drive “the economy” into a recession.  They don’t give much thought to the route we’d take to get there;  What sub-sectors of the economy are (or are not) taking the most damage right now?  Banking and Commercial Real Estate (CRE).  They are already bending. Pressed harder for longer, those sectors will break.  That break would likely cause the recession so many seek. 

So that belief boils down to the Fed will raise rates and force a Banking and Commercial Real Estate crisis (to get that hoped-for recession).

That belief boils down to the Fed has the courage and/or stupidity to call in an airstrike on its own position.

I don’t believe Powell has that courage.  He’s a politician.  He also isn’t stupid.  It would be a horrendous mistake for his reputation, the Fed’s independence, and the economy as a whole.  Better to suffer the ghastly fate of… 2.75% inflation.

Is that a forecast from some left-loony MMT opinion?  No.  The Cleveland Fed’s Center for Inflation Research put this paper out 3 months ago.  I’m reading “would not be optimal” as Fed-speak for “fantastically stupid…”

“Our model projects that… core PCE inflation moderates to only 2.75 percent by the end of 2025: inflation will be higher for longer. A deep recession would be necessary to achieve [2% inflation].  A simple… welfare analysis… suggests that such a recession would not be optimal.

This is Powell’s way out…

More on why blowing up the Banks and Real Estate would be an airstrike on the Fed’s own  position tomorrow.

Markets now see a a 97.6% chance of a Fed rate cut by September 2023.   Market consensus is “the Fed will have to cut rates because we will have a recession.” But what if we get a rate cut without a (major) recession?   What if the Fed starts cutting rates while many sectors of the economy are doing OK?

The Fed itself is predicting only 0.4% GDP growth in 2023.  The consensus view is below (per DataTrek)

Takeaway: Markets walked away from today’s FOMC announcement and Chair press conference even more convinced that the Fed will have to cut rates before the end of the year. The yield on 1- and 2-year Treasuries, which fell today to 4.51 and 3.96 percent, confirms that sentiment. That goes counter to the FOMC’s latest Summary of Economic Projections, as we will shortly discuss.

The important question is “what does the market think it sees”? The short answer is the growing risk of a US recession. During his post-meeting press conference, Chair Powell was very clear in his message that the Fed will not try to predict what effect a slowdown in bank lending may have on the American economy. Rather, it will wait and see what the incoming economic data has to say about both economic growth in inflation. The market seems rightly concerned about that idea. After all, by the time growth is clearly slowing and inflation is waning, it may well be too late to adjust monetary policy enough to avoid a significant economic slowdown.  (DataTrek Research 23March23)

Either we are going to have a mega-fast deceleration over the next 3 Q’s or….  we won’t.  The problem?  The real economy doesn’t look to be cooperating.

• A 3.6% YoY growth forecast from the Atlanta Fed’s GDPNow estimate for the March quarter.  This is usually directionally correct by this far into the quarter.   https://www.atlantafed.org/cqer/research/gdpnow
• Unemployment is at 3.6% (the Fed’s expectations are 4.5% by year end but “everyone” knows that is a low-ball vs their real expected number).
• The labor market is showing no signs of cracking.  Jobless claims went down this week.  Vacancies remain high.  Wage growth is solid.

Again, we do likely get a slowdown.  Economic data points to deceleration.  But there aren’t a lot of obvious signs of a screeching, shuddering, smoking-tires, next-3-6-months hard stop.  Which is kind’ve what you’d need to see for the the Fed to start cutting rates big-time (97% chance) by September 2023.

Maybe the market is wrong about the rate cuts?  Those expectations have bounced around a lot.

Or maybe the market is right about the rate cuts, but NOT because of a general recession?  Maybe (ahem) incipient signs of crisis in sectors near and dear to the Fed’s institutional heart?**

Certain sectors – Banking and Commercial Real Estate – are definitely sliding into crisis.  How fast and how deep and how bad?  It depends partly on how you weight various scenarios.  It depends mostly on the future trajectory of Fed rate decisions.

The Fed and the Treasury are ALREADY (quietly, but obviously) panicking.  How else would you describe the last 2 weeks?  What are they worried about?  Bank failures.  Driven by high rates (directly hurting bank profits) and by Commercial Real Estate (indirectly threatening bank loan books – especially smaller regional banks).

How does the Fed prevent those nightmare scenarios?  They cut rates.

Even if the economy is NOT in a tailspin recession.  Even if most of the economy is chugging along.  Because the banking sector and Commercial Real estate are systemically important.  They are also institutionally important to the Fed.  And those sectors are pretty clearly already in a recession.

Seen in this light, the Fed is praying the headlines go its way on inflation and the economy.  Declining headline CPI and some economic softening to provide a fig leaf of cover for a move the Fed is going to have to make anyway.

** Yes, a major Banking and Real Estate crisis would almost certainly cause a general recession.  What I am saying is the Fed will act to save its children before we get to that major crisis and subsequent recession.  We likely don’t get a real crisis if rates only stay high until September-December (per the market’s prediction).  The crisis risk goes up as/if rates stay high into 2024.  The problem with the Fed’s Higher for Longer promises was always the “for Longer” part.

More Context on the Slow-Rolling Crisis:  From the Financial Times (subscription required). 

But even if SVB-style dramas can be avoided, the pattern is creating “a long tail of zombie banks”, as the hedge fund Bridgewater says. “Policymakers can stop a bank run but unless the Fed cuts rates they can’t stop the repricing in banks funding costs.” That feeds into a third issue: a credit crunch. As funding costs rise, banks will cut loans.

In some senses this is what Fed officials want, since slower credit creation will curb inflation. But the rub is that it is extremely hard to predict the impact of a credit squeeze since it can create a self-reinforcing downward spiral of recession and defaults. So while the crisis in American banks was initially sparked by interest rate (and liquidity) risks, it could now slowly morph into a problem of credit risk too.

The $5.6tn commercial real estate lending market illustrates the problem. At present 70 per cent of these loans comes from small and medium-sized groups. “Small banks’ absolute dollar exposure to CRE lending has grown at an accelerating rate over the past ten years,” notes Morgan Stanley;

Even before the interest rate cycle turned, CRE values were starting to come under pressure because the rise of internet shopping and homeworking hurt retail and office space. But with rates rising, “all of a sudden those assets become very hard to roll over” as Rick Rieder of BlackRock says. Since $2.5tn of loans are due to be refinanced in the next five years, this will eventually create pain for borrowers — and banks.

This was supposed to go out Tuesday night, but the power went out here.  It still holds pretty well. 

Addendum:  The Fed did raise rates 25 bps, but made noises about slowing down etc…. In “potential bar fight” terms, the guy is still shouting threats and looking tough, but his feet are ever so slightly edging backwards.  Market sees that – now pricing in rising probabilities of rate cuts between September 2023 (77%) to December ’23 (95%).

By that time headline CPI is probably fading and the Fed will have an excuse to rush to rescue of the banks and commercial Real Estate.  Maybe labor markets and wages have tanked, but that would have to be a pretty dramatic deceleration over a a very short time period.  More likely the economy is humming along and maybe we just have to get used to (gasp) 3% inflation….

Tuesday Night Post

The fix might be in. The Treasury and Fed have now both placed mutually self-destructive bets on the table.  They don’t want to lose those bets.  That suggests the Fed’s rate-raising campaign peters out from here.

If US regional banks go bust, both the Fed and the Treasury face embarrassing, publicly obvious losses.  Cue howls of protest and (maybe literal) pitchforks, and torches.  That  might happen if we tumble into a banking crisis, but regulators do set the odds of their own success.

What were those bets?

• The Treasury just stated they will guarantee the deposits of all US regional banks.  Writing a blank check (OK, the FDIC is writing the blank check but the Treasury’s neck is now stuck out).  Betting it never gets cashed (in a bank failure).
• The Fed (in its role as bank regulator) is buying (OK, “guaranteeing”) bank’s debt holdings at 100 cents on the dollar.  Knowing full well the fair market price today is (say) 85 cents.  They are deliberately over-paying to pad the banks balance sheets.  Betting that over-payment (and/or losses) never gets marked to market (in a bank failure).

Neither the Fed or the Treasury wants to lose these bets.  How do they avoid losing?  By ending rate rises sooner vs later.  Reducing the pressure on the banks.

After the Treasury announcement today, chances of a Fed rate cut in December 2023 went from 98% (2 days ago) to 58%.  We now go out to May 2024 before the betting is near-certain (96%) for rate cuts.

Is there an explicit deal here?  Probably not.  Is there an implicit deal between the two entities responsible for protecting the banks and financial system?  Probably.

The Fed (who controls rates) moved first.  The Treasury (who has a very big bully pulpit and a lot to do with banks and the Treasury market) moved second.  Now they are both publicly committed.  Tidy bit of game theory.

Mapping it out, the bank regulatory dyad (Fed/Treasury) have two paths forward.

1. Make damn sure the banks don’t go bust on, for example, soured real estate loans, rising deposit rates, and a major economic downturn.
2. Press on with rate rises – increasing the risk on those bets.  The blank check guarantees get cashed and the over-payment valuations get busted.   Cue howls of “bailout” from people who like to howl about things that rile up their base – Elizabeth Warren and Marjorie Taylor Greene for example.

My bet is they go with #1. In which case the fix is in.  The Fed steps off the gas from here and the Treasury does its bit along the way.

This might all sound a little too “political.”  But that is because it all is political.  Watch Yellen squirm here.  Powell never wants to find himself squirming alongside her.  This Oklahoma Senator does a great job of getting that point (and threat) across.  Senator Warren (originally from Oklahoma) will be happy to do the same to Powell and his precious place in history.  A few days later, Yellen says all the banks get their deposits guaranteed.  Pure politics well played,

Ohhhhh boy 👀 pic.twitter.com/sHFHjHxve3

— 𝙈𝙞𝙠𝙚 “Dr. Calm” 𝙃𝙤₿𝙖𝙧𝙩 (@theemikehobart) March 16, 2023

Looking ahead, we probably face either (mild) inflation or debt deflation.*  Both leading to the same place.  Losses on assets.

* [Debt Deflation] = deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults and because the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in lending and by extension, a reduction in spending.

What we are watching right now is “the assets” twisting and squirming to try and find a way for someone else to take the pain.  In more simple terms.  Rich people (assets) trying to somehow shift the pain to poor people (labor market).  Like we chose to do in 2008.  Homeowners suffered most of the pain (paving the way for Trump’s takeover and the effective destruction of the “traditional Republican” party, but I digress).

Don’t think it is going to work this time around.  Our current state is…

• …labor market looks fine.  If you are in the bottom quartile, it looks awesome (see the “Wage Level” tab here, 4th quartile is “poor people.” 1st quartile is “rich people.”  It explains a lot of the angst out there)
• …a LOT of assets are already carrying nasty mark-to-market losses.  When rates go up, stuff priced in a lower rate past goes down…

Near-term future.  The Fed either…

• …raises rates too high for too long.  CRACK!.  Another crisis and debt deflation.  2008 scenario.
• …raises a bit to save face, then starts cutting.  HSSSSSSS….
  • Inflation stays positive for a while (2% to 4% range?).  Assets lose more value.
  • Labor stays solid and wages keep creeping up for the bottom 1/4 (they have gotten HUGE gains in the last 2 years).  Prices don’t keep up.  Profits go down.

Is there a middle scenario?  No mega-crisis, but assets don’t take a hit?  Maybe?  “The  assets” are definitely searching for that easy exit.

• Maybe if we keep raising rates, maybe the labor market will finally break?!?  The PR is “to slay inflation and protect the little man.”  The un-spoken aim is as much to arrest continued wage gains and bargaining power.  The problem?  A labor market break would have to happen in the next few months.  That doesn’t look likely.  Especially as 4.5 points of rate increases haven’t done much so far (except wreck the banking system).
• If not, is there some other clever way we can socialize the losses and privatize the remaining profits?  Like today’s plea by regional banks to insure 100% of deposits for 2 years.  Note they are not also volunteering to submit to the more strict regulatory regime they wiggled out of a few years ago…  A government guarantee to gamble for 2 years => “privatize the gains.”  Why some Bank CEO’s are OK with a crisis.

Maybe “the assets” find a partial way out?  I don’t see a way to socialize the losses (pushing the pain into the real economy) absent a major crisis like 2008.  Maybe that is why some people seem OK risking another 2008?  2010-2020 was a pretty good decade for some…

But I’m not sure the Fed will play along this time around.  The trail of blame here leads a little too obviously to the Fed’s doorstep.  That (highly political) institution is already squirming to avoid taking the rap.  So some near-term losses probably get socialized.  The right thing to do to keep the banking system running.  But the Fed isn’t likely to sacrifice itself to cut losses outside of its immediate reach.  The best they can do is offer palliative care (ie. rate cuts).

Long-term future?  Either…

• …a virtuous circle in the real economy.  Higher wages flow through to more demand.  Tight labor markets = higher productivity (robot waiters here we come).**  Investment.  Things really start humming.  This is great for everyone EXCEPT the people suffering losses from 2%-4% inflation chewing up the 2008-2022 assets priced for a low-rate regime.
• …the air goes out of it.  Like in post-2008, the virtuous circle never gets going because too much money leaks out in each turn of the cycle.  Bled out of the real economy supply/demand cycle (really the wages/spending cycle).  Leaking into “assets” piled on top of an increasingly stagnant real economy.

What is deeply annoying (to me) is that I was pretty much here in my thinking about 2 years ago.  But I have managed the last 2 years pretty badly.  I couldn’t/didn’t see through the logic of my own damn argument.  Sigh….

**  Productivity gains are the sole driver of economy-wide prosperity.  The standard MBA myth is “far-sighted, profit seeking executives drive productivity gains.”  Economic history suggests rising wages are a more powerful driver economy-wide productivity gains.  Why?  People are lazy.  Managers are people.  Without the goad of higher wages, they don’t look for productivity gains.  But, when their backs are to a wall, they (like most people) get creative about finding a way out.  The inverse of  “Necessity is the mother of invention…” is “your average Joe doesn’t do much unless circumstances force them to…“

We risk another 2008-style crisis.   Is that really preferable to 3%-4% inflation for a year or two longer than we’d like?  Even that is a false choice – ignoring all the other tools we have to fight inflation (that don’t involve crippling the world’s financial system).

So why do so many people want the Fed to keep on yanking that lever – risk be damned?!?  I keep seeing public figures calling for the Fed to stay the course.  It is plain as day that we risk tipping the financial system over into a 2008 style financial crisis if we press too hard for too long. Is that a risk worth taking?

Am I confidently predicting a crisis?  No.  Why?  Financial crises aren’t predictable!  Who expected really expected to spend last weekend brushing up on the mechanics of a classic George Bailey “Its a Wonderful Life” bank run?

I am confidently predicting that the Fed pointlessly and exponentially increases the risk of a financial crisis the longer they keep the yield curve inverted (short-term rates higher than long-term rates).  It doesn’t matter how much they hike next week.  What matters is how long they keep rates at the current (or higher) level.  The longer we stay where we are, the higher the risk of a crisis.

The Silicon Valley Bank fiasco was one warning.  Credit Suisse’s blow-up a few days later was  another warning.  Blackstone closing the exits to its BREIT Real Estate fund a few months ago was another.

What I have not seen is a convincing argument for “We should risk a 2008-style mega crisis – keeping the yield curve inverted – in order to prevent a greater threat.”  “Inflation!!!” is the cited threat?  But is that really such a big deal?

Inflation is also NOT AN OBVIOUS CRISIS!  Look at these links to various Federal Reserve measures of inflation expectations.  Nothing here says “we should risk a bank crisis to avoid the horrible fate foretold here” IMHO

• https://www.newyorkfed.org/microeconomics/sce#/inflexp-3
• https://fred.stlouisfed.org/series/T5YIFR
• https://www.clevelandfed.org/indicators-and-data/inflation-expectations

From a newsletter I subscribe to.

“New Deal democrat argued that “Properly measured, consumer prices have been in deflation since last June “. He highlighted the lagging nature of Owners’ Equivalent Rent (OER), the major component of shelter CPI, as house prices tend to lead OER by 12 months or more. After making all the adjustments, NDD concluded:  If we substitute the FHFA house price index for OER, headline CPI would have been down -1.4% as of December (since that is when the reported FHFA data ends).” 

Current inflation is also driven mostly by real economy supply demand dynamics.  The inflation solution must also come from supply/demand.  With the price mechanism (“inflation”) doing that balancing with time and patience.  The level of short-term interest rates is, in that equation, not a particularly decisive factor.  The non-impact of 4.5 points of rate increases would seem to be evidence enough by now?

What a weekend to be locked out of your own blog account! A bit of a grab bag of thoughts here – sorry for some repetition….

Silicon Valley Bank has taken us from from “higher [rates] for longer” to “not much higher for not much longer.”  Why?

1. The Fed’s original and first priority (since 1907) is to safeguard the banking system.  Inflation (since 1977) comes second.  Employment is a distant third.  The 2% inflation target just barely turned 20 (2012).
2. The first canary just died in the banking system…  Note that Commercial Real Estate is 24% of on-book bank loans and also showing serious stress from high rates.  The labor market is showing NO signs of stress. 
3. The banking system (and commercial Real Estate) will blow up before the labor market does.  The labor market probably wouldn’t soften quickly even if the Fed hiked to 7%.  Even 6% might spell disaster for the banks and a building re-finance.

If they keep on hiking and hold for longer, Powell goes down in history as “the guy who blew up the finance and real estate industry in a quixotic, ill-judged attempt to bring down inflation driven by supply/demand factors out of the Fed’s control”  Arthur Burns #2…  Not Paul Volker. Powell does not want that to be on his gravestone.  

Even if Powell wanted to grit his teeth, he will be fighting a rising tide of anger and fear from a lot of very influential people.  Look at the howl of protests and entreaties from “libertarian” Silicon Valley after SVB went under.  Libertarians do tend to assume the little people will pay the Price of Liberty (NB – there are very few low-income libertarians).

1. Fed tightening cycles are breath-holding contests.
2. The labor market is “supposed” to gasp for breath first.  But it is doing great.  See Feb jobs report.
3. SVB is the first gasp for breath.  There are a lot more “mark to fantasy” assets sitting out there that can’t stay that way for much longer.  Rate bets (like at SVB) and precarious Real Estate assets facing re-financing risk.  Higher rates endanger both.
4. If the Fed is going to damage the economy until it slows, that damage is going to hit people who are used to getting taken care of (see “Silicon Valley Bank Depositors”).  The Fed would permanently impair a lot of wealth before that ever trickles down to the labor market.
   
5. Paul Volker did not get his Wall Street sainthood by “impairing a lot of wealth.”

In sum – the labor market looks too healthy and the financial system too shaky to do “higher for longer.”  So we hike a bit to save face.  Then find a way to justify ~3% inflation.  3% being, BTW, totally fine. 

So the collapse of Silicon Valley Bank puts an end to this tightening cycle.

Moreover, the fed will have to cut rates sooner vs later to get short-term 1-2-year rates (where the Fed has more influence) down below 10+ year long-term rates (where the free market sets prices more then the Fed does).

Will the Fed have slain inflation?  No.  We have no counter-factual, but it is pretty obvious the whole tightening exercise didn’t do much to change the course of the real economy.  The cause of the inflation was in the real economy – supply demand shocks – and the cure will be in the real economy too.  As the line goes “the cure for high prices is… high prices.”

Anyone with real faith in free markets would have told you that 18-24 months ago.  There is a stack of academic research that has long explored the limitations of the Fed’s powers.  But Wall Street types believe more in rules of thumb than in fancy academics – especially if those academics are even a teeny weeny bit to the left.  No matter that MMT has laid out a very robust framework for understanding the current inflation.  The rule of thumb was… “The Fed is all powerful.  They will crush the economy.  Unemployment will soar.  The great Oracle Larry Summers has told me so….!”  We’ve seen that on front pages for 18+ months now.  Even as the contrary evidence has steadily piled up.  Until SVB went BOOM!

So the Fed fired its big bazooka.  4.5 percentage points of rate hikes later, the real economy has gone lumbering indifferently along.  But the banking system just had a near-systemic crisis.

Never forget that the Fed was created/empowered to protect the banking system after the panic of 1907.  That mandate was strengthened after the Great Depression. 90% of what the Fed does ever day is herd, manage, and protect the banking system.  The banking system is also most Fed staffers’ revolving door employer when the retire.

That “control inflation” mandate?  It didn’t get formalized until 1977.  The “set in stone” 2% inflation target?  A creature of Ben Bernanke in 2012.  The Fed cares about the banks first, inflation second, and full employment by lip service only…

The Silicon Valley Bank crisis was unique.  But dismissing the risk signal on those grounds is like arguing this particular dead canary was a little odd, so we don’t need to get the hell out of this coal mine before the toxic gases build up and blow.  he canary is still dead and others will soon follow.  The Fed knows this.  The Fed will act accordingly.

The Fed still probably raises rates in the next meeting to save face.  But this tightening cycle is done.  They can’t keep raising for long.  Nor can they keep rates at the current level.

Why? An inverted yield curve is kryptonite for banks and all sort of other financial markets players.  A week ago, the 2 year Treasury rate was at ~5% and the 10 year rate was at 4%.   Simplifying drastically, that meant were paying deposit rates tied to that 5%, but earning loan/asset tied to that 4%.  Losing 1% a year is a path to insolvency.  The reality isn’t that simple, but an inverted curve still leads to bankruptcy or… bank runs.

This week, the 2 year had tanked almost a full point to 4.3% and the 10 year has only gone down to 3.7% from 4%.  Why?  Because the market sees the Fed can’t tighten much more for much longer.  Banks can hold their breath for a while, but they can’t hold their breath indefinitely.  They can’t outlast the labor market.

The labor market just keeps chugging along.  It isn’t going to crack soon enough for the Fed to save face.  Not before another of its bank canaries die.

Have we slain inflation? Nope. Fed was never that powerful to start with. But do we naturally fall to something like 3%? Yeah probably. And 3% is (gasp) not really that different from the (arbitrary) 2% fed target.

I am not an energy expert by any means.  Nor am I a Ukraine expert.  So why not look at them both?  🙂  At least I can ask some relevant questions even if I can’t fully answer them.

I believe the consensus view on the Energy sector incorporates the consensus view on Ukraine – “there will be a stalemate.” We don’t have conditions for a stalemate in Ukraine (see below).  That invalidates an big chunk of the energy market consensus.

I genuinely don’t know what “a flood of Russian oil and gas” does to the energy market dynamic.  Or what is priced in.  I do think you need a solid scenario to answer that question before you commit capital to the energy sector. 

If you are looking at the energy sector, your investment thesis MUST at least consider these very plausible, potentially cascading scenarios.

1. Russian retreat to (more or less) pre-invasion lines.  Ukraine breaks through (again) and routs the Russian Army locally (again).  Decisive loss (again) of Russian military hardware and trained personnel.
2. Ukraine’s breakthrough turns into a rout.  Russian equipment losses are massive.  Russian morale losses are even more catastrophic.  The Russian army melts back over the border leaving much of its equipment behind.  Crimea is threatened as the Kerch bridge comes under fire…
3. Putin’s government teeters on the brink.  Russia’s 2024 (too-obviously-rigged) national elections go badly awry.  Putin finds himself bleeding legitimacy – avoiding any windows above the 1st story.

Why does that matter to energy markets?  Russia produces a lot of oil and gas.  If they are in a hole, they will likely (choose one option only)

1. Prudently maintain production at levels that sustain the long-term profitability of the global energy sector….
2. Sell everything they can to anyone who will buy it at whatever price they can get.   Try to buy off the populace; fund a factional power grab; and/or a personal exile plan B.

#2 seems a lot more likely than #1.

What about those sanctions?  I’d expect the principled, steel-backbone politicians of Europe will find some way to buy lots of cheap Russian oil and gas once we get this whole “neighbor-invading” unpleasantness behind us.  Especially as Russia actually has…

1. …destroyed itself as a credible military threat.
2. …shown that “we’ll turn off your gas!” ultimatum is not quite the threat many  imagined it to be.  No-one in Europe froze to death this winter.  But Europe does need to re-fill for next winter.

Stalemate is a comfortable but wrong  assumption. 

The people predicting stalemate today are the same people who kept predicting Russia would  “win” long after Russia had clearly lost.  They were (obviously) wrong then.  They are still (equally obviously) wrong now.  But their collective echo chamber is big enough for them to feel comfortably wrong together.

The oil patch has a notorious political leaning (and thus a blind spot).  Its denizens tend see the world through a more (ahem) “pro-authoritarian” political lens.  The US oil industry is not known as a bastion of liberalism.  Nor are the sub-set of investors who specialize in energy.  Nor are many oil-rich US states or oil-rich countries (Norway aside).  What feels comfortable inside that echo chamber doesn’t always synch well with reality.

A stalemate in Ukraine requires BOTH sides to be either exhausted or reined in.

1. Russia is exhausted.  It has been for 6+ months now.  A stalemate is the best outcome they can hope for.
2. Ukraine is NOT exhausted.  They are winding up for a big offensive.  Fresh tanks. Fresh troops.  Fresh long-range missiles.
3. No-one is talking much about “reining in” anyone.  All the noises out of Ukraine’s backers are in the opposite direction.  With the (large) exception of a weirdly Pro-Russia, Pro-Authoritarian element in the US.  Some of whom likely live in or invest in Big Oil country…  Also various German SPD politicians with compromising photos in their FSB files… but I digress.

Ukraine has beaten consensus expectations pretty well so far.  Russia has screwed up pretty much every chance they have had.  So the high-probability bet today is not “stalemate.”

If we get to late November 2023 without a big Ukrainian breakthrough, we might have a stalemate.  That is what Russia should be playing for (instead of bleeding away tanks and troops in Bakmhut and Vuhedar). But Russia is not doing the smart thing…

This excellent Axios piece (pasted in below) gives us our Zen koan for the day.

Investors hang on every last word out of the Fed.
The real economy doesn’t give a sh*t
Which is… “reality?”

As a bonus, one of my actual favorite Koans – A Cup of Tea.  On good days I am pouring the tea.  On bad days I’m the guy with the cup… 🙂

Nan-in, a Japanese master during the Meiji era (1868-1912), received a university professor who came to inquire about Zen.

Nan-in served tea. He poured his visitor’s cup full, and then kept on pouring.

The professor watched the overflow until he no longer could restrain himself. “It is overfull. No more will go in!”

“Like this cup,” Nan-in said, “you are full of your own opinions and speculations. How can I show you Zen unless you first empty your cup?”

AXIOS:  Why rate hikes haven’t affected the economy more

Two days after Russia invaded Ukraine, I wrote “Putin is already Losing in Ukraine.”  Even back then, it was already pretty obvious.  Whatever emerged from the war, it would not be a Russian “victory.”  Putin has lost more and more with every day since.

I’ve never asked the question on the other side of that coin – Have the Ukrainians Already (Mostly)  Won?”  The answer is… yes?  Winning more every day.  Not a full-scale “victory” (yet).  But they have a decent shot at it.

A conversation around stock markets (which have recently been pretty upbeat) made me ask that question.  Maybe markets are pricing in a Ukrainian victory?  Economically, that probably re-starts Russian energy production and exports.  Lower energy costs are a good thing economically (and for headline inflation).  “Ending a hot war in Europe” would also be a good thing for markets.  Enough said.

But it already looks more like a win for Ukraine.  One or two more successful offensives and they have a decisive victory by Spring-Fall of this year.  Even if they don’t win a decisive victory, they will have largely won.

Think about what “victory” really means for Ukraine:

1. A de-fanged Russian military incapable of mounting serious offensive action.
2. Multi-layered, modern air defenses effectively denying the airspace to Russian planes and missiles.
3. NATO-standard equipment with adequate ammunition and training.
4. NATO-quality aircraft with trained crews.
5. Economic Integration with the European community.
6. Implicit defensive support/security guarantees from NATO.
7. Recapture of territory occupied in 2022.
8. Recapture of the Donbas – or the important parts of it.
9. Recapture of Crimea.

Ukraine has ticked off a lot of that checklist already.  Much of the rest could come in 2023.  That sums up to victory…

• …already or soon-to-be there on 1 to 3 (self-defense/security).  #4 (fighter jets) is likely soon.
• …well on their way to 5 and 6 (integration with the West) if Ukraine doesn’t backslide on corruption and rule of law.
• …one or two more successful offensive away from some part of  7 and 8 (taking back territory).
• 9 (Crimea) is still looking like a stretch for now, but not forever…

The next 6-12 months also favor Ukraine…

Russia is getting weaker.  It is frittering away its last dregs of offensive capability now.  They will no longer be a meaningful offensive threat to Ukraine by the end of 2023.  They might not run out of (poorly trained) men, but they will run out of advanced weapons, missiles, tanks, trucks, and artillery shells.  Most damaging, they are running out of trained officers/specialists to lead and direct that rabble.  Armies stand and fight.  Mobs generally don’t.  Russia can dig in.  Try to hold out.  But Russia won’t be taking more ground (barring a miracle).

Ukraine is getting stronger.  By year end, it will be re-armed with superior Western hardware.  They are getting longer-range missiles which will wreak further havoc on the Russian supply system.  They are also getting top-drawer air defense systems.  Top-drawer fighter aircraft look to be coming soon.  If Ukraine controls its skies, it fully controls its territory.  Russian aircraft already don’t fly over Ukraine.  If Ukraine’s aircraft can fly, Russian troops will be sitting ducks.  At that point, Russia REALLY ceases to be an offensive threat.  They will struggle to supply defensive positions, with no ability to supply meaningful offensive gains.

For a complete victory, Ukraine still needs luck on its side.  Another breakthrough like Kyiv, Kharkiv, Izyum, and Kherson.  The Russians have “collapsed” locally in those 4 breakthroughs,  but we have not (yet) seen the general military collapse I’ve been looking for…  Yet those are 4 more breakthrough than the Russians have had over the past 6-8 months.  The Ukrainians have been winning.  The Russians have been losing.

The least likely win above is #9 – Crimea.   Note that Crimeans themselves don’t feel particularly “Ukrainian.”  But Ukraine does have a long-game, non-military path to re-taking Crimea.  The Crimeans themselves might eventually choose to be rich in a prosperous, EU-adjacent Ukraine vs poor in corrupt, China-dependent, petro-state Russia.

Crimea remains – legally – part of Ukraine.  A local popular uprising would be enough for international recognition.  That local revolt doesn’t happen unless/until the Russian central government is seriously weakened and/or distracted.  But the richer and more “European” Ukraine gets, the more likely it is to re-absorb Crimea.

Many call the present situation a stalemate.  Based on the false expectations that wars are fast-paced, action-packed, decisive affairs.  A mental error compounded from a mixture of recency effects (US in Iraq), historical telescoping (WW2 history is a series of decisive battles, but WW2’s reality was MONTHS of “no major news from the front”) and Hollywood thinking (fast cuts over the boring stuff).

Reality on the ground is not a stalemate.  It is just the messy business of grinding it out.  The parts of history that don’t often make it into the history books.

Putin is Already Losing in Ukraine