Since the Fed started to hike interest rates, risk markets have been calling bullshit on the Fed’s ability to get interest rates to where they are today – a frog’s toe under 5%.

And we’re pretty much here. A little too late and not high enough, but there are reasons for that.

But in getting here a massive arm wrestle has taken place over (a) withdrawal of liquidity promised by the Fed, versus (b) more liquidity wanted by risk markets once the Fed is done raising rates.

Markets have chosen to invest on (b) on the basis that eventually, the Fed will pause interest rate hikes and ‘pivot’, i.e., cut rates.

Why? Because risk asset traders and investors want lower interest rates as it means higher asset valuations and a return to all-time-high markets.

So, when pivot?

Like we’ve all been saying, probably not until U.S. inflation is back to a level of around 2%, or until something major ‘breaks’ and requires the Fed and Treasury to step in and bail out the economy.

I think we’re getting closer to understanding what that night be - and that is that the Fed might need to let a few more banks break to curtail the lending machine (money printer).

And where are we on that score?

Funny you should ask. Deposits and loans did trail off in the weeks following the SVB, Signature barbeques (and the Credit Suisse sale) however more recently they have popped. Probably as a result of the ‘confidence building’ safeguards put in place by the Fed, Treasury and the Biden Put (no depositor will lose money).

Bank deposits showed a drop of around $1 trillion, but they recently ticked up 👇

And in tandem, so did loans 👇

We’ll just have to wait see if the above trend continues or reverses.

If it continues up, the Fed continues with restrictive policy until unemployment shows signs of increasing materially and a Fed pivot floats further out on the horizon while risk assets move sideways and selectively down.

If it doesn’t, some or all of the BTFP, discount window and the Biden Put safeguards get called on and if enough important banks that are long bonds and commercial real estate break, we have a predicament.

And the predicament would be that because banks are the real money printers (each time they make a loan new money is introduced into the economy) credit becomes difficult to access as they withdraw, and this in turn causes business and household investment to dry up, margins to crater, revenues to fall, and unemployment to rise – a garden variety credit crunch - and finally, the Fed pivot comes into the foreground.

When you think about that, it’s not such a bad outcome for the Fed, right?

Imagine the story Chair Powell could spin. Inflation gone without having to lift rates much more than 5/5.25. What a hero. High and fast saved the day! You can refinance at lower (not higher, if at all) rates. And as far as those pesky bank collapses go, well that’s simply down to bank mismanagement and a welcome spring clean (and not the Fed’s mismanagement of QE, Dodd-Frank, SIFI, shredding the Volcker rule, etc).

So, in conclusion, breaking its own money creation mechanism by letting a few money printing banks go, so that exigent circumstances (and rate cuts) can make a return, might be the clandestine plan.

Until then, higher rates for longer unless unemployment gets uncomfortable, and recession takes hold, or Joe Biden changes his mind.

And as for Australia? Mind the gap.

Catch you in the shallow end.

Mike