Charts of the Week

Happy Friday! We’ve got some interesting charts to share with you all from this past week, starting with the probability of recession calculated from the yield curve.

This chart comes from the Cleveland Federal Reserve Bank, and what it is saying is that by April 2024 there is a 75.54% chance of a recession. Meaning that we’re likely to already be in a recession by then, not that it is likely to start at that point.

This is an important differentiation as many interpreted this chart as a bit of goalpost moving, but it is more a calculation of probabilities rising based on the yield curve.

One of the reasons we’ve seen such a dramatic yield curve inversion has been the pace at which the Federal Reserve as been hiking interest rates over the last 14 months, which is the fastest at any point in recent history, and from trough to peak the rate of change is the most dramatic that we’ve ever seen. Going from 0% to 0.25% to 5 to 5.25% is an increase of over 20-fold.

Because Fed rate policy primarily operates on the shorter end of the yield curve, this hiking cycle has boosted short-dated yields significantly. Combine the aggressive hiking with QT, and that tightening of policy led to 2022 being one of the worst years for the US Treasury market that we’ve ever experienced.

But we may not be set to see a pivot in policy anytime too soon with inflation remaining somewhat stubbornly high. While the last several tightening cycles reversed rather quickly, what made those periods different than now is that we were not experiencing high inflation at the time, and the economy was meaningfully weaker than it is now.

We also have a labor force participation rate that is rather low compared to prior periods. In fact, we haven’t seen the labor force participation rate stage any meaningful recovery since the Dot Com Bust, as it’s made a series of lower highs and lower lows since then. In essence, labor force participation has been in a downwardly trending trajectory for over two decades.

This has helped to create the tightness that we see in the jobs market, which has helped to feed inflationary pressures. As a result, the Fed remains adamant about keeping policy tight in order to try to loosen the employment situation, which they can do in three ways:

1. Increase labor force participation by ending early retirements that were enabled through wealth effects of over a decade of ultra-easy monetary policy (lower stock, bond, real estate, and crypto prices)

2. Reduce job openings by tightening financial conditions such that businesses are not hiring as many

3. Increase unemployment due to the aforementioned factors combined with more businesses struggling to finance their operational costs, sadly leading to job losses

Shifting over to the banks, we can see that many have high exposure to office building commercial real estate debt, which could prove to become a drag for lending. It also may complicate the refinancing for building owners as they are experiencing the lowest occupancy rates in history.

This is likely to have two major impacts:

1. Banks will be less likely to want to lend if the debt they hold is already appreciably troubled

2. Building owners will face a tough time refinancing, and those that are able to refinance will do so at meaningfully higher interest rates, putting upward pressure on costs during a time when revenues are dropping

Many US banks also have large amounts of uninsured deposits. While the FDIC is expected to come up with a plan to help insure those deposits over $250,000, or potentially provide some other kind of backstop, we know that their insurance fund is running a bit low.

As a result they are tapping the largest banks with fees to help replenish the fund.

US banks are also struggling with large unrealized losses that track back to the aggressive tightening cycle of the Fed and over a decade of chasing yield further out on the duration curve, and often at higher levels of risk.

About 50% of US banks have larger liabilities than assets, which may create concerns regarding solvency as we head towards a more challenging economic environment in the back half of 2023.

As a result, we see lending conditions tightening, and that is likely to create more unemployment and put downward pressure on the overall economy as well as corporate earnings.

Perhaps that gives us cause to have a discussion about just how overpaid CEOs in the US are as they make about 399 times as much as typical workers.