At Wednesday’s conclusion of the latest meeting of the Federal Open Market Committee, Fed Chairman Jay Powell did what Wall Street and corporate media anticipated, and stood pat on the federal funds rate.
However, even as Wall Street is arguably pleased with the Fed’s decision, Wall Street will not be able to avoid for long the exposures and vulnerabilities still present within the banking system and in the overall economy.
The Fed may think the federal funds rate sets other interest rates in the marketplace. The data says other factors are far more important, and the federal funds rate is now merely a sideshow.
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The committee decided at today’s meeting to maintain the target range for the federal-funds rate at 5 ¼ to 5 ½ percent and to continue the process of significantly reducing our securities holdings. We are committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation sustainably down to 2 percent over time and to keeping policy restrictive until we are confident that inflation is on a path to that objective.
We are attentive to recent data showing the resilience of economic growth and demand for labor. Evidence of growth persistently above potential, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.
Financial conditions have tightened significantly in recent months, driven by higher longer-term bond yields among other factors. Because persistent changes in financial conditions can have implications for the path of monetary policy, we monitor financial developments closely.
Arguably, one might even conclude that Wall Street is simply no longer worried about the Fed’s course of action on interest rates, so long as the Fed does not radically shift gears or change directions without warning.
Indeed, JPMorgan CEO Jaime Dimon has gone so far as to state outright that it does not matter if the Fed does or does not raise the federal funds rate another 25bps. Market interest rates are going to go wherever they are going to go, regardless of the federal funds rate.
The outspoken JPMorgan Chase CEO blasted the Federal Reserve — which has hiked the benchmark federal funds rate to between 5.25% and 5.5%, a 22-year high — and downplayed the importance of the central bank’s next move.
“I don’t think it makes a piece of difference whether rates go up 25 basis points or more,” Dimon said during a panel at the Future investment Initiative summit in Riyadh, Saudi Arabia, per Bloomberg.
“Whether the whole curve goes up 100 basis points, be prepared for it. I don’t know if it’s going to happen,” he added, according to Bloomberg.
This is quite a statement by Dimon. In effect, he has declared the Federal Reserve’s federal funds rate strategy to no longer be relevant to market interest rates, if it ever was relevant. It is even more remarkable a statement because I happen to broadly agree with him on the question of the Fed’s relevance.
JPMorgan Chase CEO Jamie Dimon issued a stark warning Monday to Wall Street: The Federal Reserve may be far from finished with itsaggressive regimen of interest rate hikes in the fight against elevated inflation.
Most analysts say the central bank will raise interest rates just one more time, in November, by 0.25 percentage points from its current range of 5.25%-5.50%. However, Dimon told Bloomberg TV it’s possible the central bank will continue hiking rates by another 1.5 percentage points, to 7%.
That would be the highest federal funds rate since December 1990. In March 2022, when the current hiking regimen began, rates were at 0.25%-0.50%.
Whether yields rise because of the federal funds rate or because of other market forces, Dimon is quite probably not wrong, at least not on the future direction of interest rates. No matter what, the near term trajectory is almost certainly higher rather than lower.
What the corporate media persists in overlooking is that increases to the federal funds rate is not the only action the Federal Reserve has been taking to tighten monetary policy. Since June of last year the Fed has been steadily shrinking its holdings of Treasuries as well as mortgage backed securities.
As the Fed has reiterated that it is not planning to curtail the roll-off of Treasuries from its balance sheet, we must anticipate that the Fed’s balance sheet reduction will produce further upward pressure on market interest rates.
There are two consequences of this reduction of both the Fed balance sheet and the money supply which can produce upward pressure on interest rates.
First, with the Federal Reserve no longer being a net purchaser of Treasuries, aggregate market demand for Treasuries is declining. Declining demand leads to declining prices—and Treasury yields are the inverse of price, so that as they rise Treasury prices fall. Put another way, as Treasury prices fall, Treasury yields rise, and that is a good description of what is happening in the market.
Additionally, a reduction in the money supply is also a reduction in aggregate capital, meaning capital is more scarce for purposes of lending. Yields might be the inverse of securities prices with respect to purchasers of securities, but they are also the cost of capital to the issuers of such securities. When there is less capital available for borrowers to access the cost of that capital to borrowers must increase, and that again means higher interest rates.
Regardless of how one apprehends market interest rates, as the inverse of securities prices or the cost of capital, the end result is the same: the Fed’s balance sheet reductions are moving interest rates higher.
Intriguingly, Wednesday’s decline in yields came even as the Treasury released its quarterly refunding plan, outlining future Treasury issuances in the coming quarter. With a shrinking money supply and shrinking demand for Treasuries, one might plausibly expect the announcement of still more Treasury sales to push prices down and yields up.
The table below presents, in billions of dollars, the actual auction sizes for the August to October 2023 quarter and the anticipated auction sizes for the November 2023 to January 2024 quarter:
“Market participants are really hyper-focused on supply now and we kind of know the Fed is on hold,” Angelo Manolatos, a strategist at Wells Fargo Securities, said in a telephone interview. “So the refunding is a bigger event than the FOMC. It also has a lot to do with the moves we’ve seen in yields since the August refunding.”
It would seem that market participants are not hyperfocused on supply at the moment, even though the Fed is “on hold.”
This is even more counterintuitive when one considers that Treasury bond sales have recently had significant “tails” where the anticipated yields ended up below the final yields—meaning the Treasury had to come down on price.
Although Treasuries are still considered the world’s risk-free haven of choice, the Treasury Department has recently had to pay a premium to buyers of its debt. That is, more auctions have been completed with so-called tails, which means that debt was sold at a yield that was above the yield that was anticipated ahead of the sale. That’s a sign of tepid demand for the securities. So while there’s no real risk of a Treasury auction failing — meaning the government can’t find sufficient demand in an auction to borrow the amount it wants — the deluge of supply could cause Treasury to increasingly have to offer better prices to investors to sell the securities. In this way, the Nov. 1 statement will provide clues about how much of a premium the government will have to continue to pay. Investors and market participants will be watching to see, among other things, how the Treasury distributes its issuances across the various maturities, indicating whether it’s seeking to extend the maturity of its debt profile or the reverse.
Wall Street seems to be content with present and future Treasury offerings.
However, while Wall Street may be content today, there is no denying the warning signs to suggest that, once again, Wall Street may be horribly mistaken in its non-chalance.
Most notably, bank deposits have declined significantly in recent weeks.
We can see the magnitudes of the deposit decline more clearly if we index deposit levels for the various size categories of banking institutions to January of 2022.
Foreign-related banks had the largest relative decline, shedding a full percentage point of deposits as of January 2022 in the week ending October 18. Large domestically chartered banks were not far behind, having shed 0.9 percentage points in that same interval. Even small domestically chartered banks, which have managed to retain the greatest portion of their deposits, saw a 0.3 percentage point drop in the week ending October 18.
In dollar terms, large banks shed $100 billion in deposits, small banks shed $15 billion, and foreign-related banks shed $12 billion during that week.
According to Federal Reserve Economic Data, there was a staggering $100 billion reduction in deposits within U.S. commercial banks in just three weeks.
Breaking down the numbers, JPMorgan Chase's deposits shrunk by $31 billion, while Wells Fargo's deposits decreased by $7.1 billion. Citigroup faced the steepest decline, with a drop of $46.4 billion. Despite these challenges, JPMorgan Chase reported a net income of $13.2 billion for the quarter.
Not only are large banks losing the most deposits in absolute dollar and relative percentage terms, JPMorgan is leading the pack. The biggest banks are seeing the biggest deposit drops.
These were among the assets that became the source of lending problems for regional banks in the third quarter as corporate borrowers and commercial real estate began to show more signs of strain.
In recent weeks many mid-sized financial institutions across the country reported that nonperforming loans, a measure that tracks borrowers that are behind on their payments, rose during the third quarter. They also disclosed mounting costs from unpaid debts written off as losses.
While the 3rd quarter delinquency data has yet to be published to the Federal Reserve Economic Data system, what is being reported is a furtherance of trends that have been building for some time.
That the Fed is committed to shrinking its balance sheet and not lowering the federal funds rate means there is exactly zero reason to believe existing securities portfolios will not continue to hemorrhage value, and that existing CRE loans will not continue to fall into delinquency and default as the cost of refinancing continues to rise.
The Fed’s decision on Wednesday, the Treasury’s refunding announcement, and Wall Street’s blase reaction to both do exactly nothing to ameliorate any of these red flags and warning signs for the US banking system.
There was a time when this sort of market lassitude by Wall Street would have been remarkable, when “bond vigilantes” and other players would be driving the narrative far more than they have been. However, this time around such activist voices have been largely passive. The warning signs may be there, but there are no signs that Wall Street is taking active interest in them.
Yet the warning signs remain, and recent events like the deposit drops merely add to their significance. Wall Street may be complacent for now, but that does not eliminate the vulnerabilities and frailties building within the banking system. Steadily, and almost imperceptibly, the US banking system is becoming more brittle and less able to respond to liquidity and demand shocks.
That there will be shocks is an unavoidable reality for any economy. The US banking system will endure various shocks, as indeed will the US economy and the overall global economy. This has not changed one iota since the formation of the Federal Reserve System. Shocks happen, and banking systems have to contend with them.
Prudent bank management, and a forward-looking Wall Street, would recognize this and respond accordingly, pricing in new asset valuations and shedding the underperforming assets before they became too much of a problem. As we discovered—or, rather, relearned—earlier this year, we do not have either prudent bank management or a forward-looking Wall Street.
Instead, we have a banking system which has outsourced its independent thinking to the Federal Reserve, and Wall Street fund managers who have done likewise. We also have a Federal Reserve that ultimately is not thinking at all, but merely repeating the same formulaic steps on the federal funds rate while ignoring other policy mechanisms and their impact.
Consequently, no one in banking or on Wall Street has truly come to terms with the reality that the Fed does not have a firm hand on the wheel, not of the economy and certainly not on inflation or interest rates. The Federal Reserve has lost control, and the only reason markets are not in a panic is that they have so far failed to notice.
This is not going to end well.
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