Fed’s Rate Pause Gets Closer

The stock market tumbled a few days ago when JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon noted that the banking crisis wasn’t over and that there would be repercussions for years.

Mr. Dimon is likely correct as some relatively underground Federal Reserve statistics support his view. A few days later, Warren Buffett echoed Dimon’s comments, adding he had sold some of his bank stock holdings.

And while stocks have recovered since Dimon’s remarks and are showing resilience in the wake of Buffett’s confirmation of the situation, the banking sector’s outlook remains murky.

That’s because it’s getting harder to obtain loans as banks tighten lending standards amid a general uneasiness about the future of the U.S. economy. I’ll get this part of the article over with now: you can blame the Fed for waiting too long to raise interest rates and then going too far.

But with the latest U.S. consumer price index (CPI) data showing a slowing in inflation, this may be a window of opportunity for the Fed, at its next Federal Open Market Committee (FOMC) meeting scheduled for May 2-3, to announce a “pause” in rate hikes.

The Inside Skinny from Loan Officers

There is an obscure monthly report issued by the Fed titled the Senior Loan Officer Opinion Survey on Bank Lending practices (SLOOS), whose most recent issuance (January 2023), covering data mostly from Q4 2022, came out well before the Silicon Valley Bank (SVB) collapse. SLOOS already was displaying some troubling signs.

Read This Story: Bank Earnings: The Next Test for Stocks

Specifically, respondents reported weaker loan demand and a tightening of banking standards. Of note, a focal point of the weakness revolved around commercial real estate (CRE).

Other nuggets in the report included banks referring to an increase in:

  • Less favorable or more uncertain economic outlook;
  • Decreased liquidity in the secondary market;
  • Weaker loan demand from all types of firms;
  • A decrease in queries from clients regarding new lines of credit or increases in existing lines;
  • Tighter standards for home equity lines of credit and credit cards; and
  • Weaker demand for consumer loans, especially auto loans.

The Fed summarized the survey’s responses as: “On balance, banks reported expecting lending standards to tighten and loan demand to weaken. Meanwhile, banks reported expectations of a broad deterioration in loan quality during 2023.”

Even more prescient, think Credit Suisse NYSE: CS), was this: “Regarding foreign banks, significant net shares of such banks reported expecting tighter standards for all C&I and CRE loans over 2023. In addition, foreign banks also reported expecting weaker or basically unchanged demand and a broad deterioration in the quality of C&I and CRE loans during 2023.”

As a result, given that this report was available weeks before the SVB disaster, you must wonder if the Fed, the U.S. Treasury, or the Federal Deposit Insurance Corp. (FDIC) even read any of it. Moreover, if they did, then how could anyone in any of those three agencies have been surprised by the collapses of SVB, Signature and Silvergate?

In addition, given that this was Q4 2022 data, it would not be surprising that the next SLOOS will paint an even darker picture of the banking sector.

Here’s what’s most compelling. The Dallas Fed recently reported that loan demand declined for the fifth period in a row as bankers in the March survey revealed worsening business activity. Loan volumes fell, driven largely by a sharp contraction in consumer loans.

Loan nonperformance increased slightly overall, with the only notable rise over the past six weeks coming from consumer lending. Credit standards and terms continued to tighten sharply, and marked rises in loan pricing were also noted over the reporting period.

Banking outlooks continued to deteriorate, with contacts expecting a contraction in loan demand and business activity and an increase in nonperforming loans over the next six months.”

All of which, of course, puts an emphasis on Jamie Dimon’s comments and Warren Buffett’s dumping of his bank holdings.

Making Lemonade Out of Lemons

It’s clear that Dimon is aware of what could lie ahead. It’s also clear that the bond market is becoming a more reliable indicator of what lies ahead than government statistics which are a window to the past.

And the most recent action in the U.S. Treasury Ten Year Note (TNX) suggests that bond traders are fully aware of what could lie ahead. i.e. more trouble in the banking sector, and eventually, an easing of rates from the Fed.

Specifically, you can see that in Q4, as bankers were turning bearish on loan demand, TNX rolled over and fell until its CPI-related rise in November. Yet, yields fell and rose twice more before breaking to new lows in the aftermath of the “banking crisis.” More recently, TNX traded at a new low for the past 12 months, well below 3.5%, and its 200-day moving average.

We may see a rebound in rates in the short term, but the bond market is confirming Mr. Dimon’s perception of what could lie ahead.

Moreover, the stock market is also showing some hopeful signs. Note the recent action in the New York Stock Exchange Advance Decline line (NYAD) where the line held at its 200-day moving average, recovered, and has since moved back above its 50-day moving average. Those are bullish signs, which until reversed, suggest money is moving back into stocks.

Playing the Bond Game

Aside from holding bonds to maturity as part of a diversified portfolio, shorter term trading strategies sometimes make sense. This may be one of them, via the iShares 20 + Year Treasury Bond ETF (NSDQ: TLT). This exchange-traded fund invests in a mix of long-term Treasury bonds with maturity above 20 years.

Generally speaking, TLT is very sensitive to inflation. Thus, its price fluctuates in the opposite direction of long-term bond yields. And although it’s not a perfect inverse match to TNX (above), its share price generally moves in the opposite direction of TNX as a rise in bond prices leads to a decrease in yields and vice-versa.

Currently, TLT is tracing a bullish chart pattern which is the inverse of what is evident in TNX. Both the Accumulation Distribution Indicator (ADI) and On Balance Volume (OBV) are in uptrends, which means short sellers are scarce (ADI) and buyers are outnumbering sellers (OBV). TLT also pays a monthly dividend which varies with rates but over the last 12 months has averaged somewhere near $0.24 per share.

Bonds and Stocks are Betting on a Fed Pause

The banking sector is a risky place. Jamie Dimon, rhe CEO of the largest bank in the U.S., JP Morgan Chase, has sounded the alarm. Mega-investor Warren Buffett agrees. The Fed’s own SLOOS banking survey sounded the alarm back in Q4 2022 before the SVB collapse.

The U.S. Treasury bond market has been an excellent indicator of where the economy may be heading. Currently it’s betting that even if there isn’t a full-blown banking crash, the U.S. economy is heading for a recession. For its part the stock market is starting to perk up.

Of course, there are no guarantees. And yes, there is always something nasty lurking in the shadows.

Yet, based on the current market action, when you put it all together, falling bond yields and steady stock prices paint a picture which suggests the Fed will likely pause its interest rate increases at its May FOMC meeting.

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