The Problem With Fed Cuts Getting Priced in at Warp Speed

The failure of two US regional banks and vapid concerns about Credit Suisse Group (NYSE:CS) completely turned the risk appetite off. The sell-off in banks has led to a high level of market stress. And while spillovers from bank stress have been relatively ringfenced so far, US recession risk has sharply increased due to a lightning-speed reassessment of the FOMC policy path.

Indeed with Fed rate cuts getting priced into the curve at warp speed, the far more immediate and present recession danger occurs when a rapid yield curve steepening occurs after a lengthy inversion. That event usually informs investors it could be time to get out of dodge.

US regional banks are less a story of creditworthiness and more a story of the degradation of forward earnings power. At current levels, one can argue that it's mainly in the price of these stocks. Looking further ahead, however, it's hard not to be concerned about the medium-term availability of bank lending in the real economy. This is a new challenge, and the impulse for financial conditions -- broadly defined in a practical sense -- is likely to worsen.

Small and medium-sized banks play an essential role in the US economy. Banks with less than $250bn in assets account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending.

The macroeconomic impact of a pullback in lending will remain highly uncertain until the extent of the stress on the banking system has run its course. Still, if lending to the real economy dries up, you can almost assuredly pencil in a recession this year in your investment calendar.

As I find myself foolishly daydreaming again, I think of the golf course or Deep Sea fishing in Sarawak, at which point the mind further wanders to what will the Fed be doing this summer -- hiking, pausing, or cutting? I can't remember a point in my multidecade trading career when each scenario carried a reasonable near-term delta.

Given the velocity of the moves in rates the past few weeks, sending an overt recession signal, most folks in the levered community were exceptionally negative on equity risk (anecdotal observation). Still, when taken together with the genuinely stunning drop in front-end yields, there was kindling for the short-term, counter-sentiment rally we saw overnight. I'm not saying this is a recipe for lasting strength --but in a post-pandemic environment, stocks initially tend to do better when Fed cuts get priced in.

In a tactical context, however, equity market price action determines sentiment and narrative. And today, the signal is improving; I will note we are only a fortnight into a new chapter, but as I did write in my morning Asia open note, and unlike some esoteric observations getting picked up, I believe the balance of risks is shifting to the downside. Hence we will look to continue selling ViX volatility on any move higher to fund SPX and DAX puts where the latter screens cheap.