The markets gave up a little ground this week although ended on a high note. The highlight this week was the FOMC announcement which, in typical fashion, was more ambiguous than one might desire. By now you probably know the Federal Reserve raised rates an additional 0.25% putting the Fed Funds rate between 5.00-5.25%. While that was widely expected, the big question remains what now? Investors were looking for the Fed to declare an end to interest rate hikes but the Fed minutes and Jerome Powell’s announcement leave the door open for further tightening. The market temporarily sold off on the news but has recovered on better-than-expected economic data. At this point, the markets remain in a tight trading range and will likely remain there until a catalyst comes along. What that may be is anyone’s guess but it is reasonable to think the debt ceiling might just be that catalyst. My second guess would be the acceleration of tightening credit and lending.
Let’s start with the interest rate hike. Despite the Fed leaving the door open for another rate hike, it seems more probable that they will pause at their next meeting in June. After all, it has raised rates for ten consecutive meetings going back fifteen months. As most recognize, the effects of the rate hikes are lagging and will play catch-up for some months to come. In fact, amid renewed concerns about the health of regional banks, traders priced in a likelihood of three rate cuts by the end of 2023. While I don’t believe this will be the case, I cannot rule out the possibility of one rate cut later this year or early next year. The wildcard is the regional banks that continue to struggle due to the mismanagement of their liabilities.
While we believed we were out of the woods after SVB and Signature Bank were bailed out, it is now clear that there are other banks that may be in trouble. First Republic, which I mentioned last week was in distress, was acquired this past weekend by JPMorgan. This week there were rumors about Western Alliance Bancorp whose stock fell 50% but looks to close only slightly down and PacWest Bancorp whose stock fell 65% but looks to close higher for the week. I am a firm believer of the adage “where there’s smoke there’s fire,” and wonder what is really going on with these financial institutions. One thing is clear and that is that we are not out of the woods regarding regional banks.
Along those lines, there is a new belief emerging on the recent rout in smaller banks that manipulation is playing a big part in this issue. U.S. federal and state officials are considering whether market manipulation has prompted the recent volatility in banking shares, according to Reuters. Short-sellers raked in $380 million in profits on Thursday alone from betting against regional banks. As I highlighted above, PacWest and Western Alliance plunged 51% and 39% respectively, as investors grew nervous about the possibility of a stockholder wipeout – like the ones that followed the collapse of Silicon Valley Bank, Signature Bank, and First Republic. White House Press Secretary Karine Jean-Pierre said the administration is closely monitoring the developments, including the short-selling pressures.
Lastly, we turn to the debt ceiling which is approaching quickly. Goldman Sachs pointed out this week that there is very little time on the legislative calendar to reach a deal. The House is scheduled to be in recess this week and again starting May 26, while the Senate recesses the week of May 22, returning May 29. This leaves only two weeks when both chambers are in session before early June. If negotiations stall or simply run out of time, a near-term deal could lead Congress to consider a short-term extension. If deemed necessary, the most likely new deadline would be late July, which coincides with the long August recess, or late September which is the end of the fiscal year coinciding with the FY2024 budget. Either way, until a deal is reached, the potential for a government shutdown cannot be ruled out. As I said, this could be the next catalyst for the market.
In closing, I turn to a question that is popping up more and more these days. Is the debt ceiling even constitutional? The Biden Administration is exploring the constitutionality of the ceiling as the U.S. inches closer to a default. While President Biden has repeatedly said it is the job of Congress to raise the ceiling, what happens if a compromise cannot be reached? One such theory, which would surely expose the government to lawsuits, would see the new debt continue to be issued under the 14th Amendment, which maintains that the “validity of the public debt of the United States… shall not be questioned.” Lawyers at the White House, Treasury, and Department of Justice have never issued a formal opinion on the matter, but expect the backlash to be immense if the option was used. There’s still time for a resolution but time is running short. Now you know.Bruce J. Mason, MBA