Did OPEC+ Just Make the Fed's Job Harder?

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1:24And now to the top analysis of today's markets.

1:33Did OPEC just make the Fed's job harder? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Mustafa Chowdhury, Chief Rate Strategist at MicroHive. Hi, Mustafa. How are you? Very well, Maggie. Thanks for having me on your show. We're thrilled to have you. And welcome to the Daily Briefing. It's the first time you've been on with us. So before we jump in, why don't you just tell us a little bit about the area that you focus on? Yes, good question to start with. I focus on rates. I have a background in rates, either rates business and both rates business and rates research for last 30 years at various roles.

2:20at Deutsche Bank. I was head of rates research at Voyager Investments, ING, former ING, where I was also head of rates. So rates is what I focus, which basically means the interest rates, yield curve, vol, swaps, swap options, all of that. Oh, it's a good day to have you on because there's not been too much happening in that part of the universe. It has been, we've been seeing moves and things happening to the yield curve that are really unprecedented, as many of our guests have talked about. So we're lucky for us that we have you here today. So if you, by the way, obviously everyone knows the drill.

3:03We're going to take questions. So go ahead and put them in the chat and we'll get to as many as we can. But just keep in mind that Mustafa's area is rate. So hold off on any of those real specific questions about equities, I think, for this time. Let's concentrate and lean into his expertise. So we did have the markets today really reacting, all markets reacting to that surprise OPEC plus production cut. Oil prices jumped 6%. Stocks were mixed. Energy shares up at the NASDAQ down. But I'm really curious about what this will mean for the Fed and for interest rates. I think it doesn't directly mean much for Fed's decision.

3:45The next question of next meeting in May, whether it will be another 25 base point hike or not, maybe a little bit of an input there, but directly, but indirectly, it means a lot. I think if you look at the oil prices since the beginning of this year, it's fluctuated between$73 and$80 in a very tight range. And this banking crisis a few weeks ago suddenly threw this, pushed this oil price out of this range and all the way down to 66. And I think that OPEC plus pretty much responding to that, probably it's a response to the credit tightening that they anticipate because of the banking crisis that has started.

4:35And so they just preempted the slowdown in the economy by cutting some of the supply so that they can get back to the rent. I don't know whether that's what they're thinking, but that's what it feels like. So if Fed's taking all this information, it should take it as a cue that there is a potential for economy to slow down. Yeah, like maybe another forward indicator, which is really interesting because I think people are laying a lot of geopolitical tensions on it and all super important. And we will, of course, be digging into all of that in coming days with the U.S. relationship with Saudi Arabia, etc.

5:13But if OPEC, their job is forecasting demand and they're looking out and saying, hang on a second, why do we have a situation where we're hearing about – so there's the demand side, but then there's the inflation side, right? And we started with that question at the top because Bullard's coming out and saying, oh, this makes our job harder. And what about that inflation? Are we going to have high inflation? Banks are calling for oil to go back to$100 again. Do you think officials and market participants are paying too much attention to the inflation side? Will that start to come down as demand as we see the economy slow?

5:53Well, inflation seems like not going down as fast as anybody anticipated. If you look at just the core inflation, which excludes the energy prices and food prices, We're still lingering at way above 4%, and no one expects it to be closer to 3 % by 2025. Even Fed's governors, that UFMC members in their speeches, some of them are calling for 3%, some thinking 3.5%, 3.25%. So inflation is expected to be high for a while. And that's mostly because the shelter cost in the economy is still pretty high. And we know that that lags. So what is your position? What are you expecting from the Fed? I think that Fed will most probably will do a 25 basis point in the next bidding, and then they will try to communicate that they are sort of done.

7:09But it's a market pricing about 50-50 chance of a May hike. And so there is a, and I am kind of comfortable with that view also, that it's, there is a good chance that it may not happen. Because it's not about, inflation is a big problem, but the banking, the issues that's going on in the banking sector is also a very large, actually looming very large, in my opinion. And there are lots of pieces, moving pieces in inflation. So it all depends on the Fed's resolve about inflation fighting versus giving in to the banking situation. Yeah, which is, I mean, this is the dilemma, isn't it? So interestingly, we had last week, I spoke to Luke Roman, who is very concerned that the banking stress we've seen is actually just a symptom of a much bigger problem.

8:12Let's have a listen to a clip from that, and then we'll talk on the other side. I would describe this as a U.S. balance of payments crisis disguised as a bank crisis. And so really what the issue is, is there is a shortage of aggregate global balance sheet capacity, private sector balance sheet capacity relative to the deficits that the United States government is running. And so we have seen really the kickoff to this crisis that we've been sort of detailing in real time for almost a decade now started in the third quarter of 2014, when for the first time in 50 plus years, foreign central banks stopped growing their holdings of U.S.

9:00Treasury bonds. They stopped sterilizing U.S. deficits as their FX reserves. And it was a pivotal, a pivotal, epical moment in macro that not a lot of people notice that specific. But we've all been spending the next decade, spending a lot of our lives trying to diagnose, position for, react to the symptoms and outcomes of this.

9:28And that full interview is available on our website. I encourage everyone to have a listen to it. If you are not a member, scan that QR code and find out how you can sign up. We've got free trials and such going on. So Mustafa, I keep coming back to that every time I'm listening to people talk about us getting over it and putting Silicon Valley behind us. Are you concerned that there is a larger systemic risk here? Yes, he's making really a key point. On the one hand, the government balance sheet is really, really large. Just look at the coupon that Federal Reserve have to pay to the banking system and also for the reverse repo program, a couple of hundred billion, maybe more.

10:16as just the interest on excess reserves, interest on the repo. So that payment has, so that's costly for the government. The government, also the U.S. government, the Treasury has to, the interest expense is approaching trillion dollars a year. So governments is leading up to a point where it's more and more difficult to handle the debt, the higher interest rate. And if Fed keeps raising interest rate, that makes it more costly to sustain this massive government balance sheet. But it definitely reflects on the banking system as well. Yeah, so we started with the giant issue, But I think it's really important because I hear every day, and this concerns me, I hear pundits on television saying it's over, it's taken care of.

11:23And that just makes me really nervous that it's giving people a false sense of calm when there are some problems. So we started with the big issue of the balance of payments. And as Luke says, it's a U.S. Treasury market problem. But when we look at the banks, because I know you've been looking at this carefully, what's happening with the banking system itself? So first of all, everybody's like, okay, they put that lending program in, the BTFP, that bank lending emergency program, and that's going to be what's needed. Can that work for everyone? I mean, does the banking system still have shoes to drop here?

12:05Yes. it's definitely not over yet I think it's just the beginning what we saw in the two banks that just just recently collapsed in they had some unique issues themselves however they also had problems that are problems for the banking system as well that's not gone away So what Fed has done with these two banks is that they dealt with the immediate liquidity issue in the system, any kind of systemic risk, by creating this new facility where banks can come and borrow using underwater collateral and get$100 back. So it gives them peace of mind and then guaranteed the uninsured deposits for these two specific banks, but hasn't expanded for the rest of the banking system.

13:10In fact, the Treasury Secretary, one day she said it is available for everyone, then she retracted because they figured out that it's not a simple task. and they didn't really guarantee. And I don't think there is a clear guarantee that all banks would be... would be... the uninsured deposits would be... guaranteed in case of larger number, larger banks and larger institutions collapse. And I think that... But that is not the main problem. The main problem is the balance sheets of the banks... the mark-to-market value has declined a lot. And when the market analysts and the whole world talks about the U.S.

14:01bank's mark-to-market problem, they talk about the mark-to-market issues of the securities in their balance sheet, the health-to-maturity securities and the available-for-salec securities. But banks have 12 trillion plus of whole loans. They have direct whole loan mortgages. They have credit cards. They have car loans. They have commercial mortgage max securities. And not only do they have credit risk, which seems like less than it used to be, but they have pieces there that has credit risk, especially in the office commercial real estate. But that aside, there is a massive amount of interest rate risk also in the loan portfolio that no one's yet talking about.

14:56So, but - Okay, that's, let me stop you there because I think that's very important. And you're looking at this in a way that most of us aren't. So first of all, let me just back up for a second so we all understand you. When you say people are focusing on the mark to market for their longer duration, they're talking about what had happened with Silicon Valley Bank, right? Just that if they need to sell money because they're having a deposit run, sorry, if they need to sell those treasuries, if they held them to maturity, they'd be fine. But having to sell them now because of what we've seen happen with treasuries, they're taking a loss.

15:27That's the part that everyone's focused on. What is this other interest rate risk that you see that's not getting enough attention? Similar to the securities, there is an equivalent or much bigger actually, the loan portfolio where these are not securities. These are just direct loans to various various industries a big part of that is just mortgage loans but not mortgage-backed securities so then they and then of course the real estate commercial real estate loans they have credit cards they have auto loans these are these we don't talk much about the duration of these loans so is it because people will default well not because it will default but eventually as the funding cost creeps higher and higher because deposits are slowly bleeding out of the banking system, maybe it will speed up.

16:32It will probably speed up a lot if Fed hikes even more because the alternative to the depositors will be higher and higher. They will have, you can eat into the securities losses and then the loan, you may have to, the market value of the loans will come into the picture. I'll give you one example how that will come into the picture. Fed does a stress test for the American, the larger, a decent set of larger American banks, including some mid-sized banks. And this stress test is basically give the banks a very difficult scenario and then puts the bank's balance sheets and income statement through those difficult scenarios.

17:26And then the test tells how long the bank survives and the Fed gives a pass or fail every year. So going into the hiking scenario, Fed never gave a upgrade scenario to the banking system in the U.S. So all the stress test scenarios that were given to the banking system were credit scenarios and also declines in rates, widening of credit spreads, etc. but not a scenario where what we actually observed in the last one year, which is the front-end interest rates goes up from zero to 5%, and the long-end goes up to 4 % or even higher. So that scenario, which is a reality of today, banks were not tested.

18:26So Fed's now talking about handing out that particular scenario middle of this year, right now to the GC banks, the large, systematically important banks. But I think that highly likely that they will end up expanding to the others. So the moment banks put their balance sheet through those tests, they will have to put their loans as well through those tests, not just the securities. So suddenly, they may not find themselves as capitalized as they thought they were. Some of them may not pass the upgrade stress test. So these are ways that the mark-to-market decline, the implied value decline due to higher interest rates, not just of the securities, but also the loans, will matter a lot for the banks.

19:31So every decision that the management makes, there is the accounting capital according to the accounting definition, and then the capital according to the stress test that was already given to them. But then there is an implied true capital, which depends on what the real true value of the balance sheet is. And just saying that, oh, eventually I'll get my power value back 10 years later doesn't help you in various decision-making processes. So decision across the banking system will slow down because everyone's going to be busy working on that. So what are the implications of that? The first one is that we will see way more credit contraction from the banking system than anyone is expecting because they would be busy fixing their balance sheet.

20:36So that's one. I think also that they not only that they will be busy fixing their balance sheet and they would probably there will probably be gradually reducing some of the balance sheet by not a desperate selling or not a not the Silicon Valley type situation. but there would still be gradual selling by the banking institution reduction in the balance sheet. Because no matter what, if you are mark-to-market working on a minuscule capital or a small amount of capital, and I'm not talking about a big, big four guys, I'm talking about the rest of the banking universe, then your true leverage is higher.

21:22every decision you make as a senior management has a much bigger implication, despite what you think your accounting capital is. So we will see more selling of duration that provide the banking system over time. And that's going to keep pushing the yields higher in the long end of the curve. So that's one that we will see. so eventually we might see this whole inversion of the curve suddenly reverse itself so that's so interesting so that is so let's just put that off to the side for a minute because that's going to be upward pressure on rates at a time when presumably if they're contracting credit that the economy is slowing down

22:17right? So that's not great for the economy if rates are going up. Usually you would see the Fed trying to cut rates in order to, but they'd be cutting on the shorter end, I guess. So what does the yield curve look like in that kind of situation? I think that we will see. So this is the long end about the risk premium, about the financial institutions having difficulty hanging on to a lot of bonds on their balance sheet. All of this would have upward pressure in yield in the belly of the curve, in the longer end of the curve. Front end, the two-year, one-year, the euro dollar, that's just the three-month, six-month, one-year, would have many other different dynamics, which we kind of saw in this front-end drama in the last few weeks.

23:10we got the we got a major increase in the the the euro dollar or the three month rate and six month rates after the payroll date january payroll data and then suddenly the silicon value news came and we have a more than 100 basis point decline in the two-year rate on overnight on a dime just shows the front end is a very is going to be very volatile because there are lots of different kinds of positions on the front end that would be driven by Fed expectations and errors in Fed expectations. But the long end could just be drifting higher as the banking system, not just the banking system, across the universe of various types of holders of treasuries and mortgages selling it, keeping five years, 10 years under pressure.

24:09So William asking where on the curve to buy long, intermediate, or short, and when for each?

24:20In general, so let's put it a different way. William, I don't know that we, as we always say, we don't know what your risk profile is, and we're not sure what anyone's, we can't individually address people's concerns. But what would your expectation be? You talked about volatility on the short end. There are some people who are saying, listen, the Fed's backed into a corner for all the reasons you just explained. They're going to start cutting rates. They might do it really aggressively, really soon, sooner than the market thinks. I'd be buying bonds. But it sounds like the duration question is more complicated for you.

24:57So directionally, just what do you see happening on the long, intermediate, or short side? So if they end up cutting rates, and cutting rates while inflation is still pretty robust, so that means they're giving up on the inflation front, which is kind of scary because they would either be targeting a higher inflation rate, not just 2 % inflation that they have been telling us for a while. So that's not a good thing because we have a long-term sort of inflation sort of getting higher inflation more permanent. So that's one possibility. Or if the Fed's cutting in the middle of a while poor inflation is closer to 4%, then we're talking about stagflation.

25:53Yeah, we have some questions about that. What's your probability of speculation? Either of those scenarios are not good. I think if the value of the curve, I do, if I feel like, if I think of buying at the value of the curve, I would probably buy inflation indexed bonds where I get some benefit from recession because the real rates then declines. But at the same time, I get quite a bit of carry from just the higher inflation that gets baked in to the yield curve. We have a question, which is interesting. So we keep saying, will the Fed cut? Will they hike? Will they go beyond May? Someone asking, why wouldn't the Fed just pause and wait to see what happens with inflation?

26:39Do they have the wiggle room to do that? From everything you talked about, it sounds like they've got to start easing. It sounds like they are kind of boxed in, as Luke lays out. They definitely are boxed in. The market is telling us that they will ease eight eases in the rest of this year and 2024. If I just follow the market, just watch what's implied by the market. That's eight 25 basis point eases. And right now, if you look at the Fed speak and if I look at the data, it doesn't it doesn't seem like Fed wants to do that. That would be completely opposite of what they're saying. So they would like to, if they can, not do anything for the next six months and wait and watch what happens.

27:37So the problem with that scenario, that would be the Fed's ideal scenario, actually. So thanks for that question. But will they be able to pull off that ideal scenario? Because the biggest problem with inflation is that it gets ingrained into people's mind. And the longer it stays at this higher level, then it becomes more permanent. And that's something that Fed absolutely doesn't want. So we could have a 1970s type scenario where they hike and then they ease a little bit and then they have to hike a lot later on. So that's the fear Fed will have is sit and wait. That's the idea of scenarios.

28:25Not everything's fine. Economy slows down. Soft landing. But what if they have to start hiking three months down the line even more? So that's the risk. Do you have a view of what's going to happen to the economy? I myself think that we'll have a hard landing, especially now that we have the banks join in tightening credit. It's not just the Fed. And so the combined effort of the two big players of the economy will drive it to a hard landing. That's what I think. So what do you think happens to the 10-year? Because we have these two forces, right? We've got this concern that the Fed's going to have to ease.

29:12But you're talking about banks having to slowly sell some of the stuff on their balance sheets of all kinds of different. What do you think happens to the 10-year? I think that the scenario that's most likely in my mind is that we will see a scenario where what we call R-star or equilibrium interest rate would be permanently higher in the 10-year sector. so and if we stopped hiking which it feels like even either now or after the next meeting then we kind of kind of accepted at a higher inflation level and both of them that suggests that we would have long rate higher from this scenario in the 10 year so 10 year the level of inversion that we are seeing right now would start to correct itself, we could get a 5-plus percent 10-year rate.

30:22Let's say 4.5-ish percent 10-year rate, we can easily get there. So that's what I think we will have. So that's kind of a weak economy, higher inflation, and higher 10-year rate. And it sounds like when you say weak economy, is it weaker for longer? Because if those rates are kind of permanently higher on the 10-year, There's an awful lot of people who are going to reset on any kind of loans they have and have to deal with that. I mean, I'm already, you know, anecdotally, we already know people who have to, you know, if their lease is up on their car, it's$200 more a month than it was just when they, you know, first took it out a couple years ago.

31:00Is that just going to be a weight on the economy? I think it's going to be weaker or longer. One of the reasons that the labor market has been so tight and tighter than anyone's expectation was clearly there was some additional job openings, but there was also a large number of people left the labor market and just decided not to look for jobs during the pandemic. And that's like close to 4 million people. And they're not coming back. And so there was this imbalance between both the demand and supply for the labor. And that imbalance kept the shortage of workers. And then that imbalance pushed wages to stay robust.

31:52But Fed's just looking at inflation. Fed just looking at the relationship between wage inflation and goods inflation. And so Fed has no choice but to drive the economy slower. So I think it's going to be, will be here for a while. I also think that the slowdown, the quantitative tightening, will also have an effect on keeping a permanent slowdown. We were so used to a zero interest rate world. We really don't know what's a viable business and what's a business that's just surviving because of zero interest rate. That's exactly right. So as we are now at the 5%, then we'll test who survives and who doesn't.