Dominos Keep Falling in the Banking Sector

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

1:35Will a regional bank carnage create systemic stress? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is George Goncalves, head of U.S. macro strategy at MUFG. Hi, George. How are you? Hi, Maggie. I'm great. You know, we're going to have to stop meeting like this because every time you have me on, it's like there's a crisis brewing somewhere. So true. It's so true. And this is one that I know that you've been worried about and we have talked about. But of course, now we're really seeing things accelerate. We have U.S. regional banks under severe pressure again. One day after Fed Chair Jay Powell reassured everybody that the system was sound and resilient and tried to sort of downplay any trouble, seemingly ignoring what's going on, although we can discuss that.

2:22I think he was trying to maybe calm nerves of the general public. But in any case, it's sort of extraordinary to see what's happening, specifically when you look at things like PacWest and Western Alliance. We see some of the ugly charts, hopefully, up on the screen. So, you know, what is your assessment? What's happening here? So, like, we're, you know, I still think in the early innings of investors trying to discern, you know, the liquidity have and have nots. We've seen for the last basically year or so a transformation in the banking system, largely because the price of money went up. So rates are higher, creating a competition for the banking system going towards the money markets.

3:02And all that through the RRP, which is another tool the Fed has out there. And just in general, the quantitative tightening and the shrinking of the Fed's balance sheet after a time where the banking system had gotten accustomed to a lot of liquidity. So this kind of like about face and the aggressiveness of the Fed's policy of both like easing way too much and then now tightening too much is causing the banking system to really suffer some whiplash. So, but, you know, we've heard people say this. Well, it's not a solvency problem this time around, like it was in 08. It's something else. Is that accurate?

3:38And what's, is it just a confidence issue? Look, I think there's a little bit of both going on here. For one, yes, when you talk about the treasury holdings and the mortgage holdings, at some point those are going to pay out over time. The question really is where they've been marked. But then there's also the fact that these institutions, by and large, also offer out credit. And if we are at a point where the economic cycles turning down, and I think it is, we move from the rate story to the credit story, which I think that's starting to get factored into. So it's not just the fact that, yes, there's been a lot of bond holdings that are underwater, and therefore, if you had to crystallize those losses, most banks would be suffering a hit to capital.

4:26I mean, that goes without saying, but that's not the way the system works. So I think there's a combination of concerns around where the bond market or the bonds of these individual banks are being marked at. But it's probably bigger than that. I think if this were to continue, it's the market shifting from not just rate concerns, but also the credit that's embedded in all the loans that were done in the last couple of years. Yeah, I think that's an important point, George, because we look at some of the banks and they're under pressure. Clearly, the market investors are moving on and trying to identify the ones they feel are the weakest right now.

5:01But we have people in the chat saying, well, it doesn't seem that bad. KRE is only down 5%. We don't want to be alarmist. We just want to try to get a sense of what's going on. So it seems a day after the Fed chair says everything's fine to see these kind of losses seems to be problematic. Is it an issue that could turn into something systemic? Should we be looking at the KRE and not individual banks. Kind of give me on the scale of how serious this is, how we should be thinking about this. Well, look, it's serious when any sort of bank failures take place at any level, at any time in history.

5:41So I think it is a serious issue that we're dealing with. And it's still early days and how it's going to be all resolved. The way that the first few bank failures went through and then the way the most recent one went through. They're learning on the go, they meaning the policymakers on how to prescribe some sort of solution to this. But at the same time, though, if banks that are under concern, I mean, who's going to provide them new capital? If the capital has to come from some version of government support, then private investors are just not going to step up. And I think that's really the issue here, that potentially there's been an unintended consequence by the precedents that have been put in place with the last few failures, that who's going to step up and buy the banks when you can kind of wait for them to get even cheaper?

6:31Yeah, exactly. This is what one of our viewers, no one knows thyself, is saying, I always trip over your handle. Did the Fed inadvertently create a moral hazard by letting FRQ's equity get wiped out and then JPM comes in to buy the bank's assets? This would give short sellers no incentive to cover any regional shorts? It does complicate the situation. And I think then on top of that, you had to think news that short bans are not going to be allowed either. So I don't know how this gets resolved other than just through the passage of time and investors really figured out where there is value within the banking system.

7:12This is a very impatient market. This is a market that now knows where the liquidity shortfalls are. and even if deposits don't continue to fly out, now we're moving towards the economic macro implications that will hurt banks over the course of the next three to six months, if not sooner. So I think this is definitely a pressing matter and I still think it's early innings until we get a better solution from either the government or some sort of coordination with the Fed. So this is an FDIC Fed thing at some point where they're going to have to come, and the Treasury. There was during the savings and loan crisis, a resolution trust corporation, but there was the need to kind of provide support to a lot of the small banks.

7:56We'll see how it goes. So they'd have to come up with an entity to kind of manage this is what you're saying. I mean, ultimately at some point, like who's going to provide capital is the main question that we're looking at. Or the Fed has to cut rates two to 300 basis points in the next six months. They might end up doing that. Which is what the markets kind of, at least if they're not anticipating, they're hedging that possibility, right? But will it be fast enough to cure the assets that are underwater and they've lost value? That's the dilemma. So if it's all about having capital in the system that will prevent sort of these kind of bank walks turning into bank runs, as some people are calling it, or actually banks not even getting the capital they need and seeing investors fleeing on the equity side, But you might need a TARP version where the banks get injected with government-preferred type capital.

8:50And no one likes to hear that because it doesn't sound like the right thing to do. I mean, or like the capitalist thing to do, but it is the right thing to do if you really truly want to stem this from getting worse. Is there a line in the sand for you? What are you looking at that would start to concern you that this thing is systemic? Because all we had is everyone say it's regional. They're going to you're going to have failures. They're going to come in. They're going to work it out. But it just doesn't seem like that's what's happening. It seems like it's accelerating. Where's the line that you start to get concerned that this becomes systemic?

9:26I mean, I think once you get into the top 15, top 10 banks, that they start to really get under more pressure. if there is forced selling to make up, to actually shore up some of the balance sheets. When you start to see the forced selling, that's worse, especially on the asset side of these banks. So I'm not sure if we're there yet. Hopefully we don't get there, but this is a work in progress. And it's also, is this limited to the US or is this something we need to worry about globally? We saw the ECB hike rates again today, although smaller than they had been doing, but they're also still hiking.

10:03I mean, I think eventually we're going to find out and learn soon enough that the whole system has been set to a low rate environment. And although central banks are trying to fight the inflation war, you know, if you trigger a recession, you're going to clearly kill the recession war, especially if you end up impairing the banks along the way. So I think it is a global problem, not just a U.S. problem. It starts in the U.S. because we did the most tightening and the quickest. And we also are seeing the Fed's balance sheet shrinking. ECB is trying to do this for the first time as well. They're doing QT for the first time.

10:37ECB has swung rates around over 300 basis points. Their banking system is also dependent on low rates and their overall economy as well. So it will, I think at some point, also make its play overseas. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

11:02do you think the fed is okay with this level of what appears to be consolidation in the u.s banking sector is this something they want is this they do they just see this as inevitable or is there a concern i don't think they are trying to engineer anything i mean i think there's always people are trying to speculate on what the intent is but i think this you know they're sticking to the monetary policy side of why they did what they've done up until now. But now I do think that they've paused at this last meeting and they're going to have to start to tinker with how to manage the financial side of it and the banking side.

11:39A lot of the Fed's liquidity is locked up in the reverse repo program. And that liquidity could get released back into to support the bond market if the Fed were to tinker on it and also cut rates. So this is largely still coming back to how the Fed ends up engineering what they want to get later on from a monetary side. I don't think they're trying to change the composition of the U.S. system. I want to talk about the economy and the Fed and some of the effects perhaps that are going to be felt in the real economy. But there is a chart you send over that I think is really important and really clear, and you kind of put the hospital room analogy on it.

12:22And in your summary, regional banks aren't the only ones on the ropes, right? You list who's in the infirmary and who's in the ER. This is a long and disturbing list, George. It really is. Unfortunately, I mean, it's almost like a pecking order that I've been using for the last two years, and it's basically worked its way through. And now we're at this, the firewall aspect, which is the banks, but feeding into the banks will be what happens with commercial real estate. This is where the whole credit channel probably becomes for a large swath of the U.S. banking system. So that still is in the ER.

12:58I don't think we've seen that really get really marked to market. And there's a lot more of that ahead. And that could further exacerbate the issues with the banks themselves. And so that's a big one. The corporate profit recession one is, I think, also front and center. I mean, although earnings, we've had a tendency to be beating earnings, which have been managed lower, by the way, for the last three or four quarters while we've been going into this slowdown. I think now, you know, Q2, Q3, given the credit availability, credit conditions tightening as much as they've had, and just in general, the economy is looking like it's going into that recession that everyone's been kind of calling for.

13:39I think this is where the profit recession kicks in. But it's also this kind of a perverse reality where, you know, although we're seeing layoffs on the job side, there's a decent amount of labor hoarding because we spent, we meaning corporate America, has spent so much time hiring back people, they're reluctant to let them go. And so you're going to see profit margins compress as everyone's in a kind of stalemate. Is this really a bad recession or not? And I think the profit recession that's coming to the equity market coupled with what's happening here with the banking system is what's going to finally see investors relent and you finally get that final last drawdown in the markets.

14:20And for those who may be driving or walking and listening to this audio only, I just want to read through the emergency room and the infirmary room. So the emergency rooms, the folks, you know, it's flashing red. I mean, this isn't these are areas where there's a big amount of strain. Commercial real estate, corporate profits. You mentioned both of those passive ETF redemptions, private equity, credit reprice deals, pensions, insurance, all asset risk. That's emergency room. And in the infirmary, crypto, high beta, SPACs, U.S. housing activity REITs, historic bond market losses, regional banking sector, consumer finance, autos, etc.

14:59As I said, this covers a lot of areas. This sounds like it's negative for everything, for the economy and for bonds and stocks. So for credit bonds, I think we're now at the point where the buying the dip on, and it has been happening for really the last four months in the treasury market, where there is, people are going to be defensive, they're going to hide in duration. I mean, I haven't even listed some of the more near-term risks like the debt ceiling, which is a whole other topic. But in terms of financial risks that are out there, this would be the sequence of events. And we've already seen those five basically go into the infirmary, and they're not looking like they're going to come out anytime soon.

15:44And they're really dependent on Fed liquidity and the price of money. And those things aren't changing until the Fed actually changes its tune. And so far, we haven't heard that from the Fed. And they're going to try to hold the line as long as possible. We have the bond market now pricing in cuts in July, probably a little bit too soon. Wow. This is a fast market. We're now at the year-to-date lows for the five-year rate. So we've basically gotten the rates market to now accept that this is probably going to be a negative outlook over the second half of the year into early 2024. Other asset classes, especially credit and equities, are still disconnected.

16:21So a big reprice has to come. it's the only way

16:29do you see that happening what's your time frame for that because it feels like things are moving rapidly yeah well I mean you need like catalysts right so that's why I think the earnings season over the course of the summer as we get Q2 what happens with the debt ceiling what happens with European banks and overall liquidity that they're going to be rolling off through the LTROs from the ECB. So, you know, and also just in general, the summer is where a time where people rethink their investment strategies after a pretty, again, another tough year where we're really not going anywhere. And if you get to a point where it looks like there's going to be a liquidity draining event combined with this uncertainty that lingers, then I think people throw in the towel September, October.

17:21I mean, you can never time these things perfectly. Who knows exactly when? But to suggest that the October low was the final low, I think that's given a lot of people a false sense of confidence. And I think that's going to come back to haunt a lot of investors. And I think then finally, we'll get that flush out, which will create the conditions for the Fed to ease. Ultimately, we're trying to figure out a way, is inflation under control enough so the Fed can I think it will be. And then if we get into a recession, that will ensure that we don't get inflation flaring back up again. And the Fed can cut rates 200 to 300 basis points over the course of the next year.

17:56But they can't do it until they actually have a catalyst. And so we're kind of stalemate. So that's so interesting. We have a big monthly jobs number coming out. The data has been mixed, right? It hasn't been falling off a cliff. And in fact, in some cases, it's turned up. You've seen a little bit some of the price components and things, running a little hot again, or at least above expectations. They're still lower from peak, sure, but they don't seem to be rapidly moving south, which is what you need for the Fed.

18:27When would we see them substantially turn that it would finally get the Fed's attention? And what do you expect from the jobs number tomorrow? I mean, look, the jobs number, it's anyone's guess, to be honest. At this point, considering how the calibration of these models and just where we are in the business cycle. It could be consistent with the underlying growth trend of 125 ,000, 150 ,000 jobs. It could be 250 ,000, 300. I don't think anyone really knows. It's going to be really hard. It's more about what's leading to that sort of job creation. Are they part-time job workers, full-time workers?

19:03What's going on with the average work week, which has been decelerating, multiple job holders? That sort of second layer underneath the surface in the jobs market is what matters now if we truly are heading into a slowdown. But even today's Challenger Gray survey, you know, the fourth month in a row of job losses and counting, that typically only happens at the precipice or in the recession. So we're either there or getting very close to it. And all the other indicators, although they're mixed, but they're the backward-looking indicators. So all the forward-looking indicators, you know, the six-month change on the cumulative continuing claims, all the LEIs, all the PMIs regionally.

19:43We might have a little bit of a stagflation feel because prices paid her up, but I wouldn't view that as a sense of strength, if anything that's concerning. So I think that we're there. If we're not in a recession by September, October, then we're never going to really be in one, and we're probably just going to bounce along the bottom. But I do think given this sort of credit crunch that we're going through, You're seeing it in the freight transportation data. Real-time indicators are showing the economy is decelerating pretty fast. So it should show up over the course of Q2 into the summer. We're going to take another quick break to hear a word from our partners.

20:18We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

20:26One of the – in your report that you sent over, there was a line that really jumped out at me, and it said a leveraged financial system cannot afford high rates. Does that mean the Fed's forced to ease? They have to? I mean, it comes down to what's going on with financial conditions. That's why this bank story is so critical. So at some point, yes, I mean, there might have to be forced to ease because if the scenario that I'm envisioning takes hold and you get equity markets finally realizing that we're not going to see earnings upticking in Q3 and Q4, and in fact, they're going to be flat to lower, and you've got to get the final flush on risk assets coupled with the stress in the banking system, which doesn't go away overnight, then yes, they're going to have to ease.

21:18Edward is asking, are you bullish or bearish the long end of the curve? I mean, I'm much more looking for steepeners. I think the curve should be steepening. because if the Fed were to change policy here, and at the same time, there's going to be a lot more issuance if we do go into an economic slowdown. The government, like it or not, we've kind of opened up the can after COVID with fiscal stimulus. So fiscal stabilizers will come back in and the government's going to have to issue more debt. And so you're going to see more overall long-term debt and that's going to require a premium out the curve.

21:55So I'd be much more favorable on the front end of the curve as well as the steepeners. What do you think happens to the dollar in this environment? The dollar in this environment most likely has weaker, but you have these episodes where it comes down to the risk-off scenario. So it depends on how fast the risk-off scenario is. If it's a kind of flash in the pan, and we get there and you flush out those that were expecting a kind of a soft landing, which is still out there, then maybe that dollar rally would be short-lived. and it's not even worth being set up for it because what will follow will be a weaker dollar as they're adding more stimulus to the system.

22:35Someone asking, G asking, if we cut rates and especially by as much as the market's anticipating, then doesn't inflation come back? Then what? Yeah, so what I'm going to see here, if you look at this chart, kind of comparing the current experience over the last five, 10 years of inflation relative to the late 60s through the early 80s inflation cycles. And you had like two to three big waves of inflation. The first wave, I argue, we've already gone through it. And this is when the Fed says they want to avoid repeating the mistakes of the 1970s. It's largely this situation where you ease too much and then you reflare inflation.

23:17You get a second wave of inflation. So right now we're turning the corner. So inflation is turning lower. So the solid red line is the actual data. The dotted red line is my projections of where I think inflation is heading over the course of the next 12 to 18 months. Then we get to this kind of trough, and it's going to come down to, like, does the Fed hold the line? At some point, they're going to have to not go to zero again and do QE. This is where the markets will be disappointed. So initially, if they cut rates and if they stop QT, because they probably would have to at some point, then you might get a relief rally in the markets.

23:53But then the idea that they're going to turn on QE, they're not turning on QE again unless it gets really, really bad. So we're basically then from that point forward, we're going to be operating to pure fundamentals of what is the growth capability of the U.S. economy. and the Fed's going to try to have to modulate inflation. It's not going to be easy. Yeah, it seems like we've been joking and the only thing that keeps coming in our minds is between a rock and a hard place. It just seems that that is where the Fed finds themselves. John asking, George, if banks are not buying bonds and sovereigns are not buying bonds, and who buys all the new issuance from the U.S.

24:32government? Well, I mean, there's a large real money set And they're obviously buying bonds. And there's a lot of other investors, not just those few. And foreign investors have been coming into the data. We can see that in some of the publicly available data. So there's always a buyer at the right price. And this is now no longer about the supply-demand issues of the U.S. government. It's about the flight to quality, flight to safety. So when that happens, that overwhelms any concerns about who's buying our debt. It's what you park where there's safety, which is really, again, still just the treasury market.