Is A Credit Event Coming?

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1:09Is a credit event coming? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Dr. Sree Kumar, president of Sree Kumar Global Strategies. Hi, Sree. Welcome back to the Daily Briefing. Good to be back with you, Maggie. And as always, on a perfect day, we love talking to you on Fed Day. And we had the Federal Reserve Policy Committee announce that it is leaving its benchmark rate unchanged. changed that opened the door for a stock market rally. We saw a pretty decent gains across the board. NASDAQ, the best performer of about 1.6%, S &P up, S &P 500 up a percent, Dow up more than a half a percent.

1:46And even the Russell, which was down earlier, that was a laggard all day that managed to pop into positive territory at the very end. We saw the VIX come down 7 % and the treasury yields hanging the two-year below 5%, the 10-year hanging around 4.77. So when we look at, and then of course we have the press conference. So not only do we have the decision, but we had Jay Powell taking questions from journalists and reporters. What did you make of both the decision and some of what we heard from Powell, Sri? Maggie, the decision was not in doubt. It's been widely talked about that there will not be a change in the interest rate.

2:23And the Federal Open Markets Committee came out with the same kind of a decision. So no surprise on that count. The big news was how was Jerome Powell, Fed Chair, how was he going to thread the needle? How was he going to explain what was going on? And there, he had to be very careful. If he said, we are going to increase interest rates in the future, then he may undo the positive impact he is creating for the economy. He might then cause something to break very quickly in the system. And then, of course, the game is over. You have to start something new. On the other hand, if he assures the market there is not going to be any further increase in interest rates, we are off to the races.

3:09We have 1 ,000, 2 ,000 point gain in the Dow Jones in a couple of days. And that makes the Fed's job that much more difficult in the future in bringing inflation down to target. So he had to avoid both extremes. And I think he worked in a way that he thought he was going right in between the two areas. But as you described and as we found from the market, Maggie, the yields came down massively, the equities are surging. So essentially, this was taken as a dovish statement. It has taken that even though he said a future rate increase is possible, I think most market participants believe that this is it.

3:51There is going to be no further increase in interest rates. The question is only going to be how long do we stay here and when does the cut in interest rate begin? And this has really been the battle he's had the entire time, isn't it, Sri? Everyone's been looking for that pivot, no matter how much they talk about higher for longer and try to create this hawkish pause, which he did again today. Right. Because he talked about the fact that inflation is still too high, that the economy is stronger than anybody expected. Why? Where's the disconnect between the market and the Fed? What's what's happening?

4:27Is the market seeing something in the economy that the Fed's not willing to admit yet? Or is the market just rushing again too quickly to that pivot scenario? Those are great questions. And I'm going to answer you in two parts. The problems are, one, you said the market is constantly looking for Powell to pivot. Where does that come from? Because he has had a history of pivoting. It began first in December of 2018. And in a very famous statement, he said after increasing rates a lot in the first year he was as chairman, 2018, he said he was going to increase interest rates further in 2019. It was a pretty bold statement to come at year end.

5:11The markets crashed in the final 10 to 14 days of 2018. So very early in January, he came out and he said he's going to be very careful on rate hikes. And actually, he cut rates many times. That was the first pivot. Second, he and Secretary Janet Yellen have repeatedly said the banking system is very sound. But then we had March. We had three regional banks which failed. And if you look at what happened to quantitative tightening, it was abruptly given up. And in 15 days, they switched to quantitative easing. And the Federal Reserve assets went back to November 2022 levels. In other words, five months' work of QT had been removed in a matter of two weeks.

5:59That was a second pivot. And third, he has been talking about inflation being transitory. And that explained why he doubled the balance sheet of the Federal Reserve, why he kept interest rates very low. And then when suddenly inflation perked up in 2022, he just said, huh, it was unexpected. And we are going to adjust to it as quickly as we can, never recognizing the mistakes that the Fed made and the Treasury made in causing inflation rate to be that high and to be persistent. Those are the reasons why the credibility is so low, Maggie. And that's why the market doesn't believe it. And that's why even though he said interest rate increases are not over, we may increase interest rates again, the market shoots up.

6:53Yeah, that's a great, there's a really, really great point, Sri. And I think this is when, you know, the Federal Reserve's independent, but its ability to sort of speak the truth to these things, it's a little more complicated than that, isn't it? So it's not always going to talk about it maybe as bluntly as they should. So where are we? So we maybe can't trust what he's saying. Where are we with the economy and inflation? We just, just as we were coming to air, Gunnlack said, rates are going to come down. because there's going to be a recession. And of course, he's pretty widely followed. That's at odds with what Jay Powell just tried to say, to your point.

7:34So what do you see happening in the economy and inflation? Are those strong readings we're seeing right now rear view mirror? If there is a recession, Maggie, two things are going to happen. Short-term interest rate, namely the federal funds rate is going to come down, which is a Fed-managed interest rate. And the long-dated yields on the 10-year and the 30-year, they are also going to come down. So I think I would agree with Jeffrey that if that happened, you are going to have a reduction in yield as well as the short-term interest rates taking place due to the recession. But I would add one more thing.

8:14If you do have something breaking within the system, a large institution that fails, that would immediately cause both sets of interest rates come down, even if you don't yet see signs of a recession. And what do I mean by that? Just take a look at history. We had that in 1998 with the failure of a Greenwich Connecticut-based hedge fund called Long-Term Capital Management. The managers of it, the Nobel Prize winners who ran the fund, said it was essentially a risk-free arbitrage fund, but it failed. And the Fed came to the rescue and the liquidity was provided because they could not deal with it.

8:58We saw what happened when Lehman Brothers failed. This was supposed to be a small company which did not have any global implications. So you had this Treasury Secretary, Hank Paulson, Chairman Ben Bernanke decide it's OK to let this company go bankrupt. Then they found out, oops, they were wrong. So they turned the spigots on again and went to zero interest rates, massive quantitative easing from which we are still suffering. And that's what happened. So in other words, interest rates are going to come down further if something breaks in the system, even before you see signs of a recession. So you have two very different factors which can cause it.

9:44Yeah, I think that's really important. I want to talk about that a little more. But this is something that Raoul and Julian sat down for their monthly macro insider talk. And listening to you talk about that, it's something that Raoul was sort of touching on as well. He was talking about the bond volatility that we've been seeing. Let's have a listen to that, and then we'll talk on the other side. You know, it feels like the economic cycle is still slow, and that will come up in the data. It feels like there's too many bonds being issued, and that continues to come up in the daily price data of bonds.

10:15and until that stops it creates a problem and that creates the ongoing problem for the banks i mean if you look at the um the um bkx it's it's horrible right but that's created a very interesting dynamic as the lower the banks go the higher gold and crypto goes so the market is starting to say there needs to be some optionality of the outcomes of this so if bond yields go up banks go down crypto and gold goes up which is really interesting that's a kind of change that we started seeing from last summer um and it seems to be playing out so i'm watching that very closely watching how struggling the banks are now ral and julian have that chat once a month and you can find the entire thing on our website app.realvision.com and we always have viewers say they agree on some things they very much disagree on others and really digging into why they disagree.

11:10We always have people in the comments say that's where so much value is found. You can really sort of understand and test it again with what your framework is. If you are watching or listening on YouTube, you are missing the full experience and knowledge head over, jump on a trial and join our community. And if you don't get access to those macro insider, you might want to level up and do that. So Sri, I think this is really important. Let's First of all, let's talk about banking. So Raoul's concerned about it. Again, we hear over and over, as you mentioned, officials say, hey, it's fine. Not fine, but it's manageable.

11:45They created that facility in order to help with that. It seemed to smooth things over. Are you concerned that there are still problems that we need to be watching in the banking sector, or does that facility sort of take care of it? The facility that Jerome Powell and the Federal Reserve created after March, essentially bailed out the banking system. But that is not to say, as Secretary Yellen has repeatedly said, that the banking system is sound. If the banking system is sound, it does not need a bailout. The fact that they needed one shows that it was not sound. Second, look at the extent of bank assets which were underwater, which was what caused the deposits to flee and the banks to fail in March.

12:34Since then, the 10-year and 30-year yields have increased substantially. And when you take that into account, these banks are in more trouble today than they were in March. Finally, when you look at the deposits with the U.S. banking system, they went down sharply in the first half of March when the crisis took place. They still have not come back to the original level. We are still close to the floor level going there. And if you have anything like one more crisis, you're going to see the deposit number dip again further. And if that happens, you have a recurrence of the banking crisis. So I think Raul's discussion is very much timely.

13:20And I believe that that is something that is not something the Fed and the Treasury have got over at all. 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.

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14:40Is it fair to ask, do you think we get a recession first and that's what brings interest rates down or the Fed rate down? Or do we have a credit event first because the economy inflation just remained too hot and the Fed's got to hold rates at this level? Because it seems like a recession is more manageable. A credit event seems like it'd be a lot more painful, sloppier, a lot more fallout. You're absolutely correct. And first, let me support your point as to why the recession call is easier to manage. The last recession, which was a really bad one, so much so we called it a great recession, began in December of 2007.

15:25But in the first half of 2008, oil prices continued to surge in global markets, hit close to$150 a barrel by May, June of 2008. So much so that European Central Bank increased interest rates, increased, Maggie, in early July of 2008, thinking inflation is the big problem. So you can easily miss the beginnings of a recession, and you can take steps eventually to try to bring it down if you don't have a credit even. But recall that there the recession began first, December 2007. The credit even caused by the Lehman Brothers' failure happened later, in September 2008. Indeed, this time, the economy appears to be a lot stronger than it was in 2007.

16:18So I'm going to bet that the sequence is going to be reversed. You have a credit event first, and the recession follows. If you have a credit event take place, all of this employment growth and the economy growing rapidly is going to vanish overnight. and you cannot have a large institutional failure and the economy is still doing well. So the recession is going to be almost automatically to follow after that. So that's a really, really important point, I think, because you are talking about in a recession scenario, it can be more gradual. I'm not going to say soft landing, but you can have a sort of shallower recession that comes, that's manageable, that ultimately moves the Fed to take some sort of action.

17:10But it can all be it can all be quite manageable. You'll see the signs coming and they'll be in a credit event we've seen. And J &J said, oh, my gosh, I came in late. And the first words I heard were Lehman Brothers. We're not suggesting that will happen. But we know from experience last time that when you have a credit event, it's rapid. You have market conditions deteriorate rapidly. And it's only going to speed up with technology. We saw that with Silicon Valley Bank. Things can unravel extremely quickly. And then there are knock-on repercussions. You've got a wildfire you're trying to put out instead of a small controlled burn that you can manage with the team on hand.

17:55So that's a very, very important point. And it's not to say, I think if I understand you correctly, Sri, it's not to say that a recession wasn't already unfolding. It may be that the recession has started or the signs are starting. It's just that that credit event is more obvious first. So you've kind of got that to deal with, that to reckon with, even if the economy was sliding to weaken. It'll just make it that much worse, that much more quickly. That's exactly right. Again, looking back to the most recent experience we have had with recession, nobody thought that December 2007 was the beginning of the recession.

18:33Everything seemed to be hunky-dory. October 2007, just a couple of months prior to that, the S &P 500 hit a record high. And so people said, we are in a boom. This is two months before the recession began. So recessions are often very difficult to date, very difficult to time. And when it happens, it happens as a surprise. But as you said, a credit event is something which is quantifiable that happens suddenly. And a credit event is massive in scope. And you do not know where the tentacles lead to. Recall Lehman Brothers of 2008. The reason why the bailout had to be that massive was because nobody knew exactly which institutions were connected with Lehman Brothers and what kind of a relationship they had in terms of various arrangements.

19:30So they said, well, let's throw in a lot of liquidity because we simply don't know where to throw the liquidity to. We are going to make it massive and generally overall across the system. And that's why a credit even causes a shift in policy, which is a lot more direct compared with a recession, which, as you said, can be short life. It can be a soft one. And if that were the case, then the Fed has more options to go easy. But not with a credit even, it does not. Yeah, that's another great point. And JJ, that's why we were speaking about Lehman, because that entire episode really underscored the complexity of the global financial system and the tentacles of counter party risk.

20:16That's what no one could see coming when they decide to let something fail. So unlikely that there's an appetite to try to do that again because of that. And that situation's probably only increased. I mean, there are a lot more. James has a great question because obviously there's a lot more regulations that were put in place to try to prevent investment banks from being the thing that causes the credit event or at least, you know, HQ of what's going badly. So James is asking, is the thing that breaks likely to be the bond market this time around? I'm going to paraphrase James and assume you mean some people talking about a sovereign bond crisis this time.

20:58If so, will it be the long-end yields rising too high, and how high is too high? Great question by James. My answer would be that, in fact, the last time I can think of interest rates remaining high and causing a sovereign debt crisis across the world was probably 1998. We have not had that happen since. We have had individual countries which have had difficulty, whether it was Brazil or Mexico, or more recently, lower income countries, Sri Lanka, Pakistan, they have had issues as well. But you have not had something that would have systemic implications. So I don't think that is where it is going to come from.

21:47Where is the credit even going to emanate from? Now, my candidate still is the U.S. banking system due to much higher bond yields. And Secretary Yellen said very recently again, she thinks the bond yields being high is a sign of strong economic growth in the United States. I disagree strongly. If that were the case, the increase in yield would have happened a long time ago. Why did it happen just in the last three to four weeks that you had high yields? Did the market just realize that the U.S. economy is going strong? Obviously not. Then go back to Jerome Powell speaking at the Economic Club of New York on October 19th.

22:35When asked in the Q &A period why bond yields were high, he said it was because the term premium was high. He might as well have said the bond yield is high because bond yield is high, because the term premium is not measurable. And if you say it is because of the term premium, you have to explain why the term premium is high, which, of course, he did not. He cannot. He has no answer to that. So these are all the problems we face. And therefore, I see the bond market creating a problem. Going back to James's question, but not because of a sovereign debt issue, but U.S. banking system is still very weak.

23:17There are more losses today than in last March. So we are going to see what that does. Second, that's going to cause also a problem in the commercial real estate sector, which is already in a bad way. But I don't think you reach the bottom of the CRE crisis, or at least the worst of the crisis, till about the middle of 2024. So you have a few more months to run where things get bad. People continue to work at home. They do not want office space, which is as much as pre-COVID. Second, on top of that, interest rates have to be renegotiated at a much higher pace. So that, again, puts pressure on real estate developers.

23:59So this is not a story which is ending. It's going to keep going further. And then a cash crunch on it. If you have the bank regulators come down hard on the banking system, it is going to cause the banks to reduce lending just when the borrowers need it. That's going to worsen the recession. It is going to cause a credit crunch. So you can have several issues. And finally, I won't set aside a repeat of what we saw in the United Kingdom. In September, October of 2022, Liz Truss, the short live administration of the prime minister, she increased. She essentially gave tax cuts at a time when they were trying to fight inflation.

24:46bond yield surged, guilt, as they are known in the UK, the guilt yield shot up and the UK pension funds lost a lot of money and the Bank of England overnight switched over from quantitative tightening to quantitative easing. So that is one more credit event that you can anticipate. I couldn't tell you which one of them is going to happen. These are my top four candidates. Yeah, and worth reminding that we are heading into election year. So the idea of a politician promising to spend and cut taxes in order to appeal to voters is not something that we should dismiss as a distinct possibility here in the U.S.

25:27We're going to take another quick break 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.

25:39so ash bennington hi ash who's in the chat says and we all agree with this always great to have the opportunity to benefit from dr shrie kumar's decades of market experience and we got a lot of replies and here here's to that um ash i think that answers your question about where shrie thinks the next credit event might take place ash is asking does a pause in the hiking cycle limit or mitigate, to some extent, that credit event risk? Ash, I wish I could tell you that, yes, it would limit it. But this is a result of you've had the interest rates go from zero to five and a half percent from March 2022 to today.

26:21And that cannot be offset by not increasing interest rates for two or three meetings. The impact of that is going to be felt. It is going to go through very slowly across the system. So I think the damage of higher interest rates has already been done. Now, the question is, why did the Fed have to increase interest rates so sharply? And the answer is, they were reacting to the fact that they had had an unduly expansionary policy in 2020 and 2021. One, recall that we had$900 billion of fiscal stimulus in the final months of the Trump administration, another$1.9 trillion in the Biden administration.

27:10And Jerome Powell and his colleagues believed as if this was a great gift time, everybody, we are going to throw cash out of the system. And despite the fiscal stimulus being there, the balance sheet of the Federal Reserve would doubled from the beginning of 20 to the beginning of 2022. They were all the reasons why inflation went up. Those are they set the stage for a credit even to follow two or three years later. And you cannot offset it by just not increasing interest rates for two or three months because there is so much excess in the system. And now, of course, there is war funding, whether it is Russia, Ukraine, or the Middle East.