Surely Powell knows this?

Here’s a question that’s confusing me.

Why are bond markets so much more volatile than equity markets?

Taking the 2-year US Treasury bond as an example, it has been all over the shop in the past few weeks.

I mention the 2-year bond as it’s a decent proxy for where the market thinks the Fed funds rate is headed.

It hit a high of 5.07% on 8 March, just before SVB went down the gurgler.

By 14 March, it had plunged to 3.94%. That’s the biggest move in history, or since the 1987 crash, depending on your source.

The next day it surged to a high of 4.41%, before plunging later the same day to a low of 3.74%.

On 16 March, it jumped back to a high of 4.25%. By 20 March it was back to a low of 3.64%.

On 22 March, just before the Fed meeting, it was back up to 4.26%. After the Fed meeting, it was back down below 3.90%.

Clearly, the bond market is very uncertain.

Why is the equity market not in the same boat? Is this a sign of bullish resilience, or blind ignorance?

I suspect it’s the latter.

To explain, let’s visualise the bond market volatility with a look at the MOVE index. This is like the VIX index, only for bonds.

On 15 March, it surged to the highest level since the November 2008 panic.

What’s interesting is that the S&P500 didn’t plunge. Usually, the MOVE and the S&P500 are decently inversely correlated. Those peaks you see prior to the recent spike all correlated with short term lows in the stock market.

This is because rising bond market volatility is bad for liquidity. It has to do with increased margin requirements when posting collateral.

Less liquidity = lower stock prices.

So why didn’t the S&P500 fall to new lows, as the MOVE surged to new highs?

This is NOT QE

Perhaps it had something to do with the Fed offsetting this liquidity squeeze by opening up its discount window and the new Bank Term Funding Program (BTFP)? This saw the provision of $300 billion in emergency funding in a week.

This expansion of the balance sheet led to cries of ‘QE is back!’ Stocks predictably surged.

While the Fed did step in to provide liquidity, it’s not the same as QE.

In this instance, the Fed is providing short term liquidity (for up to a year) in return for collateral and is charging between 4.75% and 5.25% to do so. The lending rate on the BTFP is currently 4.88%.

For smaller banks suffering from deposit withdrawals, than can access liquidity at the Fed without having to sell assets at a loss. And they can get par value (100 cents in the dollar) on the collateral they post for these loans.

But 4.88% is a very high cost to pay for a depositor who is bailing on you anyway.

This isn’t ‘free money’. Perhaps I’m naïve to think that tapping the Fed’s discount window and BTFP will only be done by those who need to satisfy flighty depositors.

But that’s what it looks like. And that being the case, its not exactly QE-like fuel to propel the stock market higher.

But stocks don’t seem interested in this nuance.

Then there was the reaction to the Fed’s latest decision to raise the Fed Funds rate to between 4.75-5%.

Having rallied into the decision, US stocks sold off into the close. Although the selling came on the back of Janet Yellen’s comments about there being no plans to provide blanket deposit insurance. As a result, 98% of stocks in the S&P500 finished down for the day. Every stock in the Dow Industrials finished down too.

The S&P500 Real Estate index was the worst performer by sector, down 3.65%, followed by the financials, down 2.32%.

With credit expected to tighten in the US economy in the months ahead (as banks tighten lending standards), many see commercial real estate as the next shoe to drop. If so, the pressure on many bank balance sheets will persist for some time.

Keep in mind that bank credit growth for the month of February was just 1.5% (annualised). What does a slowdown from that look like?

Not good, that’s what.

Judging from Powell’s comments this week, he’s not focused on what’s coming down the road. For him, it’s all about inflation and employment, lagging indicators that will only turn once the recession is all but underway.

The bond market sees this. That’s why it fell across the board on Thursday.

The bond market is saying the Fed is too tight. The Fed is saying it doesn’t care.

The equity market, on the other hand, is living a kind of Ground Hog Day. Every day it wakes up hopeful of a Fed pivot.

Powell just told it – again – that’s not going to happen.

But old habits die hard. Since 2008, equity investors have grown used to the Fed’s sugar. It’s just how markets work, right?

Surely he knows...

Perhaps this is Powell’s ultimate goal here? To end the ‘Fed put’.

Surely he knows inflation and employment are not forward looking indicators.

Surely he knows that bank credit growth is (the lifeblood of the economy) is at stall speed and likely to fall further in the months ahead?

Surely he knows that billions in low interest rates loans are due to roll over this year at much higher rates, causing more pain?

Assuming he does know this, it’s clear he wants to reset the economy, and financial markets, from its addiction to zero percent interest rates. Failing banks is just the first sign of this.

If this is the case, expect more pain to come. And as everyone knows, pain in the US economy and financial markets means pain in Australia.

Having said that, there are still opportunities in equities. It’s a market of stocks, not a stock market. Consider bond proxies like gold (and gold miners) and even beaten up tech plays. In general, be patient, and be selective. Look for good value. There is plenty around.

Avoid the hype and hot money, that’s where the big risks are. Although based on recent action in lithium stocks, the hot money is out the door.

Buy on panics, sell on excessive hope and optimism. Because although I lean towards the bearish side, at the extremes the bears (and the bulls) are probably both wrong.

One last thought to leave you with…

Surely Powell knows there’s an election next year? Good luck trying to play tough when you have bank lobbyists AND the White House bearing down on you.

If the bears do win the arm wrestle this year, make sure you take the other side of the bet. You want to be positioned for a recovery in 2024.

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