This morning I read the transcript of an interesting interview with a senior JP Morgan bond official. The basic issue was how the bank ended up being so wrong last year about the direction of money policy, and therefore the course of both the fixed income and stock markets.
The answer I read–although not necessarily what JPM said–is that the Fed typically (always?) keeps money policy too restrictive (basically, interest rates too high) for too long as it drains the economy of extra stimulus applied earlier to soften the blow from a potential major calamity, in this case, the pandemic. The Fed was on course to do so again this time around when cracks began to appear in the capital structure of medium-sized banks in 2023.
The poster child for this phenomenon was Silicon Valley Bank, whose head sat on the board of the San Francisco Fed, but which had made the T-Ball-level blunder of investing tons of depositor money in long-dated Treasuries when interest rates were close to zero, without maintaining hedges against the inevitable losses that would be caused by a return to normal, i.e., by higher rates. That made the bank itself a huge bet on short-term rates remaining near zero. (I have no idea how this could happen; my guess is that the bank was at first properly hedged but later sold the hedges to make quarterly earnings look better. That would be sort of like the Titanic deliberately crashing into the iceberg because they’d run out of ice cubes for passengers’ drinks. Still, something that dumb had to have happened).
Anyway, the fact that the fissures occurred in the banking system made them immediately visible and fixable in a very focused way. Had they happened elsewhere, the Fed would have kept on tightening, as usual, until recession was inevitable. So in a sense SVB may have saved the wider economy from a downturn.
As for 2024, JPM thinks that, the Fed having achieved a “soft landing,” short rates will fall considerably this year and the 10-year Treasury will decline from the current 4%-ish to ~3.5%-3.75%.
Sounds plausible to me.
Three implications for the stock market if this is right:
–earnings will be better than the consensus thought late last year
–in the simple way I look at things, a 4% yield on the 10-year is sort of like a 25x multiple on stock market earnings; a 3.5% yield is like a 28.5x multiple. So the JPM view on rates suggests that mild multiple expansion for the US stock market this year is possible, in addition to whatever gains unanticipated earnings strength may bring
–there’s also a chance that declining short rates will cause a chunk of the large amount of money now in CDs or money market funds to end up in stocks (or to be spent in ways that create further positive earnings surprises).
None of this is game-changing, as they say. But together they suggest at a minimum that there’s more downside protection for stocks than I think the consensus .