Will the liquidity gloss-over last?

Markets are celebrating central-bank liquidity provisions for banks, recent inflation retreats, and a positive start of the Q1 earnings season: Permission to participate - but not without a grain of salt as the Fed gears up for its next rate hike and recession risks linger on.

Financial system health influences Fed moves

The Fed's next move is closely tied to their assessment of the health of the banking system that recently threatened to disintegrate when a few wobbly lenders were brought down by classic bank runs on deposits.

In fact, another 25-bps rate hike appears to be the most likely next step for the Fed at their meeting in May because the truth is that banks are fine. Firstly, our banking vulnerability indicator¹ reveals that banking vulnerabilities are well below levels before the Global Financial Crisis of 2008/2009 (see chart 1). Secondly, a comprehensive liquidity measure shows that US markets are well supplied with money (see chart 2). While this is good news, this also means central banks can continue tightening the screws and a dovish Fed pivot is not imminent, especially since inflation declines are still unsatisfactory and remain confined to headline levels.

Moreover, banks seem to have little problem to refinance themselves. Even if bank deposit depletion is still ongoing, albeit at a decreasing rate, banks have access to central-bank liquidity in exchange for high-quality securities and the Fed evaluates these securities at face and not at market value. This is beneficial to banks since market values have come under pressure due to policy tightening over recent quarters. Looking at the Fed account reveals, however, that drawing of liquidity is declining indicating falling stress levels in the banking sector.

Banking reaction function as the main risk

When it comes to the banking system, the main risk is not that banks will be plunged into a crisis but rather that they themselves could trigger a credit crunch which could then unleash a recession. This could happen when the effect of higher rates starts flowing through to the economy via the banks as they become more reluctant to hand out loans. Therefore, the future banking reaction function is currently more worrying than banking system health.

Liquidity trumps reality

Despite the high likelihood of more rate hikes, markets are in a celebratory mood, mainly on accounts of high liquidity and the perception that central banks will ultimately act as lenders of last resort when things get tough. Conversely, realities on the ground, such as stubborn core inflation, don’t matter so much - at least not right now. The ongoing reporting season supports the current enthusiasm. It may just have started but has already revealed 7% of positive earnings surprises among S&P500 companies. The caveat is that expectations were quite low to begin with so surprises to the upside benefit from some previously priced in pessimism. By the time we conclude the Q1 earnings season, the picture might well turn out to be more mixed.

Recent optimism has pushed volatility levels down not just in equity but also in bond markets. The shorter ends of yield curves are already pricing in rate cuts in an attempt to anticipate the end of the rate hiking cycle. As a result, inverted yield curves have started to flatten again. If volatility continues to subside this will be good for risky assets as a whole that have been thrown lately by unusually strong movements in rates.

Recession risks loom large however which could lead to a reckoning towards the end of the year which is when we will have to see if liquidity alone will continue to be able to gloss over more gruesome facts. Even if there is no recession, the question is to what extent central banks can cut rates at all especially if inflation refuses to revert back to the ambitious 2% target. A lack of outright rate cuts could confound expectations for ample QE which could lead to renewed volatility in the market. Only time will tell if current market optimism is a sign of reckless complacency or lucid foresight.

Run with it but…

Given the recent optimism, an increase in the equity allocation may make sense to participate in the strong upward movement in markets with the goal of buffering the portfolio with some gains. However, protecting the downside via out-of-the-money options is prudent as risks are still too high for a carte blanche for equities. In bonds, there is not much reason to venture out of the relatively safe place of the front end of the curve as long as inflation is still up and more rate hikes are likely coming down the pipe. Among spread products, high-quality corporates offer a risk premium often more attractive than the one equities have on offer.

Emerging markets are still dragging their feet. Their assets still trade at distressed levels harboring the potential for sizeable gains further down the line. For them to materialize however, China's recovery will play a major role. Recent positive GDP numbers for Q1 give reason to hope but it may take some time until their positive effects trickle down to market performance which will benefit other emerging economies. Ultimately, if developed markets are hit by a recession, emerging markets are likely to suffer too.

The US dollar offers a good overall portfolio hedge as the economy oscillates between hard and soft landing probabilities. In a negative scenario, the dollar is set to gain as investors will flock to safety. In the mid to long term however, the picture is more mixed since the Fed has more room to cut rates than other central banks like the ECB which will exert downward pressure on the currency.

1. Our banking vulnerability indicator includes the following figures: domestic-credit-to-GDP ratio, M2-Multiplier, our Wave business cycle model, real deposit rate, lending-to-deposit rate, tier-1 risk-weighted capital ratio, return on equity and assets and non-performing loans.