April 2023

Banking on the Fed

A look at recent market action; the banking crisis; the softening economy and the Fed; and opportunities in fixed income.



We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on recent market action; the banking crisis; the softening economy and the Fed; and opportunities in fixed income. We finished with a speed round of questions and a personal reflection.

March was an odd month with a banking crisis and market volatility, yet equities and fixed income were up over the month. What are your takeaways?

March was a good month for markets, but the real surprise to me was general performance during the first quarter.

Going into the quarter, if you were to tell me the Fed would twice raise rates; inflation, while declining, would still be elevated; M2 would continue contracting; the yield curve become more inverted; and we’re going to have the second and third-largest bank failures in our country’s history, I would have expected markets to weaken. Yet, the S&P 500 Index was up 7.5% in the first quarter.

The tech-heavy Russell 1000 Growth Index was up over 14% for the quarter and almost 7% for March. The shift came in the Russell 2000 Value Index, which consists of more traditional businesses. That was down 7% in March, and for the quarter down a little less than 1%. International equities were strong, with the MSCI EAFE up 8.5% for the quarter.

What about fixed income?

Rates have dropped on the 10-Treasury from the high threes at the start of the year to about 3.5% at the end of the first quarter. Since then, they have gone even lower.

The Bloomberg US Aggregate Bond Index (Agg) was up 2.5% in March and 3% for the year. The Bloomberg US Corporate High Yield Bond Index underperformed in March, up 1%, but was up 3.5% for the quarter. On the floating rate side, Credit Suisse Leveraged Loan Index was basically flat in March, but up about 3% for the quarter.

Overall, equities were up 7 to 8%. Fixed income across investment grade, high yield and bank loans were up about 3% over the first quarter. That makes for a pretty strong quarter. Quarterly statements should be positive for most folks.

Why the good performance?

I think a couple things in play here. This risk-on risk-off sentiment month by month is really the market trying to discount the Fed’s positioning.

I think the Fed continues to anchor that they’re going to keep interest rates around 5% in the near-term. Meanwhile, a few months ago, the market was expecting a rate cut in 2023, then pivoted as investors started to buy into the Fed’s language that essentially indicated rates will be kept where they are, which led to markets selling off.

Now, we’re back to a point where markets are expecting the Fed to ease quicker. Meanwhile, the Fed’s rhetoric continues to be, “We’re going to keep rates here.” So right now, there is a disconnect in what the market is expecting and what the Fed is saying. The capital markets are adjusting to a lower discount rate in 2023, despite the Fed’s conviction of holding.

Woes in the banking sector have been in the news quite a bit lately. What do you see happening there?

I think it’s a tough situation for banks given where the Fed is, given where the Treasury curve is, given the rate volatility. When you look through to what they’re facing, you have deposits that are decreasing due to a lack of confidence. You have a situation where the Fed continues to contract M2, and the economy is slowing. The banks are also starting to see more delinquencies in consumer loans.

From a banks perspective, I think the obvious, base decision is to tighten lending. That’s today. As it relates to what happened in March, essentially you had risk-management issues. They extended the balance sheet, which was a book-value balance sheet. And then due to the volatility and significant decline in bond value last year, you had an asset base that, if you mark to market, made some of the banks insolvent. This lack of confidence created a classic “run on the bank.”

Given that, it seems as though the regulators have come in, backed the depositors, haircut debtholders, wiped out the equity holders, and we’ve been getting through it. At this point, and in my opinion, the risk isn’t a banking risk, it is an economic risk as this will result in much tighter liquidity for businesses and consumers.

Given how much the Fed has raised rates over the past year, is the Fed responsible for precipitating this crisis?

I feel like you’d be blaming law enforcement for crimes. Responsibility can certainly be shared, but at the end of the day, the criminal in this case is the risk management of the banks. Again, you can blame to some extent the authorities for not monitoring the banks closely enough, but to assign them responsibility, I think that’s too heavy on authorities. Criminals are still the criminal in this case, but regulators probably should have been heavier handed.

What effect do you see tighter lending from banks having on the economy?

M2 is contracting, so the price of liquidity is increasing. Deposits are down because confidence has been shaken. The economy is slowing and delinquencies are starting to creep up. I have a hard time wondering why a bank would loosen standard in any way at this point in the cycle.

In the near term, you might have lower rates on a capital-market side, but I don’t know if lending rates will drop. In other words, the cost of capital from a bank may still be elevated, and, as a result of that, monetary conditions are tightening much quicker than people think.

Whether it’s a community, regional, super-regional or money-center bank, I don’t know any in that stack that’s going to want to loosen standards given everything we’re seeing. That’s extra pressure on the economy because so much of it is driven by lending and leverage. My take is it slows down the economy quicker and harder than people think.

What about the effect the banking issues are having on Fed policy?

Banking problems weren’t factored into the Fed’s outlook three months ago. The Fed has been raising rates, decreasing the balance sheet, and letting the natural course of the cost of capital play out. This is a new dynamic where you have lending institutions pulling back.

With this added tightener, is the Fed going to be able to incorporate that into their train of thought as quickly as we would like without a hard landing? I don’t know. I would say unlikely though.

Flipping to the other side of things, all the backstopping begs moral hazard. Will that play a role in the near term?

Let’s be honest, moral hazard has been part of the system since the first bailout in 2008. I would say though, to be objective, the folks in the bailout camp have experience. They went through a large bailout 14 years ago. And when you about this month, with the second and third-largest failures, the equity holders were wiped. Debt holders were hit, but the deposits were secured. The federal government was quick to act, and you still had capital markets up. Moral hazard, as much as we’d like to disagree with it, it’s experienced now. There’s a playbook, and they acted quickly.

Is the economy losing its resiliency?

We are seeing confirming data over the past week or two to suggest the economy is slowing quicker than markets thought. GDP Now is adjusting first quarter from a little over 3% to a little over 1%.

What made the economy so difficult to underwrite is despite all the tightening monetary conditions, you had a resilient job market. That has started to crack. The recent revision in unemployment claims was higher by almost 50,000 to 246,000. The four-week average for unemployment claims is moving higher.

When you look through to the Purchase Managers Index (PMI), that was above 50—and above 50 indicates an expansion—since June of 2020, just a couple months after COVID lockdown started. At one point, it hit 60. But it dipped below 50 in November and has continued to go lower. March’s print came at 46. Additionally, inflationary pressures are slowing. Prices being paid are the weakest since mid-2020. Pace of hiring is moderating.

Where does that leave the Fed?

We’ve had a pivot, at least from a market expectation standpoint, over the past month. Where we sit today, Fed futures show a 50/50 chance of a rate hike in May, meaning the market is unsure if there’s another hike on the way. And right now for July, there’s a 40% chance of a cut, a cut is baked in for September, November, AND December.

That is substantially different than two months ago and more dovish than a month ago. Why is that happening? We’re seeing the confirming economic data that we’re expecting a harder landing now than thought last month, which was “no landing ”or “ soft landing.”

The issue is the Fed continues to stay committed to keeping rates here. They have said over and over, we don’t expect to cut in 2023. Again, the market is challenging that. If the Fed holds tight to this, I think risk premium would continue widening.

A big factor as to why the Fed is committed to keeping rates here is their anchoring to a 2% inflation rate. They don’t seem to be coming off it. I believe the normalized inflation rates should probably be elevated given all the money injected in the system. However, if the Fed’s going to stick to 2%, then they’ll probably keep rates elevated for longer than they should, thus resulting in a longer, harder landing.

If the Fed comes off at two, it would give me a little bit of comfort they would begin to loosen. They appear to be very stubborn at this point.

How does all this affect opportunities for fixed income?

In general, yields are down over the past month. The Agg was at close to 4.5%and now is yielding about 4%. The 10-year Treasury is inside of 3.5%, and we started ~4% to begin the year. Investment-grade credit is still yielding over 5%, and the price is around $92. I still believe investment-grade is attractive. If you choose to move in, however, be prepared to take on the rate volatility.

High yield’s at 8.5% from a yield standpoint, with prices around $88. And then you have floating-rate loans, which are yielding over 9%. Prices dropped a little bit, down to a little under $93. I very much like the barbell positioning. You barbell with quality duration, and then you give yourself some immunity from rate volatility with floating rate. I feel comfortable on that side and that to me is where I think sound opportunities are in your coupons are between 5% and 10%.

How do you feel about duration?

I was modestly constructive on it over the past few months, especially when the 10-year Treasury was in the high threes to 4%. Now with the 10-year in the low 3s, the duration trade isn’t as compelling.

Longer-term, I would expect rates to continue grinding lower. the wildcard is if the Fed backs off its language. If they do, you could very well see the curve start to normalize, which may hurt investment grade. Again, it’s why barbelling duration is an interesting play to me.

We’re going to switch to the lightning round. We’ll start with job openings.

Declining quicker than people think.

With the banking crisis, what inning are we in?

I feel like in the short term, we’re in the seventh inning. But if we go into a recession, there could be another wave of problems in a different form

How about what inning are we in with the inflation fight?

With the fight, we punched it pretty hard, and I think inflation is weakening. I’ll say we’re in the late innings but takes a while to bring that thing down.


There are betting odds. Right now, it’s-130 that TikTok will be banned by the end of the year. So that tells you it’s a slight favorite that TikTok ends up getting banned in 2023.

OPEC cuts.

It’s just a reminder OPEC’s the marginal player.

Richard Branson’s Virgin Orbit filing for bankruptcy.

Another cautionary tale of early-stage risk. I’m wondering: Should a company like that have been public in the first place?

Commercial mortgage-backed security defaults.

There’s a lot of stress in that market, especially in the office and retail side. I think the default cycle is going to be elongated because you have different maturities, different lender base, different tenants, regional disparities—all these fragmented things. This should lead to opportunities, but I would expect a bumpy ride.

Structurally, what’s that secular play look like from a retail and office standpoint? Given this uncertainty and cost of liquidity, if you need to refi, that might be a problem. Who wants to come in? What’s the right rate for a retail shopping center or an office building? There’s a lot of price discovery going on for the assets.

Stripe, the payment processor, having a down round of funding.

I thought that was an interesting data point. You had a private company that got valued at around $100 billion dollars—a Silicon Valley unicorn. Stripe did a down round, meaning the recent capital raise was at a lower valuation.

They did a down round with a valuation around $50 billion relative to a valuation that was upwards around $100 billion. In my opinion, that’s a big data point for venture capital, Now, given publicly traded tech is down quite a bit, the marks in private equity to me haven’t been flushed out yet.

Do you have a personal reflection we can end with?

Sure. What’s happened over the past month just reflects change. There are a lot of things in flux right now. With all this items in flux, a quote I recently ran across that addresses this: “The only way to make sense out of change is top lunge into it, move with it, join the dance.”

Embracing change is the key. I think agility, flexibility, all those things are really important right now on a capital market standpoint, economic standpoint, and decision-making standpoint.

Bank loan, corporate securities, and high yield bonds involve risk of default on interest and principal payments or price changes due to changes in credit quality of the borrower, among other risks. This information is presented for informational purposes only. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole investment making decision. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions and are subject to change without notice.