“Well, I’ve wrestled with reality for 35 years, Doctor, and I’m happy to state I finally won out over it.”

^{-Elwood P. Dowd in the play/film Harvey}

Last quarter, we discussed the challenges facing the Fed as they attempted to pursue their dual mandate to achieve stable price levels and full employment (“if you chase two rabbits, both will escape”). At year end, the Fed appeared determined to chase the inflation rabbit and that the higher rates needed to slow inflation to the Fed’s 2.0% target would lead to an economic slowdown and market swoon by mid-year.

However, while the Fed was dealing with their two known rabbits, a giant, six foot three and a half inch rabbit appeared that was too big to ignore despite the fact it was invisible (to bank regulators at least). That rabbit, of course, was not the movie rabbit, Harvey, but financial instability in the form of a good old bank run. It seems that the Fed’s abrupt rate increases after a long period of zero rates left the country’s banks in a precarious position…the cheap deposits they traditionally relied upon for financing faced competition from T-bills and money market funds, while higher interest rates caused losses on their longer-term investments. The banks, of course, tried to overcome the reality of these losses by classifying them as “hold-to-maturity” assets (but that’s a story for another day).

Faced with serious issues if the bank runs continued, the Fed and Treasury decided to pursue financial stability by effectively guaranteeing all deposits at systemically important institutions and implementing a new Bank Term Funding Program to help banks shore up their finances in the event of further deposit flight. Somewhat fortuitously, troubles at the banks also reduced some of the Fed’s inflation angst since reduced bank lending and tighter credit standards should reinforce the Fed’s actions to cool the economy and inflation. As a result, longer-term interest rates fell and growth stocks rallied.

There is still a healthy debate regarding the potential depth and duration of the long-anticipated recession (if there is going to be one). However, for now the bond market appears to be more concerned than the equity market. Regarding the latter, 2023 operating earnings expectations for the S&P 500 have only come down 3-4% since the beginning of the year, while PE ratios have increased by 10-11%. Investors may be breathing a sigh of relief in the short-term, but we doubt that the Fed has finally won out over the realities of the business cycle and the long-term implications of interest rate repression.

Treasury Yields Fell Sharply on Concerns Over Health of the Banking System…..

Treasury Yields Moved Higher on Evolving Monetary Policy Expectations……

Treasuries Reversed December Weakness, Rallied to Start Year.