Private Parts

Go Big or Go Home: Investors this morning are pricing in a 65% chance of the Fed going 50 basis points at their next meeting.  This reflects a consensus that the market would be in trouble if the Fed does not move by that amount. However, it’s hard to envision the Fed moving that much, given they’ve been so adamant about controlling inflation and conveying that they have the situation under control. A shift in monetary policy of that magnitude would signal that they are behind the curve, which would likely cause more disruption than actually being a little behind the curve. We go more into this view below, but we think a 25-basis point cut is much more in keeping with a steady market for now.

Private Credit Casts a Long Shadow

Bank regulators were thrilled. The emergence of massive private credit funds displaced a sizable portion of banks’ lending exposure and solved the mismatch problems banks have struggled with when funding long-term loans with their short-term deposits.

However, that solution came with costs. These unregulated financial intermediaries are large enough to own the entire debt structure of a company. That means the credit exposure of the firms they have leant capital to are locked away for their full maturity, and the private credit firms have no incentive to disclose losses in any of these investments. The assets of private credit firms are estimated conservatively at a staggering $1.5 trillion, and the industry comprises a handful of firms operating under similar investment horizons, processes, and profit incentives. Because this closed circle of credit funds looks at the world through the same lens, there is a significant risk that an unforeseen risk can hit all their portfolio companies at once.

Global investors cannot value the risk of the private credit market because there is no information regarding how levered these portfolio companies are, whether they are using fixed or variable rate debt, the term of that debt, nor what their interest coverage is. As we have mentioned in prior weeks, Pave’s models are flagging the importance of having sufficient working capital in publicly traded equities that we analyze. We can position away from any problematic publicly traded firm because we have the tools to analyze the information. It is not possible to value these illiquid instruments and incorporate them into a general risk measure. Investors will only become aware of the risks once they become visible; by then, it will be too late.

This change in the capital markets means that any general business downturn will be more severe and more prolonged. For now, it is clear sailing…until it isn’t.

The Case for 25

The chatter in the Wall Street Journal and the Financial Times last week left the question open that the Fed may still cut a full 50 basis points after the Federal Open Market Committee (FOMC) meeting on September 18. These articles surprised us because we are in the blackout period when Fed speakers are not allowed to make comments to the press. There must have been some aspect of the inflation data that was released during the blackout period that may have pushed some FOMC members toward a more aggressive cut. We are unsure about a move of 50 basis points for three reasons:

·        There was evidence that housing inflation has remained high despite the Fed’s hope that it would have fallen by now.

·        The future path of interest rates will be released in the Summary of Economic Projections (SEP) at the same time as the interest rate announcement. They can go 25 and still convey a strong commitment to ease rates in the future without a dramatic 50 basis point cut before the election. 

·        Historically, the FOMC tends to kick off an easing campaign with a 25-basis point cut (aside from a major crisis). Recent SEP forecasts point to three 25-basis point cuts at each remaining meeting this year.

The market consensus calls for the Fed to cut rates by 100 to 125 basis points by December. We fear that the market will be disappointed.

If the September SEP contains a core PCE forecast that falls from their most recent 2.8% yearend core inflation forecast to 2.6% (2.6% is the level of the last three core PCE reports), a nominal funds rate forecast of 4.6% makes sense. That breaks down to a 2.0% real Fed funds rate plus 2.6% inflation and works out to three 25-basis point cuts in September, November, and December. We are assuming a baseline 2% real rate because that is the lowest of any 2024 SEP forecasts over the past year. That would fall short of investor expectations and spark a selloff.

The bullish outcome producing an extended stock rally would be a Fed inflation forecast of 2.4% and five 25-basis point rate cuts to arrive at a 4.1% funds forecast that equates to a 1.75% real rate. Keep in mind that would be an aggressive drop from the 2.30% June SEP real funds rate forecast, but it would not be unprecedented.

Presidential Politics Make the Shutdown Showdown Real

The clock is ticking. With Trump in the mix, the market’s assumption that the $1.6 trillion Continuing Resolution spending bill will get passed before the September 30 deadline may be too hopeful. Speaker Mike Johnson must contend with right-wing budget hard-liners who do not want to extend spending that they believe is already too high. He will also try to accommodate former President Trump’s desire to couple the stopgap spending bill with one requiring proof of U.S. citizenship when registering to vote. Those obstacles, plus Democratic opposition, caused Johnson to pull his scheduled vote on the $1.6 trillion spending proposal last Wednesday.

In the past, Johnson cobbled a bipartisan package together between the mainstream factions in both parties. His job normally would be helped by the desire to avoid a government shutdown this close to the election. However, Trump is ordering members of his party to shut down the government unless they receive election security assurances.

The House will need to speed any proposal to a vote and get it in a condition that the controlling Democrats will approve in the Senate in exactly two weeks. Both the White House and Senate Democrats are opposed to tougher voter ID requirements at the polls. Balancing Trump, budget conservatives, military hawks who want increased defense spending, and the Democrat's aversion to the voting bill seems an impossible task.

At least for now, the Treasury believes Johnson can pull it off; balances in the Treasury General Account have not been moving higher. Yellen would be adding to these reserves if she were worried about paying Federal obligations through a shutdown. We are watching those balances daily. At some point, the reality of political brinksmanship will weigh on the markets.

What to Look for This Week

1. The circus comes to town this week: Wednesday, September 18 at 2;15 p.m. E.D.T. the FOMC rate decision is released along with September’s Summary of Economic Projections, followed by Chair Powell’s press conference at 2:30 p.m.

2. Advance Retail Sales Tuesday, September 17 at 8:30 a.m. E.D.T. is not normally a market mover. However, with the split sentiment between 25 and 50 basis points for the September meeting, if the September Retail Sales print deviates from its recent tight 6-month range, it could impact the tone of the two-day FOMC meeting that starts Tuesday.

3. Wednesday, September 18 at 8:30 a.m. E.D.T August Housing Starts and Building Permits. July Housing Starts made a multi-year low and Permits have declined steadily this year. At 7:00 a.m. E.D.T. the Mortgage Banker Association Weekly Activity, Purchases, and Refinance Indices. The drop in mortgage rates has pushed the Activity and Purchases series gradually higher over the last three weeks, but refinancing activity has been static.

Also, on Thursday night, the Bank of Japan Monetary Policy Statement is expected to be unchanged.