To The Moon

Market risk-on mode returned last week, mainly due to two factors: one is the easing of liquidity crisis in the banking industry, which may have reduced the probability of financial risks and thus calmed down the market; The other is that US PCE inflation performed better than expected (which is also one of the core indicators most concerned by the Federal Reserve), confirming the "inflation easing" previously priced in by the market. Boston Fed President Collins said that lower PCE inflation is welcome news.

United States PCE Price Index Annual Change

Although there have been some scattered incidents in various industries, the bulls in the US stock market are more active due to being in the 23Q1 financial report season and the vacuum period before other important economic data releases. In addition, the yield of 2-year US Treasury bonds has dropped from over 5% in mid-March to less than 4%, and the spread with the 10-year bond yield has also begun to narrow and remain stable.

US 10Y and 2Y yield

The market estimates that the probability of the Federal Reserve raising interest rates in June has returned to over 50%.

So why can the market interpret recent events so optimistically?

Firstly, the outbreak of problems in the banking industry has actually accelerated the process of entering a credit tightening cycle. Under pressure from deposit outflows and falling asset prices, banks' liabilities will also tighten accordingly, which will weaken demand for credit in economic activity. This will inevitably reduce current inflationary pressures.

Secondly, short-term liquidity tools provided by the Federal Reserve will not become a second round of "water injection". From the Federal Reserve's balance sheet perspective, the amount of liquidity discount window provided in the short term also decreased last week while its asset shrinkage is still ongoing.

Feds Balance Sheets

Thirdly, in terms of monetary policy, the Federal Reserve is currently still cautious. It has largely restrained demand and helped inflation fall. Although the Fed also pays attention to the downward pressure on the economy from tightening, dealing with inflation is still a top priority until there are clear data indicators showing improvement.

Fourthly, advances in application technology in the tech industry have given more reasons for risk-on capital to return. The opportunities brought by artificial intelligence throughout the entire industry chain will overall improve demand expectations for hardware and software industries within the next year. The performance of technology companies related to this has been leading since early this year. Micron Technology (MU) is one example.

Currently, the US stock market has once again reached its early-year high point and is expected to reach new highs this week with further stimulation from non-farm data.

There are two key factors keeing an eye.

Firstly, stricter regulation.

Last week's congressional hearing on financial regulation mentioned issues such as the Federal Reserve's stress test threshold being too low and scenario assumptions being incorrect, resulting in liquidity problems for small and medium-sized banks like Silicon Valley Bank not being measured. Biden also called for increased regulation and more frequent capital stress tests.

If US financial regulation becomes stricter again, more banks will face greater challenges and credit tightening will suppress economic activity.

Secondly, employment situation.

Data on non-farm employment, unemployment rate, and hourly wages in the first week of April will become another new indicator to watch. Recently, many companies including technology companies have continued to lay off employees even spreading into essential industries like McDonald's which could be a catalyst for future increases in unemployment rates.

However, changes in the unemployment rate are often not linear; that is to say there may be a significant increase beyond expectations. Currently, the Fed expects the unemployment rate to rise to 4.5% by 2024 (New York Fed President Williams hinted at "stagflation" challenges facing the US economy stating that it would take time for inflation to fall back down to 2%, while unemployment rates may rise up until next year).

Therefore if there is an obvious unexpected increase in unemployment rates during H2 of 2023 it could potentially change the Fed's dot plot.

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