David Lebovitz: Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today's episode is on monetary policy and financial stability and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence.

With me today is Jared Gross, Head of Institutional Portfolio Strategy at J.P. Morgan Asset Management. Welcome to the Center for Investment Excellence.

Jared Gross: Thanks, David. It's terrific to be here as always.

David Lebovitz: Well it's good to have you back and certainly quite a bit to talk about here. So what I thought I would do is just start out with a high-level macro review of what went on during the first quarter and kind of where we stand today with respect to monetary policy and financial stability.

You know, what's interesting is that coming into this year, a lot of people, ourselves included, thought that the Fed's actions in 2022 were really going to begin to weigh on the overall pace of economic activity. And what we've seen in reality is that the economy, not just the U.S. economy, but arguably the global economy, has proven to be far more resilient than people originally thought.

The growth numbers have more momentum than people had anticipated. Atlanta Fed tracking a first quarter GDP number north of 3%. You look at the inflation numbers, not necessarily as bad as they had been, but perhaps not coming down to earth quite as quickly as a lot of people had hoped.

And it's interesting because you go back a couple of weeks and what was the conversation that we were all having? Well, we were talking about the outlook for the Fed's meeting in March, and the debate was whether or not they were going to hike by 25 basis points or 50 basis points.

We then had the issue with the regional banks. Obviously, people are pretty well-versed with respect to what happened there and that really threw a wrench in the outlook for the Fed. And the conversation then became, is the Fed going to stay on hold? Is the Fed going to do 25? And obviously, in the event, the Fed chose to hike by 25 basis points.

What I think is really interesting here, and Jared, I would love to bring you into the conversation, is that the Fed has clearly chosen to separate monetary policy from banking policy, which arguably is, I think, the right way to go about it. What's your take on what the Fed did, what the Fed said at their meeting here in March?

Jared Gross: Yes. This is a really interesting time. You know, we often talk about the Fed's dual mandate as it relates to inflation and full employment. But we also have to remember that the Fed is a bank regulator. And as you noted, the current moment has brought that sometime less well-observed element of their official capacity right to the front.

And we are watching them, as you said, separate those two core functions as best they can, trying to keep their eye on the ball with respect to inflation and maintain what I would regard as an appropriate path of monetary policy under the data that we have seen thus far while simultaneously providing liquidity to the banking system through maybe less well-followed but traditional mechanisms like the discount window and some of the logical extensions of the discount window that were created recently to help banks deal with the mark-to-market on their portfolios.

I think when you step back from the near-term stuff though, and you look at the Fed's behavior over the last couple of years, clearly they got behind the curve on inflation and they've been playing catch-up.

And I think to me, if you want to think about the Rosetta Stone that explains Fed policy actions, it's really about their credibility. It's about the Fed understanding that for the better part of 40 years since Paul Volcker, they had been trading on the sort of credibility capital that had been built up and that's important.

It's not just vanity on their part. They recognize that a Central Bank that has credibility can maintain growth and low inflation and moderate expectations with less stringent policy moves than a bank that does not have credibility.

And so it's very much a valuable asset for the Fed to have. And I think they recognize that to some extent they squandered it in 2020, 2021, when inflation was percolating and they fell behind the curve.

And so when you look at their behavior in more recent quarters, what you see is a Fed that has consistently stayed on the stricter side of expectations for monetary policy. And I think that is because they recognize that regaining their credibility requires them to put a thumb on the scale in favor of tighter policy, even if that sacrifices something with respect to employment, a potential recession and volatility in the financial markets.

Now to bring this conversation back to where you introduced me, we are now watching a small but potentially concerning banking crisis, which forces the Fed to address the separate elements of their sort of policy objectives. And it remains to be seen whether they are going to blink, as it were, because of the banking crisis.

Certainly this week's announcement and the fact that they continued to hike suggests that they are not there yet. You can probably read that as the Fed having some confidence that the banking crisis is at least reasonably well contained and unlikely to spiral. I think that's probably a fair statement, but again, time will tell.

And it's certainly true that the Fed has plenty of tools left in its toolbox should the situation worsen. But they certainly don't want to take their foot off of the monetary policy tightness until they are certain that it's needed because inflation, as you said, remains much higher than people had sort of thought it would at this stage of the game.

David Lebovitz: And I think the key thing to recognize is that inflation is still public enemy number one here. You know, you think about the Fed's dual mandate. I was talking about this with a client the other day. They said, you know, what's going to get the Fed to really move in a more dovish direction?

And I said, you're going to have to see things deteriorate in the labor market or see some broader financial stability concern in order for the Fed to blink here because I do think that they remain focused on, to your point, Jared, kind of rebuilding that credibility and then maintaining that credibility, but also snuffing out the inflation candle in a permanent way.

And so what's fascinating is that you and I seemingly understand what the Fed is saying. And I think we have a pretty good grasp of the Fed's reaction function here. But we're back in a world where the market is pricing in a Fed that ends up doing a 180 in the back half of 2023.

And looking at the chart yesterday, it was, okay, so the Fed's going to hike to cut. I mean, that doesn't really make a whole lot of sense to me. But what are your thoughts there? You know, what are your thoughts around what the Fed's going to do and the difference between the Fed's forecasted path and the market's forecasted path?

And again, do you agree with me? Do you disagree with me? What do you think the Fed would need to see in order to begin to change their tone and become more dovish, which is obviously what the market has been looking for for the better part of the past nine months?

Jared Gross: Yes. This is not the first time that the market has, I think, aggressively front run a dovish turn in Fed policy. And in previous instances, the market has turned out to be wrong. So we shouldn't overpraise the market for being kind of prescient around both growth inflation and the path of Fed policy.

I think one thing I'll just also add to the comment around inflation is early in this inflationary cycle I think the Fed recognized that a lot of the inflation was supply driven. It was a result of the supply chain and some of the COVID effects.

And rightly or wrongly, I think they understood that monetary policy is not particularly effective at dealing with supply driven inflation. But now we've obviously moved to a place where inflation is largely demand driven or self-sustaining because of a higher level of demand.

And there, I think the Fed can have some confidence that its policy actions will take effect. Now there is a long and variable lag, as we frequently say. We don't know how long that lag will be. And it's certainly plausible that rates may not yet have reached a level sufficiently high to restrain economic activity.

And when we add to that the uncertainty around the banking system and how ultimately negative that may be for the lending impulse and what that means for growth, this is a moment to be a little more cautious around a policy response.

And so I think the market is looking at that fact pattern and saying, okay, well, yes, we were too early on the Fed two times ago and one time ago. But now, given this additional information, you look at what happened to the two year rate over the last couple weeks where it dropped precipitously as a result of the bank situation.

You know, here we are post the Fed meeting. The Fed did hike. The Fed has said it's not expecting to cut anytime soon. They have not given clarity on any potential pivot or the signal that will lead them to pivot. And yet the bond market does appear to be expecting a fairly rapid turnabout.

Now at some point the market may be correct and the Fed may be wrong. That's certainly plausible. But I think to your point about how to read the market right now, at least in the short term, the market does appear to be getting off sides a little bit, and are they going to have to again sort of reprice expectations around Fed policy for, if not a particularly higher terminal rate, a longer duration at that terminal rate that is currently in the market?

David Lebovitz: And I think that that's spot on. I think the other question that we need to unpack here is, you know, we do have these financial stability concerns. We obviously have some fairly notable wobbles in the banking system, particularly the regional banking system.

Do you think that what's happening here is going to make any sort of landing potentially harder or any sort of, you know, recessionary outcome potentially deeper than what we would have originally thought?

You know, I want to get to what this means for financial assets in a couple of minutes. But when you take a step back and think about the way we kicked things off with this economy has more momentum than we expected and inflation is proving to be more resilient.

I think we've done a great job of unpacking the path of said policy against the backdrop and the data that we have. What are your expectations for what all this is going to do to the economy and how that may differ from where people's forecasts for 2023 and 2024 originally stood?

Jared Gross: So I mentioned earlier that the Fed can take some comfort in monetary policy being more effective against sort of demand-driven inflation.

I think the other side of this is that we lived through a long era of exceptionally low interest rates and many economic actors. And it certainly appears that some banks could be included in that group. They optimized their balance sheets for what was effectively costless debt. And that is not going to be limited exclusively to the banks.

I think it is a very telling and potentially concerning signal that as interest rates have risen, as is clear from anyone who understands sort of basic bond math, the price of fixed income assets falls. And if you are holding those assets on your balance sheet, you have a potential challenge to face.

And so the banking system is working through this right now. And I think the measures that have been announced and seemingly implemented at scale are going to ring-fence that problem pretty well. That would be my guess. But again, time will tell. We don't know yet.

But, you know, will there be further instances of higher rates impacting other balance sheets, other economic actors? I think that's inevitable. And then how does that flow through into kind of the financial markets?

And I think a sort of secondary channel is if the banks are more focused now on rebuilding their capital base in order to offset the losses on their balance sheet holdings of either marked or unmarked fixed income portfolios, that may to some extent restrict their willingness to lend and to take risk in the more traditional channel.

Now we have a very diverse financial system that has lots of channels for allocating capital to people who need it and want it. So I'm not sort of concerned that we're facing a credit drought that is going to starve the economy of capital. I think that's pretty farfetched at this stage. But it's certainly directionally going to be negative.

And so, yes. I mean, to your original premise, the possibility of a hard or harder landing goes up and that gets priced in. And we've seen some of that. So I think where you'll see it, and maybe this will be the last phase of the conversation, is risk assets broadly are going to reprice based on higher yields.

And then the second leg of the economic factor, which is will the operating businesses behind those financial assets suffer either a decline in revenue, narrower margins, loss of profitability, a potential credit risk and the whole sort of parade of negatives that may result from this environment.

You know, we came into this situation in pretty good shape. Balance sheets were strong. Liquidity was high in many respects, and you're probably closer to this than I am, that remains the case. So I don't think we have to be alarmist about Silicon Valley Bank taking down the economy. I don't think that's kind of a plausible narrative, but directionally it's not good.

David Lebovitz: I completely agree with that. And a couple of additional thoughts. You made the very important point that capital will find a way of flowing to where it needs to go.

And one of the things that I thought was fascinating into the end of last year was how, if you look at the buyout space, the banks and the broadly syndicated lenders basically stepped away and it was all about private credit.

So you could see bank lending standards tightening into the end of last year even in advance of what happened here over the past couple of weeks with a handful of the regional players.

And I think you're spot on. When I look at where risk assets are priced today, they do not feel priced for the outcome that I think you and I both agree is more likely than not.

And so from an investment strategy standpoint, and I'd love to get your view on this, I still think you want to focus on maintaining a relatively short duration across both equities and fixed income, right? You want to own things that are going to return cash to you quickly.

And when assets reprice, if yield is back up, if the 10-Year makes a move back towards 4%, sure, adding some duration back in at those levels very much makes a lot of sense.

But given that the market does look a little bit off sides here, I think focusing on hitting singles and doubles and playing it relatively close to the chest continues to make a lot of sense, at least in the short to medium-term. But I would love to get your perspective on that as well.

Jared Gross: Yes. I think mechanically shorter duration assets are safer. And because of the inversion in the yield curve, which remains fairly steep, you're getting paid a lot of excess return to hold some of the safest assets out there, which is a very unusual circumstance.

And I think at a very basic level, any investor should take advantage of that by staying liquid, staying at the front end of the curve. And I think there are attractive opportunities in various parts of the credit markets, not just corporate credit, but also in securitized credit.

As we see dislocations, it's going to be important to deploy that liquidity into more opportunistic investments when spreads widen or markets dislocate. Those are where some of the highest long term returns are generated.

In most cases, investors have to pay the price for maintaining liquidity. Today, you're getting paid for that privilege, which is a remarkable circumstance.

And I think with respect to credit risk, and this is true for equities as well, we've seen just a number of examples, whether it's Silicon Valley Bank, whether it's Credit Suisse, active management, read the fine print.

The investors who got blown up on Credit Suisse's AT1 debt did not bother to understand that Swiss AT1s were different than the AT1s issued in the rest of Europe and that's just a manager mistake. You need to read the fine print. And broadly speaking, that's just active management at work. You have to know what you're buying.

And so in a market environment like this where there's a lot of uncertainty, you shorten your horizon. You don't take a credit bet 10 years out because you can't legitimately say that you have visibility into the health of a company 10 years from now. Even companies that appeared stable three months ago may not look stable.

So you can do the credit research. You can underwrite for liquidity, for cash flow coverage, for reading into the bond covenants, understanding what you own.

And, you know, the first couple of years of the yield curve are still paying you pretty attractive returns right now. So I wouldn't be a hero and try and front run some massive pivot on the Fed's part when you can stay safe, liquid and get paid pretty well.

David Lebovitz: I think that's the bottom line and kind of bringing it full circle. What I'm hearing from you, and I would very much agree with is, the devil is in the details. And the reality here is that eventually the Fed will cut, but they're unlikely to cut back to zero.

And if you do have a cost of capital in the market, the devil in the details matter a lot more than when money is free as was the case for 10 years following the financial crisis. So, Jared, as always, it's a pleasure to have you on the podcast. Thank you for joining us and looking forward to having you back sometime soon.

Jared Gross: Thanks, David. This was great. Take care.

David Lebovitz: Thank you for joining us today on J.P. Morgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. This is recorded on March 23, 2023.

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