Last week, Fitch downgraded U.S. debt.  This morning Moody’s downgraded some banks.

It seems that the fragility of the banking system was well exposed three months ago, when some noisy venture capitalists decided to incite a run on Silicon Valley Bank.

The heavy concentration of uninsured deposits was exposed.  The duration mismatch was exposed (which all banks have, to varying degrees).  But more importantly, they exposed the vulnerability of the banking system to bank runs, from social media-driven mob behavior.

Of course, the shock in the banking system was quickly resolved.  And once again, it was resolved by Fed intervention.

With the above in mind, given the credibility problem these ratings agencies have, and given that the most powerful central banks and governments in the world have spent the better part of the past fifteen years fixing and manipulating markets where they see fit, do these downgrades matter?

If we look to the market reaction, thus far, for answers, it’s a maybe.  Stocks have given up ground since the Fitch downgrade (2% in the S&P, 3% in the Nasdaq).  And the 10-year yield jumped from sub-4% to as much as 4.20% over just a few days.

As for this downgrade of banks, Moody’s cites “funding costs” as a concern.  With the Fed Funds rates having gone from zero to north of 5%, one would expect at some point, the banks would relent and start paying interest to depositors (or lose them to the Treasury market).

With that, the cost of capital is rising (finally) for the banks.  And it’s contributing to tightening credit conditions reported in the recent Fed Senior Loan Officer Opinion Survey (SLOOS).

For the Fed, who have been looking for signs of “lag effects” from their tightening campaign, these downgrades might be among the effects.

On that note, we have the Kansas City Fed’s economic symposium in Jackson Hole, later this month.  This annual event is well attended by the world’s most powerful central bankers and finance officials, and has a history of signaling policy adjustments.  Maybe it will be an “end of the tightening cycle” theme.

We had some very well-placed comments from a voting Fed member this morning, following the Moody’s downgrade, saying they “may be at the point where they can hold rates steady.”

We heard from two cloud giants last week, on Q2 earnings.  Microsoft had record revenues in the quarter.  Google beat on earnings and revenues. 

Today we heard from Amazon.  It was a big quarter.  They exceeded guidance on revenues and operating income.  

And similar to the earnings calls of Microsoft and Google, Amazon’s call was very focused on the generative AI opportunity.

Remember, this is the first quarter we’ve heard from the “big tech” oligopoly (in an earnings call), since Nvidia declared generative AI to be “the beginning of a major technology era” in its May earnings call.

So, what did CEO Andy Jassy have to say about it?   

Amazon is developing “Large Language Models-as-a-Service.”

It takes years and billions of dollars to build large language models (like ChatGPT).  They are enabling customers to apply already developed models to their own proprietary data, which is secured on AWS (Amazon’s cloud).

As he says, “the core of AI is data.  People want to bring generative AI models to the data, not the other way around.”  It’s the only way to keep their proprietary data secure (not leaked into the world).  

With this business, he says they are “democratizing access to generative AI.”

About this LLM-as-Service business they said it’s early, but they expect it to be “very large.”

So, we’ve heard from the top three cloud companies now.  And all of the calls were dominated by the AI opportunity, the new businesses, the investments they’re making, the new customers they’re reaching, and the expanding total addressable market in front of them.

It’s a new high growth business, where their competitive moats will grow only wider.

PS:  I’d like to invite you to join my new subscription service, the AI-Innovation Portfolio.  Join here, and I’ll send you all of the details.   

Fitch downgraded U.S. government debt today, after the market close.

Does it matter?

Fitch is one of the three “Nationally Recognized Statistical Rating Organizations” designated by the SEC.  And it was Fitch, and its two counterparts (Standard & Poors and Moody’s) that brought us the real estate bubble, which turned into the global financial crisis.

Yes, that real estate bubble was primarily driven by credit agencies stamping AAA ratings on high risk/high yielding mortgage securities.  These unwarranted ratings were a mix of fraud, mal-incentives and incompetence (on the part of the ratings agencies).

With a AAA rating and a high yield, massive pension funds had no choice, if not an obligation to plow money into those investments.  And with that insatiable demand, mortgage brokers and bankers were incentivized to keep sourcing them and packaging them.  And the bubble was blown.

With that, it’s perplexing that they (the ratings agencies) are still in business, much less have credibility.

And today’s downgrade comes as the economy is running hotter than most expected, and is on a path for a potential economic boom, which gives us a chance to grow out of the debt burden …

Nonetheless, let’s take a look at what happened when Standard & Poors downgraded U.S. debt back in 2011.

That downgrade, too, came shortly after the end of a debt ceiling standoff.

How did markets respond?

One might expect a downgrade in the credit rating of U.S. Treasuries, what the world has known to be the safest, most liquid government bond market in the world, would result in capital flight.

It was just the opposite.  

Money flowed into Treasuries.  Prices went higher, yields went lower.  

Why?  Because it was still the safest, most liquid government bond market in the world. 

The U.S. stock market bottomed a few days after the downgrade.  And so did the dollar.

It turns out the downgrade in U.S. debt amplified the relative safety, value and liquidity of U.S. markets, because it amplified the greater vulnerabilities in sovereign debt outside of the U.S., namely in Europe.

Indeed, downgrades followed in Europe.  And the sovereign debt markets of the weak spots in Europe, particularly Italy and Spain, became targets of speculative selling, sending borrowing rates soaring to unsustainable levels.  These countries were on default watch, and with default would have come a collapse of the European common currency (the euro).

The European Central Bank (Mario Draghi) finally stepped in (they crossed the line in the sand), vowing to do “whatever it takes” to save the euro, and to maintain stability and solvency in the euro zone.

The ECB was the last of the world’s most powerful central banks to cross the line, to rip up the rule book and become an explicit market manipulator.  And they haven’t looked back.  With that, we should expect any impact from this downgrade, if any, to be subdued (either by central bank action, or the implicit threat of action).

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After a series of ten consecutive Fed rate hikes, last month the Fed “skipped” an opportunity to make it eleven.  It was a skip, but not a stop.  Today they raised the Fed Funds rate again, to the highest level since 2001.

As we discussed last month, the decision on the May hike was unanimous, despite plenty of uncertainty surrounding the bank shock (of March).

The June skip was unanimous, though the economic projections from that meeting reflected the Fed’s view of hotter growth and firmer levels of inflation.

And this July hike was unanimous, despite a headline inflation rate that has fallen to 3% — a full percentage point lower than the inflation data available to them the month prior, within which they chose to hold rates steady (unanimously).

In one of the more complicated environments in history, finding eleven (in the case of today’s vote) economists to agree with each other, so consistently, is hard to believe.

But unanimity strengthens the Fed’s ability to manipulate public perception (or as they call it, “guidance”).

And today, with a market that had fully priced in a rate hike, and with unemployment still near record lows, stock markets having resumed flight over the past quarter, and the economy likely growing better than 2%, the Fed, assumingly, thought it could only lose by showing any dissension that might imply a victory on inflation.

Why don’t they want to claim victory?  Because that signal (to consumers, businesses and investors) would be the equivalent of pressing the “gas pedal” on the economy.

And they would be doing so with an economy already positioned to ride tailwinds of big government spending programs, and a technological revolution (in generative AI).

Would a boom-time economy reignite the inflation they’ve been working to get control of?

As you can see in the chart below, the Fed Funds rate is now well ABOVE the inflation rate — as measured by the Fed’s favored inflation gauge, core PCE.

This is historically where the Fed has taken rates to get inflation under control (i.e. above the rate of inflation).  They’ve been there since March.  And this purple line should drop to about 4.2% when we get Friday’s June core PCE report.

So, this dynamic of a positive real interest rate, for the past four months, should be putting downward pressure on inflation.

And it has been. 

Add to this, money supply growth has been the historic driver of inflation.  It soared.  Inflation soared.  It has since contracted sharply as you can see in this next chart.  Inflation has fallen.