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“Higher for Longer” Rates Have Risks – Especially for Banks

As expected, at its recently concluded March meeting, the Fed stood pat on interest rates. Of greater interest, the “dot-plot,” a picture of FOMC thinking about rates over the next two years, stayed at three cuts for 2024. Looking at the chart (the 2024 column), the median dot is 4.625%. That is a 75 basis point difference from today’s 5.375% rate, or three 25 basis point rate cuts by the end of 2024.

A change of opinion to a higher end of year number by two participants would put the median at 4.875% and represent only two cuts. Markets, pre-meeting, were worried that such could be the case based upon hawkish public statements by several FOMC members. But, that did not occur. Note that the dots are skewed much more to the hawkish (higher) side. There are only two dots indicating FOMC opinions that rates will be lower than the median by the end of 2024, whereas there are nine dots saying higher. In December, five dots were below the median. Thus, it appears that the hotter than expected CPI and PPI prints in January and February moved the FOMC to an even more hawkish position than it had in December.

Note, however, the changes penciled in for 2025, 2026 and beyond. The median rate for 2025 is 3.75%. It was 3.5% in December. This represents one less rate cut for 2025. In 2026, the median plot is 3.125% vs. 2.875% in December. Again, one less cut. We don’t put too much credence in these longer term dots. A lot can and will change by then. Note also that after 2024, the dots become much more dovish: the median dot has fewer compatriots, and the dots have a much wider dispersion.

Because Chairman Powell was not as hawkish at the press conference as the markets feared, equities ran to record highs. In the press conference, Powell indicated that January’s and February’s elevated inflation readings were likely just “bumps in the road” and the path to 2% inflation was still intact. He also noted that wage growth was moderating satisfactorily, thus removing any lingering worries about a 1970s style wage-price spiral.

It appears that the reason for the reduced number of rate cuts in the dot-plot was due, at least in part, to a more optimistic view of the economy. 2024’s GDP forecast was raised from 1.4% to 2.1%, the U3 Unemployment Rate was revised lower to 4.0% from 4.1%, and the core inflation rate was raised to 2.6% from December’s 2.4%. The latter implies that the FOMC now sees a much slower path to the 2% inflation goal than they saw just three months ago. So, while Powell said that the January/February uptick in inflation was “just a bump in the road,” apparently in the eyes of the FOMC, that bump has slowed the journey!

Adding to the hawkish flavor of the meeting, the Fed has continues to reduce its securities holdings (Quantitative Tightening (QT)). Powell indicated such in the press conference. The result, as seen in the right-hand portion of the M2 chart, is a continuation of the contraction in the money supply, now more than a year old. Monetary economists of the Milton Friedman school would point to that as the reason for the disinflation. In addition, prolonged bouts of money supply contraction have always been associated with Recessions.

Financial Markets: The DJIA and the S&P500 set records on Thursday (March 21st) (S&P500: 5,241.33; DJIA: 39,781.37) but gave a little back on Friday. Nasdaq, however, still being propelled by AI mania, continued its record setting ways rising on Friday to 16,428.82. For the week, the DJIA gained 1.97%, S&P500 gained 2.29%, and the Nasdaq was up 2.85%.

Housing

Existing Home Sales rose +9.5% in February. As a single data point, that looks pretty impressive. But, a look at the chart tells a different story. Despite the recent uptick, sales are still at Great Recession levels. There are several reasons. First and foremost, there is a lack of inventory. Most existing homeowners have low mortgage rates, having purchased prior to the Fed’s latest tightening move. Today’s high mortgage rates are a huge disincentive for existing homeowners to sell. Even a lateral move is likely to almost double the monthly mortgage payment. In addition, the Fed’s “higher for longer” policy has pushed interest rates higher since December as shown in the chart of the 10-Year Treasury yield.

A Weakening Financial System

A year ago (March ’23), there was a mini Regional Bank meltdown. Several banks, the most noteworthy being Silicon Valley Bank (SVB) and Signature Bank, failed. The culprit was the unrecognized losses in their “Held to Maturity” (HTM) bond portfolios. Under bank accounting rules, a bond in the HTM account doesn’t have to be marked to market. However, if a single bond in that HTM account is sold prior to maturity, the whole HTM account must be marked to market. When SVB and others had deposit runs, they had to sell from their HTM accounts to meet the deposit runoff. That caused all of the bonds to be marked to market. Because interest rates had risen so fast, all those bonds, purchased prior to the Fed’s rate hiking cycle, were at deep discounts to purchase price. The loss recognition was large enough to eat up all the bank’s capital.

One of the bandages the Fed applied was to establish a loan facility such that the Fed would loan the banks money at the bond’s face value rather than at its market value. Thus, any additional deposit runs could be met by borrowing using the face value of those bonds a collateral. Noteworthy: This month, the Fed closed that facility!!

The chart below shows the weakness in Commercial Real Estate (CRE) prices. The banking system holds $2.7 trillion of CRE loans, about 30% by the Regional Banks, only 6% by the Money Center Banks, leaving more than 60% in the hands of small banks. We recently reported on the issues at New York Community Bank (symbol: NYCB) where an expected Q4 earnings of +$200 million turned into -$200 million due to CRE write downs. Since then, former Treasury Secretary Mnuchin put together a group of investors to inject capital.

The “work from home” craze that began in the pandemic has continued to have a large impact on office building rents. We recently reported that the mortgage on a New York City office building (360 Park Avenue) was sold by a Canadian Pension Fund for $1. CRE loan delinquencies are rising (see chart).

The Kansas City Fed’s CRE Index is falling. It appears inevitable that CRE issues will soon begin to cause havoc in the banking system. We wonder how many banks will be able to raise additional capital if this becomes a trend.

Final Thoughts

The economy continues to show mixed (conflicting) signals, like large positive Non-Farm Payrolls but negative job creation in the sister Household Survey. While Existing Home Sales rose what looked to be a large +9.5% in February, a closer look reveals that such sales are still at Great Recession levels – although +9.5% is a good start!

We continue to be concerned about CRE values. They continue to plummet. The small and Regional Banks appear most at risk. We don’t think this is a problem that will go away, and expect some fallout this year.

The Fed, via its dot-plot, has told us that it is serious about “higher of longer.” They base it on a “strong” economy. As discussed in our blogs, we see emerging weakness. Perhaps the Fed’s opinion is too heavily based on lagging indicators (like the Unemployment Rate). Manufacturing already appears to be in Recession with Industrial Production and Capacity Utilization falling. Not a single full-time job, on net, has been created in over a year. We think the Fed would be wise to start cutting rates sooner rather than later.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)

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