The Board of Directors of the Federal Reserve Bank had their meeting today to discuss monetary policy. They will continue to have those discussions on Wednesday morning. After a hearty lunch, the Federal Reserve Board will announce its new target Federal Funds Rate.
We think Tuesday’s active trading will impact the Board’s thinking, but it will not change the rate increase that is all but accepted and complete. The chart below tells us that the Fed Funds Futures contracts indicate a 92% chance the Fed will raise their target Fed Funds rate by 25 basis points.
When the Fed makes this announcement, we do not believe Tuesday’s market share price selloff will affect market rates. What will get their attention is the underlying cause of the selloff. Janet Yellen, one of the great money printers of our day, turned politician, said the banking industry is sound. Maybe so, or maybe not. We ask, “When has the Treasury Secretary stated otherwise.” No matter what the circumstance, they will always make this assertion.
Our favorite statement comes from the European central banker, Jean-Claude Juncker: “When it becomes serious, you have to lie.” We think today’s selloff, which was particularly bad for the Small Cap Stocks, signals trouble for the banking sector.
Small; cap stocks were down about twice as much as the overall market. The big losers were the regional, small-cap banks. Names like Comerica, Zions, KeyCorp, Trust & US Bancorp were down about 10%. This is an ominous sign. The big problem is disintermediation and commercial real estate. One can earn 5% on a money market account or 0.1% on a band deposit. It is natural and makes sense that people are taking money out of the making systems and investing directly into short-term treasuries and commercial paper through the money market funds. So banks of all stripes are losing deposits. It just happens to be the regional banks getting hit the worst. In time, it probably travels to the money centers.
The second big problem is commercial real estate. $1.5 trillion of commercial real estate loans are coming due in the next three years. These loans are barely holding on at 4% interest rates. They cannot make it at the going rate of 9%, if and that is a big if, once they can find someone to lend.
The challenges of the banking industry will cause the Fed to halt rising short-term rates after Wednesday’s announcement. The Fed has a big task tomorrow. They have to convince the world that inflation will be cured with the rate increases that have already taken place. So to thread the needle, the Fed has to persuade people their work on inflation is done. If they hit that they are halting rate increases to save the banks, we think it might be appropriate to hide under the desk.
Fed Funds Futures indicate that rates will start to fall sometime late in Q3 or early Q4 2023. If this happens because price inflation falls, debt gets refinanced at lower rates, the rise in interest expense for the federal government will moderate, the economy gets the green light to grow, and investors get to pile into stocks again. This is the scenario we hope to see take place.
Our concern is that rates fall because commercial real estate becomes uninvestable at current prices. We are already hearings rumors that office buildings in downtown San Francisco could sell for as little as 20 cents on the dollar. These properties may be forced into bankruptcy as companies choose to exit these buildings when their leases come due for renewal. Without cash flow, the buildings will be sold in the bankruptcy process. The new landlords will have a massive cost advantage and can offer space at half the price or less. This loss in collateral value means investors in Office REITs will continue to take it on the chin in the months ahead. As landlords walk away from their buildings, the region’s banks will take a second gut punch. These losses and dislocation to the financial system will broadly lead to a recession, and rates will fall. These lower rates may help but will not likely save the day.
If, in this scenario, price inflation does not come down, the Fed will have to choose between its inflation goal and saving the banking industry. Higher for longer pon the inflation front may be what we get, as inflation typically takes place in times of war. (Budget deficits, which are often monetized and inflationary, cause prices to rise. The potential for product shortages is common during war, which also tends to push prices up.) In the end, they will save the banking industry, which is why the Fed was created in the first place. That would mean abandoning the inflation threat, and things could get ugly.
For the first time in years, the members of the Federal Reserve Board might just earn their seven-figure salaries. Their statement will be far more important than the change in rate. Equity investors and borrowers are desperate to see the end of rate increases. If they convince people they have done enough and the banks & economy will hold up, stock prices will rip. If they fail, the next move in asset prices will be uncomfortable.
In yesterday’s post, we show the technical setup in the S&P500 is for a selloff to begin at any time. There is room for a pop before a selloff begins, so we might see a head fake before a selloff occurs. We are in the middle of earnings season, and the numbers appear ok so far. This supports the thesis we made a year ago that rising rates would cause a reduction in intrinsic value and, therefore, a fall in the price of stocks and real estate. If rates stabilize at current levels, we suspect the broad market averages will chop sideways (3,600 on the low side, 4,300 on the high side for the S&P500) in a wide range for a while. We hold this view as long as the banking industry holds up. If the banking industry tips over, all bets are off.
The uncertain macro picture seems to conflict with the reasonably decent performance of many individual companies, making stock picking particularly hard. We are certainly trading in interesting times.
Photo by Christina Morillo: https://www.pexels.com/photo/group-of-people-on-conference-room-1181396
