Darkening Outlook Ensures Q3 Recession
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What You Missed
Despite lingering turmoil in the banking industry, the Fed stood resolute in prioritizing its fight against inflation by hiking the Fed Funds rate by 25 basis points, to a 5.00% upper bound, while implying that there’s likely another 25 basis points on tap in May before likely pausing for the year. Risk assets recovered, while oil prices fell. The overarching fear remains that ballooning concerns over financial stability will cause banks to tighten lending standards, further subduing economic activity while increasing the chances of recession.
After rising into last Wednesday’s Fed policy meeting, yields across the maturity spectrum ended slightly lower than where they started. For the week, the 2, 5 and 10-year Treasury yields fell 3, 3 and 1 basis points, to 3.95%, 3.56% and 3.49% respectively. The slight fall in short-term yields released more pressure in the 2s-10s yield curve, a widely watched barometer of looming recession, for the second consecutive week, to -46 basis points, well off its most inverted level since the 1980s around -108, briefly seen a few weeks ago.
Elsewhere, it was another wild ride last week. The global stock market has been bouncing up and down like a yo-yo, leaving investors dizzy and confused. Especially in Europe, where the banks are having a bad hair day. Deutsche Bank, the biggest loser of the week, saw its share price drop by 13% on Friday alone on credit related fears. Other European banks didn’t fare much better, losing more than 6% of their value. Oil prices eased a bit, while the US Dollar weakened, and Gold traded steady.
**Borrrowers: Have you received a notice, like this one from your rate cap bank asking you to contact them to address the LIBOR transition? Contact us before you respond, as making the wrong decision will cost you money.**
Hedging Costs Remain Elevated Despite Fall in Rates
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, clawed back some of its recent declines to 4.81%, but remains well off its all-time high near 5.12% seen March 10th. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate of where markets expect 3-month Term SOFR to be a year from now, fell 10 basis points from this time last week, to 4.00%, reflecting the market’s view that the Fed may not hike rates as high as previously thought.
The SOFR futures market is implying that 3-month SOFR, trading at 4.81% right now, is already close to where markets expect it to peak – 5.14% – and will start to decline precipitously over the next year, starting in June, as the economy enters a recession and the Fed eventually eases.
Finally, interest rate volatility, a key driver of the cost of interest rate caps, rose anew late in the week and this morning after backing off eye-watering levels last seen during the 2008 financial crises (even higher than that seen during the onset of COVID), somewhat derailing hopes of lower rate cap costs emanating from lower short-term yields.
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
Fed’s FOMO: How the Central Bank Prioritized Price Stability Over Calming Mayhem
The Fed hiked a quarter-point just as we and markets expected. But they also changed their tune in a notable way in the meeting’s official, written statement. They stopped implying they expect to keep hiking rates like there’s no tomorrow. Instead, they stated they expect “some additional policy firming.” That’s Fed-speak for “we’re almost done here, folks.” That matches their updated dot plot, which shows that Fed members expects Fed funds to peak near 5.13% (Fed Funds’ range midpoint is 4.875% now).
Before Silicon Valley Bank went belly up, Fed Chair Jerome Powell had hinted that the dots in the dot plot would go higher – we think the Fed would’ve hiked Fed Funds to 5.6% had the SVB-failure never happened. This means that they likely view the recent banking-sector turmoil as replacing 50-baisis points or so of rate hikes. How convenient!
Our take: The Fed had two options: keep raising interest rates in an effort to fight still-high inflation, or step back and take a pause to see how the banking turmoil works through the system. They decided on the former. We think they did the right thing, as the move shows everyone how strong and confident they are in the US banking system, even though some banks are struggling more than others.
Hedging their stance, the change of wording in the meeting statement to “additional” rate hikes, instead of “ongoing” ones, means they believe the current hiking campaign is nearly complete.
Draining Deposits from Small Banks Imply Tighter Credit Ahead
According to the Fed, the week after Silicon Valley Bank (SVB) went bust, people and businesses got a bit nervous and took out $98.4 billion from their bank accounts. Where did they put it? Probably in money-market funds, which saw a $121 billion increase in the same time span.
Despite the fact that bank runs appear to be largely under control for the time being, tighter credit conditions, particularly during economic downturns, are brought on by the withdrawal of deposits from the commercial banking system as well as the ongoing transfer of deposits from small banks to large ones. This dynamic will likely lead to tighter lending standards, especially given that the economy appears to be on the verge of a recession (keep reading).
As a result, we are all kind of keeping an eye on the economy and the flow of credit right now. The starting point is not a healthy one, it should be noted. The immediate effects of the fiscal windfall and refinancing boom at the height of the Covid crisis prevented the need for additional borrowing, but their positive effects are slowly eroding away, and will continue to diminish over time. Also, the US credit impulse, which is effectively the second derivative of private sector borrowing as a proportion of GDP, had already entered recessionary territory in Q4 of last year. As of now, the modest increase in credit spreads has probably been more than offset by the decline in Treasury bond yields in 2023. We’ll see if it lasts.
Activity Data are Flashing Red
February was not a great month for the economy, according to the latest data. Durable goods orders, which measure how much businesses are spending on long-lasting items like washers, refrigerators and heavy machinery, came in lower than expected. That means companies are probably holding back on investing in new equipment or projects, as they worry about the future. The same goes for the transportation sector, which also saw a drop in orders.
Another indicator that showed a decline was the Chicago Fed activity index, which tracks 85 different measures of economic activity across the nation. And that’s not all. Several surveys of business and consumer confidence also showed signs of weakness, especially in the manufacturing and services sectors. The used-car market, which used to be booming, is now losing steam. And consumers are feeling less optimistic and more worried about inflation, especially after the rattles in the bakning sector. Most of these surveys were done before SVB went bust, so the final numbers might look even worse than they do now.
Commodity prices also took a hit, as demand for raw materials from the likes of China and other countries slowed. China tried to boost its economy by cutting the amount of money that banks must keep in reserve, but that didn’t seem to help much. Lower demand for commodities means lower prices, which is bad news for producers and exporters. All in all, these are not very encouraging signs for the economy.
What to Watch: Data to Solidify Q3 Recession Expectation
Further information about how the Fed anticipates the economy will evolve can be found in its revised Summary of Economic Projections. Published during last week’s Fed meeting, the projections show the average growth expectation for Fed members was lowered just slightly for this year, indicating that financial instability effectively cancelled out any positive growth surprises prior to SVB’s collapse. Consumer confidence data (Tuesday) is expected to support the idea that consumers continue to be cautiously optimistic about the future and still expect promising job and earning opportunities.
However, it is obvious that the Fed anticipates a recession in the second half of the year. With the Atlanta Fed now predicting a 3.2% growth rate in Q1, growth in the second half of 2023 would have to be negative to achieve the Fed’s median growth prediction of 0.4% for the entire year. This lines up with our expectation that the US economy will find itself in recession in Q3.
Even before SVB’s demise, credit conditions had been tightening. A useful indicator of the state of credit for consumers is households’ response to the University of Michigan consumer sentiment survey (Friday) for buying conditions for bigger-ticket durable goods.
Finally, last week’s Fed meeting showed that Fed officials reduced their unemployment and increased their annual inflation projection amid slower economic growth and financial turmoil. That demonstrates the committee members’ belief that inflation will remain sticky even during a recession due to structural reasons in the jobs market (e.g., a labor shortage via baby boomers’ retiring). Fed Chair Powell’s chosen “supercore” gauge of inflation, core PCE services excluding (Friday), will likely reveal that the sticky component of inflation has been maintaining a steady rate of 4% to 5% over the past few months, which is not a promising sign, since we’re all hoping inflation pressures are subsiding.
Big Picture: Banking Turmoil Puts Spotlight on CRE Loans
If you’re looking for a laugh, you might want to skip this section. But if you’re an investor who’s worried that the banks could be headed for another wave of trouble because of all the empty office buildings, you might want to pay attention.
Via data from the MSCI, prices of CRE assets are indeed dropping, sales of assets are slow as players wait for fresh price discovery, and it seems that small banks are holding the bag. Some questions to consider as we march through the bog:
How much CRE debt sits on bank balance sheets? Since the 2008 financial crises, commercial mortgage debt has grown at a 5% to 10% clip (quarter-over-quarter, annualized), and it has mainly stayed in that range after Covid. One of the key factors to assess the potential domino effect of CRE on the financial system is how much of it is sitting on the banks’ balance sheets. As of March 8, commercial banks had a whopping $2.9 trillion of CRE loans, making up 12.8% of their total assets. That’s a lot of money tied up in buildings that may or may not be occupied or profitable.
Amid the large, medium and small institutions that make up the banking landscape, it’s the small banks that dominate CRE lending, holding 67% of loans. Smaller banks might be less willing to work out difficult loans with borrowers as deposits shift to larger banks.
Outside of the banks, life insurance companies own around $500 billion in CRE loans, Federal agencies and mortgage pools also hold about $1.7 trillion (or about 32% of the total outstanding CRE debt) in commercial mortgage-backed securities (CMBS). Of the $1 trillion in CMBS, $120 billion will mature in 2023, a significant portion of which may be exposed to higher interest rate resets upon refinancing.
Is CRE in distress? It doesn’t seem so – yet. Although working from home is still commonplace nationwide, CRE vacancy rates have reached almost 15-year lows. As the pandemic started, office and retail rents fell 1.7%, but they have subsequently steadied at a rate that is somewhat lower than the growth rate prior to the Covid outbreak. The average annual growth rate in the years just prior to the pandemic was roughly 2.2%, thus the present pace of growth, at 1.2%, is still tepid. The low vacancy dynamic explains why widespread CRE loan delinquencies haven’t – and may never – show up.
Looking ahead, the number of debtors who are underwater will determine how severe suffering will be for regional and small banks. There is a small silver lining in the data however: rent growth has steadied, and vacancies are declining. Despite the good news, higher rates are making properties less attractive and probably harder to sell. With a large part of CRE loans having floating interest rates, balloon payments, or are otherwise maturing, now is an excellent time for owners to engage with experts who understand how to use financial derivatives – notably rate caps, swaps, swaptions and corridors – to help take the sting off excessively expensive financing.
We’re in the midst of a wave of inqueries from borrowers who are seeking ways to benefit from a steadying or decline in interest rates over the coming months. Curious? Reach out to us.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
10-year Treasury Yield:
Source for all: Bloomberg Professional