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The US Federal Reserve Bank’s strategy for its battle against inflation was a simple one. Keep increasing the official rate of interest at a record breaking pace until inflation comes down or until something breaks, which in turn would bring inflation down.
In March something broke. 15 years after the 2008/09 Credit Crunch which saw the bankruptcy of Bear Sterns and Lehman Brothers, Northern Rock etc.
Signature, Silicon Valley and First Republic Banks all faltered. In Europe the grand old name of Credit Suisse was forced into an arranged marriage with long-time rival UBS. The Fed had to flood the money markets with cash and dollar swaps. This so far has worked and the contagion, at least for now, has been stemmed.
But then again we thought that in 2008 after Bear Stearns collapsed! If we then couple this with the rapidly developing collapse in the US Commercial Property values which will lead to defaults, then we are close to a watershed for markets. Why?
All of this is bad news for the US and thus the global economy, but we have to remember markets work 12 to 18 months ahead of the real economy, they have been fretting about a recession for over a year. Growth, unemployment and thus inflation have remained stubbornly higher than ideal.
But now the pain from the interest rate increases is finally coming (there is always a lag just like turning a super-tanker) and thus the economic bad news is good news for markets.
This turning point, as we have highlighted before, comes when the last interest rate increase has occurred and that normally comes when recession arrives.
Markets can then look forward 12 months to the recession passing and thus price-in the arrival of the peak period for corporate profit and share price performance.
The 2023 Banking Crisis
Post the 2008/09 Great Financial Crisis, banks were supposed to be “bulletproof”, their balance sheets had been strengthened, regulation tightened and they are regularly stress-tested to see how they would cope with various financial crises.
But it just shows how dramatic the speed and magnitude of the Fed’s interest rate increases have been. Interest rates rising from 0.5% to 5.0% should have helped the banks, they could finally make a “turn” between deposit rates and loan rates.
However, whilst it is theoretically fine that a large percentage of bank balance sheets can be held in high quality corporate bonds and US Treasuries (unlike the fabricated bonds of the Great Financial Crisis), it is not when the Fed’s action cause them to fall in value by c20%.
An accounting quirk meant that if these bonds were being held to redemption any loss in market value did not have to be recognised in the Profit and Loss Account.
Unless of course someone realises that the bank’s assets were in reality too low and asks for their cash back.
In the old days this meant queues of depositors with suitcases demanding their cash, in today’s world this means a few clicks with a mouse and the cash is moved.
Hence the collapse/ forced mergers of a number of banks. The Fed acted promptly and as the first chart shows flooded the market with cash.
Depositors could be paid and confidence, hopefully, restored.
The scale was huge and of a magnitude not far off the levels of 2008, though less than during the Covid-19 pandemic. But this is not the end of the story.
The problem now is that banks globally will turn very defensive, as the second chart shows Lending Standards are already being tightened.
Bank Chief Executives will be looking closely at their loan books and their balance sheets. They will seek to raise liquidity whist temporarily halting lending. This will create recessionary conditions.
Markets are now pricing in a 100% probability of a US recession in the second half of this year. Bond yields have thus fallen and are firmly indicating that there will be no further increases in US interest rates.
This is what the Fed wants, this will bring inflation down. But it might just get worse before it gets better.
The US Commercial Property Market
We highlighted a couple of newsletters ago that some US Commercial Property funds were collapsing.
Personal mortgages in the USA can be fixed for 30 years but not in the commercial world. Two to five years is more typical and many of those loans that were taken out when US interest rates were 0.5% are now maturing.
The current commercial mortgage rate is over 6.0%.
This is above most rental yields.
The other problem is voids. Work from Home and online shopping has reduced demand and if a recession starts to hit, then this market could face severe turbulence. Estimates vary with Morgan Stanley suggesting c$900bn of loans expiring in the next 12 months. US banks are very exposed and Risk Managers will be nervous. This will impact all lending decisions and slow the US economy down.
But remember bad news is good news for the markets.
The Emotional Market Roadmap
Markets are part rational and in the short term especially, part emotion.
Fear and Greed drive valuations and flow of cash into and out of individual markets and investments, Following “the herd” is usually the worst investment decision an investor can make. Whereas being contrarian (doing the opposite of everyone else) particularly during times of high emotion can be very rewarding.
This chart is widely used and from such a long time ago that no-one knows who created it.
But it does give an emotional roadmap for the markets. It does “feel” like we are at the point of “Anxiety”. This also nicely coincides with the typical 18 month timeframe (currently in month 15) for a negative return cycle and that markets tend to turn up at the beginning of a recession and the last interest rate increase.
Markets
The markets and the real economy operate in two parallel universes on different timescales. The markets have spent the past 15 months worrying about an imminent recession.
The real economy has, so far, carried on regardless, ignoring the rapid increase in interest rates, protected by mass early retirement and immigrant labour going home during Covid. But now we seem to be at a watershed.
Regional US banks are collapsing and the US Commercial Real Estate market is facing an imminent funding crisis.
History tells us that such circumstances lead to a lending strike by the banks (a Credit Crunch) and the economy inevitably moves into recession as weak businesses collapse and thus unemployment rises.
What does the Fed do now? Does it declare victory and say “that’s it for now”, the markets think so.
US Treasury Bonds are now indicating interest rate cuts in the second half of the
year.
However, inflation is slowly creeping down but remains nowhere near the target of 2.5%, US CPI seems to be running at around 4.5%. Does the Fed therefore “turn the screw” and raise rates one last time, just to be sure?
Indeed, they could say that a recession is the pain necessary and thus doesn’t cut later in the year, making the recession deeper and longer? However, the next US Presidential Election has started early with the Arraignment of Donald Trump.
Joe Biden does not want a deep recession, he wants the US booming by the end of this year at the earliest, the Fed is running out of time.
So markets seem to be entering the final stage of this difficult period. The Fed needs inflation to fall to target soon, the US bank and forthcoming Commercial Real Estate crisis may just be the final dose of economic medicine to help them achieve their goal.
Markets meanwhile are looking for the peak in interest rates, it has either just happened or is very close.
April 2023
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This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
