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Week In Review: Hawkish statements out of the Fed keep the pressure on rates.
Investors who were hoping for indications that the Fed is going to stop tightening were disappointed last week. Dallas Fed President Lorie Logan said that "The data in coming weeks could yet show that it is appropriate to skip a meeting," she told the Texas Bankers Association in San Antonio. "As of today, though, we aren’t there yet." And though inflation is down from last year's peaks and the economy overall is less out of balance than it had been, she said, "we haven’t yet made the progress we need to make" on inflation. St. Louis Fed President James Bullard talked about the Fed needing to take out some “insurance” against inflation by maybe hiking a little bit more.
After breathing a sigh of relief after the Fed’s early May pause, the futures are now handicapping a 1 in 5 chance of another 25 basis points in rate hikes this year, although they still see the Fed cutting rates by the end of the year. Meanwhile, the 10 year bond yield has tacked on about 25 basis points in yield over the past week. While media is trying to pin this on the debt ceiling talks, in reality global sovereign yields are increasing across the board, with Japan, the UK, the German Bund and Treasuries seeing increased yields.
European inflation is a lot more of a problem than US inflation at the moment. The United Kingdom is seeing double-digit inflation, while Germany is 7.2%. Italy is running at 8.2%. The German Bund, which is the benchmark rate for Euro sovereigns yields just 2.4%, which means that long-term rates overseas are still highly negative when inflation is taken into account. In the United States, the inflation rate is 4.9%, and the Fed has just tightened 500 basis points.
The labor market remains tight, although we are starting to see cracks for white collar workers. The tech sector has been laying off workers as the rate-driven flood of investor money is retreating Chicago Fed Chairman Austan Goolsbee said in an interview with Bloomberg that we are finally seeing some weakening in the labor market, with declining job openings, but wage inflation remains too high. He is waiting for more data before making any decisions on what to do in June. The Fed is hoping to avoid a hard landing, and the strength of the labor market might be able to cushion the blow a bit.
There are some big changes happening in the labor market, as you are seeing unions have more victories than they have had in decades. Wages are rising. If you look at the US labor market, it benefited in the 70s through the 2010s from two seismic changes. First, the entrance of women into the labor market added to the labor force, while the sheer size of the baby boom also fed Corporate America a bunch of bodies. Corporations generally held the whip hand when it came to wages and expectations. Wage growth was sluggish, and benefits were trimmed while expectations were increased. I sense that the momentum has shifted in the battle between labor and capital.
Today, the number of women entering the labor force has probably peaked so there is no more incremental supply coming from there. Second, the baby boomers are retiring en masse, so the supply of workers is falling. From the New Deal until the 1970s, workers held the upper hand, and I wonder if we might be returning to a situation where workers will be able to negotiate better wages. If so, then the Fed is going to have its hands full with trying to get the 2% inflation genie back into the bottle, and the return to the office might remain an elusive dream for white collar managers. The vacancy rates for office buildings are much higher than the reported occupancy numbers. In New York City, it is roughly 50%. San Francisco is even worse. This is putting pressure on commercial real estate prices, and office properties are going for a song. The Union Bank Building in San Francisco just sold for 25% of its prior valuation on a price-per-square-foot basis. This is definitely not good news for the banks and could be the second shoe to drop as the Treasury / MBS capital issue gets worked out. Retail is another tough area, although there has been so little retail development over the past two decades that leasing demand remains strong, at least for the best malls and strip malls.
The regional banks seem to be holding up, with the fears of future contagion seeming to fade into the background. The only name in trouble is PacWest, and even that stock seems to be stabilizing. The 10 year bond was yielding 4% prior to the Silicon Valley Bank failure, so we could see further increases in yield as this problem seems to be contained.
Janet Yellen suggested that more bank mergers might be necessary in order to strengthen the banking system. This is definitely not reading the room when you look at the current political environment. The left is against further mergers for antitrust reasons, while the right is suspicious of the banks implementing a social credit policy. That said, the US banking system is pretty unique in terms of the sheer number of banks. Most countries have a handful of massive banks that control the market. Much of this goes back to the New Deal regulation when interstate banking was prohibited. But aside from Italy, basically nobody else has a banking system that resembles the US with its large multi-nationals like JP Morgan and Citi, its regionals with Comerica and PNC and its thrifts.
For mortgage banks, the past quarter was bad, although not as bad as Q4 of 2022. Only about a third of mortgage banks were profitable, and most mortgage companies lost about 2 grand per loan. Mortgage companies continue to shed workers, replacing high salaries with cheaper ones by churning the workforce. We are probably past the worst point for this cycle, but the recovery remains elusive as long as mortgage rates are stuck in the mid-6s. Cost to produce continues to increase, which isn’t helping matters. The only saving grace for the industry is that delinquencies remain low.