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Week In Review: The Fed hikes again
The big event last week was the Fed decision where the FOMC raised the Fed Funds rate by 25 basis points and made a minor adjustment to the language concerning future rate hikes. The dot plot was more or less unchanged, and the economic forecasts were tweaked a touch. 2023 GDP estimates were pared to 0.4% growth from 0.5%, the 2023 final Fed Funds rate was unchanged at 5.1%, and inflation estimates were nudged upwards 3.3% to 3.5%. The banking crisis was addressed, however Jerome Powell said that the situation is so new that the impact is highly uncertain.
Despite the bad news about further hikes in the Fed Funds rate, we saw a powerful rally in the 10 year, which lowered the yield below 3.3% before finishing out the week at 3.37%. The two-year had an even bigger move, falling from 4.24% to 3.57% before selling off late Friday to end up at 3.78%. The Fed Funds futures are now handicapping an 88% chance of no move at the May meeting and they see a higher probability of a cut than a hike in June.
While we didn’t have any further blow ups last week, regional banks remained under pressure, and the bears surrounded Deutsche Bank. This was driven by a spike in the cost of insuring Deutsche Bank debt rose to 220 basis points, which was the highest since 2018. During the European debt crisis in 2011, they hit 300 basis points. Deutsche Banks’s Additional Tier 1 bonds saw their yield increase to 27%. These bonds are similar to Credit Suisse’s AT1 bonds which were wiped out in the UBS merger. Earnings season starts in about 3 weeks, and the banking earnings calls will be interesting, to say the least.
In an interview for Bloomberg TV, former Treasury Secretary Larry Summers asked ex-Fed Governor Daniel Tarullo about the Fed’s stress tests, and it turns out that the Fed’s stress tests didn’t really look at what happens during a rapid increase in interest rates. The operating assumption is that the banks will be stressed during a recession, and interest rates fall in recessions. The current situation of rising interest rates during an expansion was not looked at. Since Treasuries and mortgage backed securities are treated as Tier 1 capital, they were considered more or less as riskless.
The funny thing is that we have seen this movie before in the 1970s and 1980s. As interest rates rose, banks had to raise deposit rates in order to keep their customers. That only worked to a point. Back then, there was a 5.25% cap on deposit rates (called Regulation Q) which was part of the New Deal regulatory landscape. It was intended to prevent “ruinous competition.” Old timers might remember when banks would give you a free toaster if you opened up a savings account. Since all banks paid the same rate, that was how they competed. Eventually people started pulling money out of banks and began putting them into money market deposit accounts which had no interest caps. This was called disintermediation and was the impetus for the banking deregulation in the late 70s and early 80s which removed the caps.
Removing the caps didn’t fix the problem though. Bank balance sheets were loaded with home mortgages originated in the 1960s with rates in the 3% range. Paying 6% to fund an asset paying 3% is a bad business model. In order to cover the higher deposit rates, banks had to reach up the risk curve, which meant high-yield corporate debt. The collapse of commodity prices in the early 80s caused a lot of bank collapses as oil drillers and farmers defaulted. Roughly half of the savings and loans that were in business in 1970 were gone by 1989 either through mergers or failures. While the business press and academia has pushed the idea that banking deregulation was a Reaganesque free-market folly, the banks and S&Ls were really done in by inflation. Borrowing short and lending long in a rising interest rate environment is treacherous. The fact that Fed stress tests didn’t consider the effect of rapid rates hikes on Tier 1 capital proves again that in the physical sciences, knowledge is cumulative while in finance and economics it is cyclical.
So how will the Fed react? They generally raise rates until they break something, and that is where we are now. The quickest way to fix the banks is to start cutting rates, which will probably contain the problem for the near term. While they won’t officially say they will tolerate a higher inflation rate, that will be the result. With labor in the driver’s seat, wages will rise and prices will follow.
St Louis Fed President James Bullard gave a speech last week where he put the current situation into perspective. He compared the problems at some of these regional banks to crises in the past such as the Continental Illinois failure in 1984, the Orange County / Mexican Peso crisis of the early 90s, and Long Term Capital Management in the late 90s. In all of these instances, there was a lot of press attention, but ultimately the economy was never severely impacted like it was in 2008. I think in this case that probably follows as well, simply because the securities that are causing the losses (Treasuries and MBS) are money good.
There is a lot of talk about how this will affect the CMBS space. Certainly office CMBS are struggling as vacancy rates continue to fall. We have seen some issues in retail as well, but logistics REITs like Prologis report vacancy rates are de minimus, and apartment REITs are enjoying low vacancy rates as well. This will be a space to watch, but so far it doesn’t appear to be anything that can topple the economy. That said, Neel Kashkari did say that the chances of a recession have risen.
How will Washington react? First, the government will probably end up having to guarantee all deposits at this point. The precedent has been set and if they don’t we will probably see people take their money out of smaller banks and put them in the too big to fail banks. Deposit insurance fees are going to have to increase, which will of course get passed onto the saver. Since the biggest banks can absorb that cost more than the smaller banks it probably won’t change things all that much. We probably will see a lot more M&A activity in the banking sector, much to the chagrin of the Elizabeth Warrens of the world.