The Breakdown - The Fed Hikes, Credit Tightens and Commercial Real Estate Looks Like the Next Problem for Banks

Episode Date: March 25, 2023

NLW catches up on the macro in the wake of the recent Federal Open Market Committee meeting and interest rate decision. The stakes were higher going into this meeting thanks to the banking crisis. As the Federal Reserve stays determined to keep hiking, is commercial real estate poised to be the next challenge?    “The Breakdown” is written, produced and narrated by Nathaniel Whittemore aka NLW, with editing by Michele Musso and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Foothill Blvd” by Sam Barsh. Image credit: Malte Mueller/Getty Images, modified by CoinDesk.  Join the discussion at discord.gg/VrKRrfKCz8.  

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Breakdown. Register now at Consensus.com and join CoinDest at Consensus 2023. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the Big Picture Power Shifts remaking our world. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Friday, March 24th, and today we're talking about why Powell has laughed off banking concerns with another 25 basis point. hike. A quick note before we dive in, there are two ways to listen to The Breakdown. You can hear us on the Coin Desk Podcast Network feed, which comes out every afternoon and features other great Coin Desk shows, or you can listen on the breakdown only feed, which comes out a few hours later

in the evening. Wherever you listen, if you are enjoying the show, I would so appreciate it if you would take the time to leave a rating or a review. All right, guys, so as I said, today we are catching up on the macro, as we had an important moment to understand how the powers that be were feeling in the wake of the last few weeks' turbulence in the banking space. Indeed, the world for this FOMC meeting looked very different from where things were last time, at least or especially to the casual observer. Now, consensus had been building for a shift back to a larger 50-bases point hike. In early March, Powell attended annual congressional oversight hearings and delivered a frank assessment of the macro situation. He said, quote, if the totality of the data were

to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes. Jobs and CPI data for February had shown some cooling but were beginning to tell the story of sticky high inflation. Interpreting this as guidance that a re-acceleration in rate hikes was in the cards, markets quickly adjusted, pricing in a 78% chance that the Fed would deliver a 50-basis-point hike. Just days later, however, when the bank run at Silicon Valley was in full swing, the odds of a faster hike collapsed entirely. Some market participants began to price in a chance that the Fed would pause rate hikes, with the probability peaking at 45% at the height of the panic. On Tuesday night of this week, heading into the FOMC meeting, however,

markets had priced a 73% chance of a 25 basis point hike, with the remaining probability assigned to a rate pause. Importantly, while this might sound like a strong consensus, that's actually the most uncertain market position in recent Fed history. The Fed almost always follows the market, but with a major economic shock occurring so close to a Fed meeting, it was hard to know how the FMC would weigh volatile market pricing. Jim Bianco actually outlined this in an excellent Twitter thread earlier in the week.

He shared that the only example of the Fed going against market consensus in the post-1994 forward guidance era was in September 2008. Bear Stearns had collapsed in March leading to large rate cuts, but by June, policy had stabilized. Then Lehman Brothers filed for bankruptcy the day before the FOMC meeting, and markets scrambled to price in a 68% chance of a rate cut, where they had previously been signaling the expectation of no move. Fed Chairman Ben Bernanke ignored this repricing of policy and held rate steady. Three weeks later, however, the FACTS. FOMC would hold an emergency meeting to deliver a 50 basis point rate cut as markets rapidly deteriorated. So what was the Fed thinking coming into this meeting?

Let's take it out of market terms, i.e. things like bank stock prices, which the Fed doesn't really care about, and put it in terms of things they do care about. One of the key stated aims of the Federal Reserve over this hiking cycle has been to tighten financial conditions and keep them tight for a protracted period. This has had mixed results. Conditions were reasonably tight throughout most of last year, but became dramatically less tight in the final quarter as the FOMC slowed down the pace of rate hikes. This change in direction was so strong that the first three months of this year actually saw a net loosening effect.

That'll change at the beginning of the banking crisis, with financial conditions rapidly switching from slightly loose to the tightest they have been since March 2020. While this effect hasn't significantly impacted equity markets so far, the dramatically reduced liquidity conditions for banks could take some time to feed through. A big part of the calculus the Fed needed to make this week then, was whether they viewed this rapid tightening as excessively dangerous for financial stability, or if they were taking it as a sign that tight-fed policy is finally being transmitted. Powell had repeatedly stated that policy acts with long and variable lags, as well as explicitly warning back in August that this path will require, quote-unquote, some pain. So, given that,

there was room to consider this situation as necessary collateral damage to aggressive Fed policy. In an opinion article on Tuesday, Bloomberg editor John Authors noted that although the Bloomberg and Goldman Sachs financial conditions indices are the industry standard, they primarily measure financial asset dislocations and could be more accurately thought of as an indicator of risk appetite in financial markets. Instead, he presents an alternative measure, the True Financial Conditions Index, designed by Gavicle Research, which incorporates broader data, including money supply growth, yield curves, and a number of real economic data points across the banking, housing, and commercial sectors. According to this alternate gauge, financial conditions are close to a 40-year low. M2, money

supply growth is a particularly troubling data point. After seeing a 150-year high growth of 26% in 2020, money supply shrank by 2% last year, the first contraction since the Great Depression. In 1933, money supply contracted by 12% the most on record, but a 2% contraction is broadly in line with monetary conditions in 1931, and the three major depressions 1921, 1893, and 1873. Last week, Lynn Alden pointed out the risk that Fed may not be looking at M2 money supply as an important piece of data. In early 2021, she writes, Powell said that it was unlikely that the recent surge in broad money supply would cause high price inflation, and that we have to unlearn the importance of monetary aggregates. He did say, however, that he can't, he did, however, say he can't be

sure, and said the Fed had the tools to combat inflation if it should arise. Similarly to how Powell underestimated the importance of money supply growth to the upside, he may be doing so to the downside. End quote. Skanda Amernath, the executive director of Employe America, out that the excessive tightening outside of the Fed's influence presents a dangerous situation. He said this will be Powell's trickiest press conference yet. Either there is exogenous financial conditions tightening that the Fed leans against, or if the Fed keeps going, they have to be ready for a less stable financial system as a result. Putting it more crisply, the economist framed the decision clearly in an article earlier this week, stating that the Fed must choose

between inflation and market chaos. The article noted that while Silicon Valley Bank may not have been the paragon of prudent bank management, its failure was due to a much broader problem of bank's warehousing mark-to-market losses on their bond holdings. It pointed out that further rate hikes will only increase those losses, adding additional stress to the banking system. While they noted that pressing forward with rate hikes would likely further tighten financial conditions to fight inflation, they also pointed out that we've now entered the part of the hiking cycle where tightening is done through chaotic financial instability rather than a constriction of interest rates, giving the Fed much less control over the situation. Perhaps the most

important point was that a rate hike here would convey confidence in the facilities the Fed has set up over the past two weeks. A rate rise would also demonstrate that the Fed can chew gum and walk at the same time. In an ideal world, officials should be able to manage financial stability while keeping inflation in check. With a combination of deposit guarantees, a new liquidity facility, and support from bigger banks, a framework is now in place to shore up America's financial institutions. Now, I think the reason that a 25 basis point hike was priced in by 70 plus percent of the market going into this meeting was exactly what the economist identified here. Many people took the assertiveness of setting up the bank term funding program as the Fed giving an indication that they wanted to be

able to keep tightening. In other words, that they were recognizing that their tightening was having collateral damage that was causing problems in the market, but that they had other tools in their toolkit other than just stopping or reversing rate hikes in order to deal with it. And indeed, ultimately, the decision was what the market expected. Powell and the Fed raised rates by another 25 basis points. Now, as is always the case, markets don't just look at the rate hike, but also dig into what Powell said afterwards. I think it's safe to say that markets reacted poorly to Powell's commentary.

Prior to taking the stage, the S&P 500 rose slightly as downside hedges unwound in response to the initial confirmation that the FOMC had hiked rates in line with expectations. equities then dived hard, though, as Powell and Yellen pushed back on calls for a generalized bailout of the financial system. Both the S&P 500 and NASDAQ closed the session down 1.6%. Longer-term bonds adjusted lower, with the two-year treasury yield moving down by 25 basis points to 3.93%. Now, the two-year treasury is typically seen as an indication of the Fed's terminal rate, suggesting that markets do not believe that a Fed funds rate above 4% is sustainable for much longer. Broadly, we saw a fairly negative reaction across all major asset classes. Stocks were down. Stocks were

down, Bitcoin was down, although it was also down because of a huge number of SEC actions, dollar down, and bond yields down is not a typical correlation pattern, and that should cause some pause. But when all was said and done, the move didn't really look crashy and indicated some level of reluctant tolerance, a Fed and Treasury policy, and a continuation of the fight against inflation. Still, most analysts saw in Powell's comments, some indicators that the hiking cycle might be coming to a close. At one point, Powell said, if we need to raise rates higher, we will. I think for now, though, we see the likelihood of credit tightening. We know that that can have an effect on the macro economy. Wells Fargo economists echoed this idea that the

banking crisis will lead to tighter credit conditions, meaning that, quote, the end of the current tightening cycle is likely coming into view. Joe Gilbert portfolio manager at Integrity Asset Management said, Powell is trying to have it both ways. He's trying to appease both the hawks and the doves. This ultimately may be the last rate hike this year, but Powell has to make the market believe that it isn't because that would loosen financial conditions too much. The softening to come in the economy from the banking collapses has yet to be felt, and the Fed knows this, but they cannot be alarmists. Now, expanding out the market reaction a little bit, the Koba-easy letter writes, this is incredible. The Fed raises the rates and said more hikes possible, but the base case

for futures show no more rate hikes. The Fed said they, quote, don't expect rate reductions this year, but futures see up to four rate cuts by December. Markets are saying the Fed is lying. It seems like markets have become more comfortable fighting the Fed. Now, one other weird note from this whole affair. As Powell was talking, Janet Yellen also made a bunch of comments. And they seemed to be walking back the idea that the U.S. government was committing to backstopping all U.S. bank deposits. Indeed, the headline that went out, again, as Powell was talking, was U.S. Treasury Secretary

Yellen, we are not considering insuring all uninsured banking deposits. Guy LaBass pointed out that, quote, dropping this during a post-OFMC presser is like burying it at 8 p.m. on a Friday. Steve Chiverone, senior portfolio manager at Federated Ermes, said, It's astounding that Yellen and Powell would have given contradictory messages on bank deposits at the same time. Powell essentially said that all deposits are safe. Yelan said, hold my beer. You would have thought that they would have coordinated. Now again, that was just on Wednesday, but then less than 24 hours later, Yelan was walking it all back. The headlines read Yelan, prepared for additional deposit actions if warranted. Yelan says strong actions taken to ensure

deposits are safe. Yell an important anti-contagent tools may be applied again. So suffice it to say, communications challenges around the banking issue remain. Join CoinDesk's Consensus 2023, the most important conversation in crypto and Web3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immers yourself in all that blockchain technology has to offer creators, builders, founders, brand leaders, entrepreneurs, and more. Use code breakdown to get 15% off your paths. Visit consensus.coindex.com or check the link in the show notes. Now, one more interesting thing to hone it on before we wrap up. It's something that's brewing

that I'm noticing a lot more conversation about and so I wanted to share a little bit here. On Tuesday, the Wall Street Journal presented a hypothesis about where the next problem on bank balance sheets could show up, and they think it's in commercial property. to the article, this year will see a record amount of commercial mortgages expire and need to be refinanced at much higher interest rates if Fed policy remains static. This commercial property debt is concentrated in smaller banks who carry around $2.3 trillion in total, almost 80% of commercial mortgages held by the banking sector. Commercial property prices have already been under pressure with work from home driving down demand for office space. But in that context, relatively few markdowns

have been realized so far. Around 270 billion in commercial mortgages held by banks are set to expire this year, with most of these loans held by banks with less than 250 billion in assets, and therefore exempt from Fed stress tests. If commercial property owners manage to pay down or refinance these loans, then there's no problem. But a major default wave could cause a ripple effect as other commercial loans are marked down to recognize looming credit risk. In other words, while so far this banking crisis has been about a duration mismatch, which causes a liquidity crisis. This looming refinancing wave opens up the possibility that it will turn into a credit crisis. In a recent paper, a group of economists estimated that the value of loans and securities held by U.S. banks

is around $2.2 trillion lower than their current book value. Although this research did not take into consideration the value of hedges, the authors of the paper said this impairment could put 186 banks at risk of failure. And around one quarter of these impairments are due to real estate loans. At the median U.S. Bank, commercial real estate makes up 38% of all loan holdings. What's more, we're already seeing signs that a default wave could be looming. Major commercial landlords Pimco and Brookfield Asset Management defaulted on several billion in loans on office buildings in February. Blackstone defaulted on more than 500 million of commercial mortgage-backed securities in early March after property sales were delayed.

Blackstone's $71 billion real estate investment trust halted withdrawals in December and has been struggling to find the liquidity to service investor demands ever since. Data firm TREP reported that the delinquency rate for commercial properties ticked up by 18 basis points in February to reach 3.12%, which represents the second largest monthly increase since June 2020. While this delinquency rate sounds small and manageable, it's the highest level since 2013. The trouble could compound if small and regional banks continue to face strong outflows and deposits. For anyone who's been paying attention to the last few weeks, these issues will sound familiar. Banks typically hold commercial loans to maturity so do not need to recognize market prices. If banks are forced to sell

these loans to raise capital, they will need to recognize the losses, impairing their balance sheet and further spooking depositors. Now, of course, so far, the Fed's solution to this sort of balance sheet impairment in the banking sector has been to recognize those loans at face value, and offering banks collateral against them rather than forcing them to sell them and realize the losses through the bank term funding program. However, right now, that program is only available to U.S. Treasury's and agency mortgage-backed securities. While some commercial real estate loans are packaged as agency MBS, others simply sit intact on bank balance sheets, making them ineligible for these Fed programs. And what's more, commercial

real estate loans have a much less liquid market than other types of bank balance sheet assets, which might mean banks are stuck realizing the losses if this scenario plays out. Now, for those of you keeping track at home, this sort of potential impairment is exactly what has folks like Arthur Hayes convinced that what is supposed to be a limited short-term bank-term funding program is likely to expand in scope and duration almost immediately. Anyways, guys, that is the macro story from here. Lots of other things still going on. Yesterday, after I told you about Doe Kwan's arrest, we also got an indictment from the

U.S. Justice Department. Doe is accused of eight charges of fraud officially, so it seems like we will have some trials to watch in the months to come. But for now, happy Friday. Hope you are heading into a great weekend. And as always, until tomorrow, be safe and take care of each other. Peace.