Hitting a Wall?

TLDR:

1. Fed doesn’t blink, continues to hike rates
2. Lending hits a brick wall
3. Non-Farm Payrolls remain strong

That’s how regional banks should feel following the Fed’s rate hike last month. Literally no less than 2 hours after the hike, stocks of various regional banks such as PacWest tanked. While it rebounded strongly this week, it’s still below pre FOMC levels, and declining again with broader markets.

Is this what a “sound and resilient” banking system looks like? Ideally banks should be extremely low beta stocks near utility levels of excitement due to their heavily regulated nature, and unusual amount of support from regulators. Yet they are now more volatile than dog-themed crypto tokens.

To make matters worse, in a separate action, TD Bank announced that they are canceling their merger with First Horizon, sending First Horizon’s shares down by over 40%. This is unfortunate given that rules were bent to make sure JPMorgan was able to absorb First Republic despite having a ban on consolidation for banks that hold in excess of 10% of all deposits.

In short the US Treasury and the Fed want to have their cake and eat it too: they want to support the banking sector while continuing to hike rates to quash inflation. It is clear that Powell does not want a replay of the 1970’s in which Arthur Burns, then chairman of the Fed, let inflation run rampant. So what does he do despite the clear beginning of a banking crisis?

Fed Doesn’t Blink, Continues to Hike

With fed funds rate comfortably above 5% now and most metropolitan area real estate cap rates barely a percent above these levels, we are beginning to hear the giant sucking sound of the Fed draining deposits from the banking system. No chart is more evident than the M2 money supply, which is what most people colloquially think of as cash, bank deposits, CDs and money market funds.

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Over $1 trillion has been lost from the peak, which represents significant de-leveraging. This is because banks typically use the deposits for loans or investments, creating a multiplier effect. For instance, with 15% reserves, banks can multiply each dollar of capital by 7.

From another angle, if a loan is repaid and no new loans are made, the total deposits in the system decrease since the borrower's liability (the loan is the bank’s asset) is paid off. This reduces both deposits and assets in the banking system, and a larger proportion of capital supports fewer assets, leading to de-leveraging in the banking system, which is the chart you see above.

So deposits are down, do we have evidence of banks tightening standards for new loans? Fortunately, yes! Fresh off the press, we have the Senior Loan Officer Opinion Survey (SLOOS)

Lending Hits a Brick Wall

Roughly half of banks are tightening their standards for new loans according to the recently released SLOOS. While we aren’t at the local extremes yet in terms of tightness, it’s instructive to see how the responses have changed over time.

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The gray bars indicate recessions. Usually at these levels of tightening, we are either squarely in a recession, or about to fall into one.

Similarly, the survey also shows that demand for loans has also been dropping, so it is not only a case of tightening standards amid a hot economy. Businesses are meaningfully cutting back. And the one sector that stands out amongst the data is again…commercial real estate!

So while the business environment has gotten more difficult, there’s still a spot of sunshine in the labor market.

Non-Farm Payrolls Remain Strong

According to the NFP Report, the US created over 253k jobs last month, handily beating expectations of around 180k. Unemployment dropped to a 55 year low of 3.4%.

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To top it all off, wage growth of 4.4% annualized is also much higher than the Fed’s perrate of 3%.

With numbers like these, it’s really hard to argue that labor markets are softening so there is support for the Fed to remain steadfast in their rate hikes. Bonds naturally reacted very negatively to the report for higher rates for longer.

This leaves us in the very unfortunate position that banks will receive no relief in terms of short term funding costs. Meaning that there’s essentially no way out of their declining net interest margins.

Ivan’s Take

The standouts in the last couple weeks are the commercial real estate and banking sector. With a tremendous amount of lead time in terms of replacing new commercial tenants, as well as structural changes from COVID, the slow-motion train wreck of commercial real estate will continue to hurt.

This will likely coincide with the deepening banking crisis induced by the massively inverted yield curve. Banks will have a hard time replacing aging loans with profitable new loans due to the inverted yield curve, and declining loan opportunities in the commercial real estate sector.

For individuals that were lucky to lock-in mortgages sub 3%, they are sitting on healthy “unrealized” gains. Unfortunately, it’s difficult for them to cash out from this bonanza other than just sitting on the property or earning it back slowly through above normal rental returns. This means that residential real estate activity will likely be depressed until rates or home prices come down, neither of which is happening fast.

Elsewhere in markets, crude oil prices have dropped to fresh local lows despite OPEC’s recent commitment to curb production in April. We are also seeing early signs that consumers are rebelling against price increases, on a number of fronts. Tyson stock tanked as much as 16% as the company reported mid single digit percentage drops in pork and beef prices.

We are squarely in a 2-track economy. Individuals are seeing healthy pay increases, household balance sheets are still strong and prices for goods are coming down. Meanwhile, some businesses are experiencing post-COVID whiplash, and certain sectors are heading towards disaster. Stocks are up, gold and crypto are up, even the dollar is holding during a US banking crisis while regional banks (KRE) and commercial real estate (VNO) are collapsing despite assurances from the Fed to the contrary.

How long can this bi-polar situation last? My take is we should see this play out soon, this quarter will be the first full quarter post SVB, we should see some players throw in the towel. This means that it’s likely that stocks remain challenged for the coming few months until we see the first evidence of a potential ease. However given the strength of the consumer balance sheet, this might not come soon enough to help regional banks and CRE.