The Rate-Hike Finish Line is Visible

The Fed raises rates 25 basis points and suggests it’s nearly done … no cuts in 2023 … will the FDIC raise its deposit insurance amount? … commercial real estate is in trouble

This afternoon, the Fed matched most investors’ expectations by raising rates 25 basis points.The target rate now clocks in at 4.75% – 5.00%, the highest level since October 2007.The Fed also telegraphed that it’s likely nearly done with its rate hike efforts. It did this by removing the phrase “ongoing increases” in its policy statement, instead opting for “some additional policy firming may be appropriate.”The Fed also updated its Dot Plot, which reveals policymakers’ expectations for where interest rates could be headed in the future.This latest Dot Plot indicated that the Fed’s terminal rate will peak at 5.1% this year. More importantly, no officials see a rate-cut coming in 2023.As to the turmoil in the banking sector, in Federal Reserve Chairman Jerome Powell’s press conference, he said that it’s too soon to know how monetary policy should respond. He added that it’s possible the banking stress could have modest or stronger effects on the economy, but stated “we really don’t know.”The market received the updated policy statement, as well as Powell’s live comments well, until Powell threw cold water on bullish hopes by saying that no rate cuts in 2023 is the “most likely case.”Here’s a 1-minute chart of the S&P, showing the impact.

Chart showing the S&P crashing after Powell's comment about no rate cuts in 2023

Wall Street’s reaction is evidence of key point we’d all be wise to remember

What matters for the economy and your portfolio isn’t when the Fed pauses interest rate hikes, it’s when the Fed cuts interest rates.As an analogy, think about a 30-year fixed mortgage rate. Say it’s been climbing, month-after-month, reaching levels that are too high for you to finance a home purchase.When the mortgage rate finally “pauses,” does that help you?Well, not if the pause is at a level that’s too high for you to finance a new home.What would help you is a mortgage-rate cut. Until that happens, nothing will change about your situation.This afternoon, the Fed and Powell both said the plan is for no rate cuts this year. In other words, the interest rate environment that helped create the mess we’re in right now isn’t going to improve anytime soon if things go as expected.Wall Street ended the day down. But part of the selloff is being attributed to Treasury Secretary Janet Yellen, who also spoke this afternoon.Here’s MarketWatch explaining:

Testifying before a Senate panel, Yellen, who preceded Powell as Fed chief, was asked about reports that officials are studying ways to expand FDIC coverage to all deposits.“This not something we have looked at, it’s not something that we’re considering,” she said.

The Federal Deposit Insurance Corporation (FDIC) provides Federally-backed deposit insurance for bank accounts

The government created the FDIC in 1933 in the wake of the stock market crash of 1929 and the ensuing early years of the Great Depression. The initial protected deposit amount was $2,500.The size of the deposit insurance rose over the decades reaching $100,000 in 1980.In the wake of the 2008/2009 crash, new legislation raised the amount to today’s insured level of $250,000.Now, just for context, has our government done a good job of protecting the purchasing power of your FDIC savings is we use 1980 as our measuring stick?Nope.To equal $250,000 in 1980, the required FDIC-insured value would have to clock in at $365,097.09 in today’s dollars.That’s a whopping 46% higher.

Here in the wake of the recent banking collapses, we’re seeing the politicians and various special interest groups put this insured-amount in the spotlight

Though Yellen wasn’t supportive of increasing FDIC coverage today, some groups are calling for it.For example, the Mid-Size Bank Coalition of America is pushing regulators to extend FDIC insurance to all deposits for two years. That’s intended to halt an “exodus” of funds from smaller banks.This exodus is real. Here’s Financial Times:

Large US banks are being inundated with requests from customers trying to transfer funds from smaller lenders, as the failure of Silicon Valley Bank results in what executives say is the biggest movement of deposits in more than a decade.…Depositors are still attempting to move balances into larger banks such as JPMorgan, Citi and Bank of America, as well as money market funds, the people said.That is especially the case when balances exceed the $250,000 threshold that is guaranteed by federal insurance.

It would seem a no-brainer to raise the insured amount, but there’s an interesting Catch-22 at work here…The greater the deposit amount that the government decides to backstop, the more protected the Main Street saver is, yet also the more incentivized banks are to take risks because Big Brother is there to save the day when they mess up.From House Financial Services Chair Patrick McHenry:

“What I want to know is the trade-off … of moral hazard, of having more risk-taking in the financial sector, and also the impact it would have on community banks.”

We’ll see more headlines on this issue in the coming days/weeks. We’ll keep you updated.

Related to this, keep your eyes on small banks and the real estate sector

In yesterday’s Digest, we noted that commercial real estate sector could be next to come under pressure due to the Fed’s historic rate-hikes.Commercial real estate is highly-leveraged. As rates have exploded over the last year, real estate companies have increased exposure to these higher rates because of variable-rate loans and/or refinancing needs.And don’t think that commercial real estate companies knew better than to use variable debt.Bloomberg reports that nearly 48% of debt on office properties that matures this year has a variable rate.Meanwhile, as “work from home” remains popular, commercial real estate space demand has shrunk, which translates into lower revenues.Clearly, higher financing costs and lower revenues means commercial real estate is coming under pressure. By extension, the small banks that finance them are under pressure as well.Here’s The Wall Street Journal reporting on how connected real estate and small banks are (bold added):

Smaller banks are crucial drivers of credit growth, the fuel that powers the economy.Banks smaller than the top 25 largest account for around 38% of all outstanding loans, according to Federal Reserve data.They account for 67% of commercial real estate lending. 

Okay, so small banks are especially vulnerable to commercial real estate. But is commercial real estate really in trouble, or are we begin overly concerned?Here’s Bloomberg:

Sales of commercial mortgage bonds have fallen off a cliff, plummeting about 85% year-over-year, as rising interest rates cut into lending volume and defaults spook investors…Investors blame the Federal Reserve’s aggressive interest rate campaign, which has made it more expensive for borrowers to refinance.Higher rates have also cut into sales of properties by effectively lifting prices for buyers.

And now let’s jump to Urban Land:

Office property owners who were able to weather the worst of the pandemic are crashing into a hard reality wrought by sharply lower demand and higher interest rates.Undercurrents of stress are now emerging in a growing wave of loan defaults.Notably, Columbia Property Trust made headlines with news that it had defaulted on $1.7 billion in loans tied to seven buildings.In another high-profile example, a fund managed by Brookfield also is reportedly defaulting on roughly $750 million in loans for two L.A. properties—Gas Company Tower and the 777 Tower…

Even if we can sidestep commercial real estate defaults and small banking stress, it’s unlikely we’ll avoid tighter lending standards, which raises the odds of one thing…

Recession.What do banks do when a few banks go under and there are signs of economic trouble?They tighten their lending standards.But too much tightening dries up liquidity in the economy, which kills growth and innovation, which can result in a recession.So, how much are small banks tightening today?From Axios:

By the end of last year, banks were already pulling back on lending, as they saw more deposits head out the door…About 40% of loan officers said they had tightened lending standards in the commercial real estate space during the last quarter of 2022, per an analysis of the Fed’s most recent quarterly survey of loan officers by CoStar.Only about 5% said they were tightening at the end of the previous year.

That’s a 700% increase in the number of reported tighter lending standards. Think that might suggest there’s a problem?

Coming full circle to the Fed

Skyrocketing rates are behind recent banking failures. They’re also behind the growing risk of commercial real estate defaults, and by extension, even more stress in small/regional banks.This afternoon, the Fed raised those skyrocketing rates even higher.Translation, the interest rate environment that landed us in this mess won’t be improving anytime soon.Yes, inflation might be dropping. But what does that do for a commercial real estate company that can’t make refinancing numbers work today?What does that do for the small bank that now holds the keys but not the cash?What does that do for the small business that was counting on a much-needed bank loan but no longer qualifies for tighter lending standards? And the employees that lose their job as management turns to cost-cutting?We’re glad to see the finish line of the Fed’s rate-hike campaign, but the Fed has already set in motion an economic daisy chain that’s likely to get bumpy.“How bumpy?” is the big question now.Have a good evening,Jeff Remsburg

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