No surprise hike from the Fed … one more hike coming later this year? … elevated rates for longer in 2024 … a look at how the U.S. banking system is holding up

 

As expected, the Federal Reserve maintained its fed funds target rate of 5.25% – 5.50% this afternoon.

The real story came from the Fed’s updated dot plot, which shows us each committee member’s anonymous projection of where they believe rates will be at upcoming dates in the future.

Here’s CNBC with those details:

…The Fed’s dot plot showed the likelihood of one more increase this year, then two cuts in 2024, two fewer than were indicated during the last update in June. That would put the funds rate around 5.1%…

Twelve participants at the meeting penciled in the additional hike, while seven opposed it…

The projection for the fed funds rate also moved higher for 2025, with the median outlook at 3.9%, compared with 3.4% previously.

In his press conference, Federal Reserve Chairman Jerome Powell maintained a balanced tone. Neither expressly bullish nor bearish, he continued his months-long policy of pointing toward “the data.”

However, he noted that the strength of the economic data has surprised many people this year, Fed members included. We see the impact of this surprise strength through the tighter policy forecasts of one more hike this year, followed by two fewer rate cuts next year.

Wall Street had hoped for a blatantly dovish Powell. In his absence, this morning’s market gains have turned to losses.

Below is a 1-minute chart of today, highlighting the three major indexes. As you can see, all three have given up their gains, closing at their respective lows of the day.

As we stand now, the question becomes: “If we do have one more hike this year, and if the Fed only enacts two quarter-point cuts next year, what will it mean for the economy?”

Today, let’s wrestle with this question through one specific lens – the U.S. banking system.

How are banks holding up in today’s economic climate?

Banks are the backbone of our economy.

As the primary supplier of credit, they enable consumers like you and me to buy homes, cars, and whatever other major capital expenditures we need.

Banks also are the major credit supplier to businesses. Their loans fund new equipment purchases, enable expansions of operations, and can help meet payrolls when times are tight.

When banks are tighter about lending, it slams the brakes on consumer spending, corporate expansion, and banking profitability. It’s a lose, lose, lose.

So, what’s the status of bank lending today?

From Axios:

The share of America’s banks that said they’re making it harder for consumers and companies to get a loan is still growing, according to a survey conducted by the Federal Reserve…

It all adds up to possible headwinds for the U.S. economy. Banks are being choosier about extending credit, making it more expensive for households and businesses to get a loan…

A net 51% of banks said they had tightened lending standards for larger and medium-sized businesses over the last three months… That’s up from roughly 46% of banks who said the same in the first quarter of this year…

For consumers, a higher net share of banks said they toughened up standards for credit card loans (36%).

Remember, this reflects what’s already happened. It doesn’t include the impact of one more hike, as well as the 2024 “higher for longer” rate expectation.

In other words, conditions won’t be improving anytime soon.

That’s especially dangerous when it comes to banks and the commercial real estate sector

Commercial lending plummeted 52% in the second quarter. With property values and rents crashing as loans roll over at vastly higher rates than a few years ago, banks are turning down many would-be real estate investors. The mantra of those investors has become “survive until ’25.”

Here are more details from Commercial Observer:

If the headlines hinted at struggles in commercial real estate, then just wait until you see the data. 

A second quarter 2023 U.S. capital markets report from Newmark (NMRK) found CRE debt origination volumes have declined by 52 percent year-over-year, and that the current market has 32 percent fewer lenders than it did at this time last year.

Moreover, while private equity sits on a record $219 billion of dry powder, that might not be enough to stave off the wave of $625 billion in CRE debt maturing over the next three years…

Loan originations by debt funds are down 73 percent year-over-year, while CMBS and collateralized loan obligations originations dropped by 79 percent from July 2022, according to Newmark data. 

Turning to U.S. consumers, how is their health impacting banks?

We’ve profiled the weakening economic condition of the U.S. consumer repeatedly here in the Digest this year. But we’ve been less explicit about tying their health to overall banking health.

To set the stage for this connection, here’s The Wall Street Journal from its article titled “’Almost All Loans Are Bad’ – Why Banks Aren’t Lending”:

Banks would love to lend more, but not to just anyone.

One way for American banks to offset the pressure coming from rising deposit costs would be to boost business: More loans, even if earning less individually, could still lead to overall revenue growth. 

But right now, their lending is expanding very slowly. As of the latest Federal Reserve weekly tally, overall loan growth at U.S. banks has been 3.6% on an annualized, seasonally adjusted basis so far in the third quarter—well below the long-term average of 7%, according to Autonomous Research analyst Brian Foran.

There are a handful of reasons behind this, but a big one is the riskier condition of loans thanks to the deteriorating U.S. consumer.

Here’s Yahoo! Finance:

Thus far the consumer has been relatively resilient…

But headwinds are mounting as job and wage growth slow, student loan payments restart, and borrowing conditions tighten.

That could all spell some trouble for banks that have been leaning heavily on consumer lending in recent quarters as companies turn more cautious about the economy.

Credit card delinquencies have been steadily rising since 2021, according to Fed data, a steeper climb than any point since 2009 after dropping to multi-decade lows…

Mike Mayo, a bank analyst for Wells Fargo, said the largest banks have already set aside money for loan losses in a potential scenario where the unemployment rate reaches 5%. It was 3.8% in August, up from 3.6%…

Banks are starting to pull away from making as many new consumer loans as they have in the past, especially those deemed riskiest.

With rates likely headed higher this year and remaining higher than previously expected next year, odds are we’ll see even fewer consumer loans over the next 12 months.

Even if the U.S. consumer remains healthy, banks are still likely to turn away an increasing number of borrowers in the months to come which will slow economic growth

Why? Turning down business just hurts their own profitability.

You might have missed it, but this summer, U.S. regulators proposed that big banks increase their capital levels. This is to protect against future blowups following this year’s regional banking meltdowns. The impacted banks would see an aggregate 16% increase in their capital requirements.

Last week, JPMorgan CEO Jamie Dimon sounded off on the proposal, calling it “hugely disappointing” and warning that it could have “unintended consequences” for the U.S. economy.

Back to the WSJ:

Bank of America said that, at higher required capital levels, it would have to evaluate things such as how much of unused credit-card lines it can offer. 

JPMorgan Chase Chief Executive Jamie Dimon said the new set of capital proposals by the Fed imply that “certain things should not be held in the banking system. That’s what it means. Almost all loans are bad.” 

If almost all loans are bad, then bank lending will fall off a cliff. And that’s like draining an engine of oil. Without it, it’s only a matter of time before the pistons grind together and the engine locks up.

Putting it all together, it’s hard to look at the U.S. banking system today and not anticipate worsening conditions on the way based on today’s Fed meeting

The deteriorating lending environment in which we find ourselves won’t improve anytime soon if we continue along this trajectory.

If the Fed’s updated dot plot plays out, then rates are headed higher, and they won’t drop as quickly next year. So, the pressures that have hurt bank lending this year will only intensify.

While that doesn’t mean a recession or a market crash, it certainly doesn’t suggest blue-sky conditions are right around the corner.

We’ll keep you updated here in the Digest.

Have a good evening,

Jeff Remsburg