US Markets have pushed to all-time highs this year from the euphoria of Nvidia’s AI earnings and the magnificent 7’s dominance of US indices. Inflation is dropping fast, and the Federal Reserve have kept stock markets buoyant by promising interest rate cuts as soon as the data allows them. Commentators suggest the Fed has manoeuvred an unbelievable goldilocks soft landing, with interest rates having had little or no impact upon the economy, but is that really the situation or are we facing a nightmare on Elm St in the coming 6 months?
What if the data is slowly deteriorating but it’s being ignored because this time it’s different!
What does the inverted yield curve indicate?
Generally, investors receive higher returns when they agree to commit their cash for longer time periods. So the fact that a Treasury investor today could lock in at a 5.32% effective annual yield with principle paid back in one month, but just 4.31%pa for one decade, doesn't sound quite right does it?
An inverted yield curve occurs when near term risks increase. Investors demand greater compensation from shorter term treasuries, when long term expectations for the economy sour.
Inverted yield curves can be more clearly illustrated through yield spreads. The 10 year compared to three month spread is a popular recession indicator and represents the relationship between long term bonds and what's often considered the risk free interest rate. In late October 2022, the 10 year-three month spread turned negative for the first time since February 2020 and has remained negative for the last 18 months. Does this matter? Well only time will tell if a recession is around the corner, but maybe there are other signs of the economy weakening.
How strong is the US consumer market?
Well McKinsey & Company suggest that US consumer confidence has dipped in the second quarter of this year with economic pessimism growing, fuelled by concerns over inflation, the depletion of personal savings and the weakness in the labour market. Consumers are starting to cut back on non-essential items, and many are taking on several jobs to make ends meet. Nike just reported a surprise 10% drop in quarterly revenue and blamed it on growing market competition, but maybe consumers are deciding to rein in spending.
Total overall commercial bankruptcies increased 22% in the first three months of 2024 with credit card and auto loan delinquency rates are also rising.
What about the US housing market?
Interest rates aren’t impacting the US consumer as they are in the UK, as they can fix their rates for 30 years, so as long as they don’t move home, their rates remain low. Currently 63% of US mortgages have interest rates below 4% despite the current rates being 7%. This has definitely helped the US consumer, but for the first time since June 2021, it is now cheaper to buy a new house than an existing house. The median new home is selling for $417,400, while the median existing house is selling for $419,300. This occurred in 2005 before the housing market crash.
What about US Commercial Property?
Unlike the residential property market that has been protected from higher interest rates for longer, commercial real estate values having taken a serious hit this year as loans need to be refinanced on a rolling basis within a 10 year term.
To get a clearer picture of what’s happening in the sector, watch Barry Sternlicht, Chairman & CEO at Starwood Capital Group, considered the Lionel Messi of REIT’s at the IConnections 2024 conference. He sums up why rates are higher for longer, the massive losses incurred on properties, and how it’s impacted the sector.
What about the US Banking sector?
It’s around 18 months since the 2023 bank crisis in which several large banks, including Silicon Valley Bank and Signature Bank, failed.
However, for the majority of this year, there was little activity, the financial sector remained relatively tranquil, largely due to a special initiative launched by the Federal Reserve to rescue other banks facing difficulties. This initiative was known as the Bank Term Funding Programme (BTFP), and it has now come to an end, meaning there are no longer any emergency loans available to banks in trouble.
We've already seen our first casualty: a Pennsylvania-based institution, Republic First, was shut down by regulators in April 24.
Republic First faced the same challenges as the others that collapsed last year — an excessive number of 'unrealised bond losses' on their financial statements.
Similar to other banks in Silicon Valley and elsewhere last year, Republic First utilised their customers' deposits to purchase US Treasury bonds in 2021 and 2022, during a period when bond prices were at record highs.
By early 2023, the scenario had turned around. Bond prices had dropped significantly; even what were considered 'safe' and 'stable' US Treasury bonds had seen a substantial decline in value, leaving banks with substantial losses.
Bond prices fall when interest rates rise. So, when the Federal Reserve raised interest rates from 0% to 5% in an effort to manage inflation, they were also creating major losses in the bond market, which in turn led to significant losses for banks.
Silicon Valley Bank was merely the beginning. Many other banks, including Bank of America, had accumulated large losses in bonds. In fact, the total unrealised losses in the banking sector last year reached a staggering $620 billion.
The Federal Reserve recognised the enormity of the issue. To address this, they introduced the Bank Term Funding Program, essentially a scheme of 'make believe'.
Through the BTFP, banks were permitted to borrow from the Federal Reserve using their declining bond portfolios as collateral. However, instead of valuing the bonds at their actual market value, everyone simply assumed the bonds were still worth 100 cents on the dollar.
In essence, the banks were assigning their own values to their assets, with the Federal Reserve endorsing this practice.
(It's somewhat ironic that a former President is currently on trial in New York City for inflating the value of his assets, while banks inflated the value of their bonds through the BTFP.)
The Federal Reserve managed to avert any further embarrassing bank failures last year by applying this 'magic fairy dust' across the banking system.
However, with the expiration of the BTFP, it's clear that issues within the banking system remain unresolved. Republic First's shutdown in April is just one example of this.
Consider this: Bond prices are still falling (due to interest rates remaining higher than in 2021-2022). Banks are still holding onto massive unrealised losses.
And now that the Federal Reserve has stopped engaging in 'make believe', the issue of bank failures has resurfaced.
It's important to note that not all banks are in dire straits; some have used the past year to improve their financial health.
Unfortunately, the majority have not, which is why there's still over half a trillion dollars in unrealised losses in the US banking system. This means that Republic First's failure in 2024 is likely not the last, unless the Federal Reserve decides to intervene once more with its 'magic fairy dust'.
So Goldilocks or Nightmare?
There is deteriorating economic data emulating from the US, probably delayed through the accumulation of substantial consumer funds on deposit following the pandemic. But this has now been spent, and credit card balances are rising to breaking point, bankruptcies are rising, consumer spending is falling, and the banks are struggling to cope with falling asset prices. Jerome Powell isn’t cutting rates anytime soon, as he retires in May 25 and won’t want to cut too early, only to see inflation rise again as it did in the 1970’s and him go down in history for it. So, he will probably cut too late, making a huge policy error in the process and as a result things could get messy.
It is therefore important to position portfolios accordingly to accommodate for the unexpected, which is what we have undertaken with our clients’ investments. If you would like to discuss how you go about this, then please make contact.
Chris Downing
Principal
Winchester Investment Solutions Ltd.
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