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Interest Rates & Dilettantes

This is a syndicated repost published with the permission of The Institutional Risk Analyst. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

September 29, 2021 | In this Premium Service issue of The Institutional Risk Analyst, we return to the world of interest rates and inflation expectations, what we laughingly refer to as monetary policy in the U.S. As was the case this past June, Treasury yields are rising and spreads are beginning to emerge from the Fed-induced coma. The vast amount of cash injected into the system by the Fed and Treasury has retarded market function and driven the portion of bank balance sheets funded with deposits to a 50-year high. But the biggest factor weighing on the debt and equity markets is the ebbing credibility of the FOMC under Jerome Powell and the Treasury under Janet Yellen. We truly live in the age of the dilettante.

Two Federal Reserve Bank Presidents have resigned in the past week following revelations regarding personal trading activities that are, at best, inexplicable. Just how did the Fed arrive to 2021 without a policy on managing conflicts and personal investing? But the bigger credibility gap for the Fed arises from the lack of consistency in Fed monetary policy. A timely research paper by Jeremy B. Rudd published by the Fed Board of Governors throws a rather critical light on Fed policy making:

“Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.”

This remarkable paper serves as a rebuke to the shepherds of conventional thinking inside the Fed and the surrounding media. If you say you are aiming for 2% inflation and you get it, then it is time to change policy toward tightening. Even the Bank of England has announced its intention to raise interest rates in light of the rapidly mounting inflation in the UK. But, of course, that assumes that the markets or members of the FOMC and other governing bodies of other central banks are inclined to listen. Rudd then states the obvious:

“Related to this last point, an important policy implication would be that it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “re-anchor” expected inflation at some level that policymakers viewed as being more consistent with their stated inflation goal. In particular, a policy of engineering a rate of price inflation that is high relative to recent experience in order to effect an increase in trend inflation would seem to run the risk of being both dangerous and counterproductive inasmuch as it might increase the probability that people would start to pay more attention to inflation and—if successful—would lead to a period where trend inflation once again began to respond to changes in economic conditions.”

As we write this report, home prices are galloping along at double-digit monthly growth rates, the highest levels of increase seen in a century. John Kenneth Galbraith wrote about this period in his classic, “The Great Crash 1929,” when tiny fractional interests in unimproved land in FL changed hands at ridiculous prices. The FL land rush of the 1920s was the precursor of crypto tokens. After the crash, it took half a century for FL land prices to recover to previous levels.

Today we see millions of people duped into “investing” in crypto currencies. A professional investor even paid $300 million for the Bob Dylan song catalog. This is a transaction supported by literally a handful of songs few people below the age of 40 even recognize. And real estate giant Zillow Group (Z) has floated hundreds of millions in ABS supported by future home sales. All of these indicia of the madness of crowds are the result of Fed monetary policy. To quote Friedrich Nietzsche:

“Madness is rare in the individual—but with groups, parties, peoples, and ages it is the rule.”

Our twitter buddy Komal Sri-Kumar noted this week: “I have said repeatedly since I changed my view Jan 5 on UST 10yr that yield will move up and, when it does, will rise sharply rather than gradually.” Of course, the 10-year has been falling in price along with the Japanese yen, even as surging dollar balances are supporting bloated stocks.

The economists at both the Fed and European Central Bank are in full retreat as “transitory” inflation becomes very real, particularly in the energy sector. You can blame soaring natural gas prices in Europe on COVID, but the more likely culprit is Russian dictator Vladimir Putin, who is squeezing EU consumers in a parting gesture of contempt for outgoing Chancellor Angela Merkel. And in recent weeks, of note, gas futures have outperformed crypto.

There are “no signs that this increase in inflation is becoming broad-based across the economy,” Christine Lagarde said at an ECB conference. “The key challenge is to ensure that we do not overreact to transitory supply shocks that have no bearing on the medium term.”

Like the Fed, Lagarde is trying to defend the ECB’s policy stance of continued bond purchases, but events are rapidly outmaneuvering all of the major central banks. When EU consumers sit freezing in their homes this winter because of the price of natural gas, Ms. Lagarde’s protestations will not matter.

Secretary Yellen has indicated to Congress and the Biden Administration that the middle of October is the deadline for raising the debt ceiling. We discussed this previously in our missive (“Debt Ceilings & Interest Rate Floors”) that the Fed is legally constrained against coming to the rescue of the Treasury. Indeed, once the U.S. government shuts down on October 1st, the tenor of the debate in Washington will grow ever more bitter.

Looking beyond the immediate issues of debt ceilings and federal spending, the past year under the Biden Administration has seen unprecedented outlays for relief to consumers and business alike. Insolvent pension funds around the country were turned aright. Consumers received benefits that were unneeded and saved the cash. The good news is that the economic crisis of COVID is over, but the larger crisis of American leadership remains.

Market Trends

In the world of mortgages, we have described how the Biden Administration is planning to loosen the floodgates of residential mortgage lending, removing at least 1.5% from the cost of an FHA loan (“Joe Biden Doubles Down on Housing”). We expect to see these changes in November, soon to be followed by similar reductions in fees for the GSEs. Overall, the reduced friction for low-FICO loans could be worth an immediate 10-15% volume increase in FHA lending. But as we pull tomorrow’s sales into today, there is always the question of tomorrow being a tad light down the road.

Source: MBA

The Biden Administration has extended forbearance for millions of borrowers who have already enjoyed a holiday from mortgage payments of a year or more, additional evidence of the breakdown of fiscal discipline in the US. Soaring real estate prices, however, are a more powerful force and will encourage many distressed homeowners to sell the property and pocket the net proceeds after the loan is paid in full.

“We estimate that $4.5 billion (roughly 4% of delinquent G2 loans) of loans will be impacted by the FB extension period,” Citigroup (C) analyst Ankur Mehta writes. Share is “disproportionally high in 2021 vintage, and it is the highest in 2.5s of 2021 at 17%.” The current extension only applies to FHA loans, but other agencies may follow, Mehta notes.

Meanwhile in commercial lending, there is good news and bad news. We noted in The IRA Bank Book that there is a segment of multifamily rental assets that are getting hammered, with loss severities nearing 100% at default. But in other corners of the world of commercial real estate, big bets are being made on the rebound of major cities. Trepp reports:

“Given the strengthening of the economy as more areas lift COVID-19-related restrictions, the number of CMBS loans that are delinquent or in special servicing has steadily declined. The percentage of loans with the special servicer, for instance, fell to 7.79% in August, representing the eleventh consecutive month that the rate has declined. Meanwhile, the percentage of loans that are more than 30-days delinquent declined last month to 5.64% from a 9.02% high seen in August of last year.”

Source: MBA CREF

Part of the reason that the visible default rates in commercial real estate (CRE) are falling is the great wall of cash chasing too few assets. The fact that loan resolution volumes are also falling, of interest, means that the delinquent note was somehow cured, is a telltale indicator of an asset price bubble. When duration-starved investors are willing to buy busted commercial loans above par, that is not a good indicator for credit or inflation.

Just as bank default rates have been driven negative by the truly insane bid for 1-4 family assets, in CRE there are literally hundreds of funds, REITs and other players scouring the landscape in search of investible assets – and most have access to leverage to juice the returns to the level required. Look for delinquency rates on CMBS to fall toward 4% by year end.

One close observer of the luxury residential scene in Whitefish, MT, reports that the out-of-town bid for even modest properties continues to push prices into the 7- or 8-digit price range. There is no rhyme or reason for the continued rise in real estate prices in Whitefish save the fact of a dearth of assets and a steady supply of greater fools. Indeed, the scarcity of assets remains the dominant theme in Q3 2021 and will likely continue until the FOMC actually begins to taper.

The fact is that the US Treasury has been the dominant issuer or debt in 2021, followed by the residential mortgage sector. Corporates have enjoyed a good year, but nothing like Treasury and mortgage issuance. Federal agency securities and ABS have been trending lower for the past year, as shown in the chart below from SIFMA.

Starting in March of 202o, mortgage issuance went through the roof, at one point around November peaking at $600 billion in new MBS is a single month. Corporate bond issuance likewise spiked during the same period. But notice that in the time since last summer, total debt issuance excluding Treasury debt has declined. Bank lending is also flat. These two data points are suggestive of coming deflation.

Depending on the outcome of the latest fiscal standoff in Washington, the interest rate picture could go from stable to decidedly bearish and in a short-period of time. Even if conservatives in Congress are able to beat back progressive demands for $4-5 trillion in new spending, an addition $2-3 trillion in US borrowing to fund all sorts of popular but ultimately ridiculous projects may finally tip the scales against the Treasury in the global markets. As we have noted previously, the assumption of stability is the key negative factor in the US economic equation.

The FOMC has already signaled that mortgage bond purchases will be reduced in coming months, but Treasury purchases will continue – if only to maintain the size of the system open market account (SOMA). A reduction in securities holdings by the SOMA implies an equal reduction in bank reserves, something most bank CEOs would welcome.

The Federal Reserve Bank of NY plans to conduct approximately $56.3 billion in agency MBS purchase operations over the period beginning September 29, 2021. As and when these purchases are actually tapered, look for 30-year mortgage rates to rise between 1-2 percentage points. The housing boom will then be well and truly ended. Home prices will start to weaken. Then comes the question: What next?

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