GSP Insights

This week’s GDP and PCE reports did not give the ever data dependent Fed any compelling reason to begin rate cuts anytime soon. In fact, the May, June, July and September meetings are now all “off the table” for cuts according to the futures markets. GDP (Thursday): The headline 1Q GDP estimate showed a 1.6% annualized increase, actually lower than expected – usually a sign of a “cooling” economy. But a look behind the numbers and the “final domestic sales” component showed a 3.1% expansion (hot). It gets hotter: the price component of GDP jumped 3.7% in the 1Q (annualized) with a whopping 5.1% increase in services costs. PCE (Today): March PCE numbers came in at 0.3% monthly with annualized core at 2.8% (well above the 2.0% target). Most of the inflation this year is not due to goods prices. It’s services (aka employment) and “ultra sticky” components like insurance, car repair costs, health care, etc. These items are not pressured by interest rates and therefore are not subject to the Fed’s only tool. The 10-year Treasury is now at 4.66% after hitting a 2024 high of about 4.75% earlier in the week. Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

This week’s CPI release for March indicated 0.4% monthly increases in core and headline inflation. Markets were expecting no more than 0.3%. The March data seemed to contradict hopes that the hot Dec-Feb CPI was due to year end seasonal factors and that the rocky path down to 2% annual inflation would resume. The inflation report came on the heels of last week’s stronger than expected jobs report (303,000 vs 212,000 expected). Fed rate cut expectations are now hugely diminished. What was once 5-6 cuts starting in March is now about 2 cuts starting in July or September (June is now off the table). The narratives are shifting again: Higher for Longer, Going Sideways, Re-Acceleration Danger. The 10-year Treasury spiked from 4.34% (just before CPI) to 4.60% (yesterday), before dropping to 4.50% today. Today’s rally wasn’t good news either as its being stoked by a “flight to quality” on the year’s biggest sell-off in stocks (Dow down over 500). The sell off is being stoked by inflation fears, geopolitical concerns (Mideast conflict widening on Israel-Iran tensions), oil price spikes and JP Morgan results and guidance. Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

The 10-year Treasury has seen a volatile week: 4.19% on Monday to 4.43% Wednesday, now at 4.31% as markets await tomorrow’s big jobs report. Everything is magnified as the “data dependent” Fed is now 2 months away from the anticipated pivot date. Fed Speak of the week: we need “time for the clouds to clear” before cutting rates (Richmond Fed Pres Barkin).

Futures markets are at 71% for a June cut (up from 62% yesterday). Monday and Tuesday both saw hot manufacturing data as the sector went into expansion mode for the first time in over a year. Then rates cooled today on higher than expected jobless claims (which could have been affected by the early Easter holiday). On deck, the big 3: jobs report tomorrow, CPI Tuesday, PPI Wednesday. Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

Fed Meeting Aftermath:

Fed policymakers kept options open at last week’s meeting. They left rates unchanged (as expected) and updated the “dot plot” prediction of three rate cuts this year (indicating they are so far undeterred by recent hotter than expected data). Fed Chair Powell was very accommodative in tone, describing the December/January data releases as “seasonal” and not concerning. Today’s February PCE release was slightly cooler than expected with core monthly at 0.3% (0.4% expected) and 2.5% annually. The next few months will have to improve on that to see the expected/hoped for/will it really happen? Rate cut at the mid-June Fed meeting (May is pretty much off the table). Right now, the Fed is hedging both sides: telegraphing 3 cuts for election year “cover” while reminding us that everything is data dependent, and they are willing to go “higher for longer”.    

The Dot Plot: 

Fed Funds rate is 5.25-5.50% today. Three cuts this year would put it at 4.50-4.75%. The dot plot predicts 3 or 4 rate cuts in 2025, followed by 2 or 3 cuts of 3 rate cuts in 2026. Assuming 9 or 10 total cuts over the next 3 years would put the Fed Funds rate at 2.75-3.25%. Neutral Rate:  The “neutral rate” (aka r*) is the equilibrium short term interest rate that would be appropriate for an economy at full employment and stable inflation – meaning the Fed’s famous “dual mandate” is  “mission accomplished.” Last week the Fed moved its estimate of the neutral rate to 2.6% (up from 2.5%). Note that the neutral rate was often predicted at 2.4% during the 2010s era of ultra-low Fed Funds rates under 1%. Many analysts believe that the Fed is gradually moving up the estimated neutral rate of 3%.

Fed Funds and Treasuries:

Of course, many real estate investors are focused on treasuries, the benchmark for debt costs on stabilized properties. The question often asked these days is “what will happen with Treasuries when the Fed finally cuts rates?” The typical CRE loan is based on the 10-year Treasury and the Fed Funds rate is short term. The 10-year Treasury yield is heavily influenced by investor expectations on where interest rates will be over the next 10 years. Remember in December when the market was predicting 9 rate cuts (!) in 2024 and the 10-year T dropped to 3.79%? Today the prediction is for 3 cuts and the 10-year Treasury is at 4.20%. When were we last at or near the neutral rate? In Dec 2018, the Fed raised rates to 2.25-2.50%, where it stayed throughout most of 2019, until rate cuts in Aug-Oct (The 10-year Treasury dropped from 3.15% to 2.00% during that period as the economy contracted). Then came the 2020 pandemic, slowdown, stimulus and severe cycle distortion. The chart above shows the spread between the Fed Funds rate (blue) and the 10-year Treasury (gold).  Since 1990, the 10-year Treasury typically ranges about 1.50% above the Fed rate. So, a 3.0% neutral rate would indicate a treasury in the 4.50% range. Of course, dot plots are superseded regularly and unless you forgot, everything is data dependent. Stay tuned…

 

George Smith Partners just connected with a National Bank that shared their targeted approach for 2024 in the CRE Lending space.

They focus on Bridge and Construction financing, with a minimum check size of $20MM. Their lending portfolio includes industrial, multifamily, retail (case-by-case), self-storage, and student housing sectors.

Pricing is competitive at S+325-350bps, aiming for 55% LTC/ LTV.

The bank emphasizes long-term relationships and requires a deposit with each transaction (5-15% of proceeds), preferring to engage with institutional clients, HNW, and family offices.

They offer non-recourse and recourse lending, with a standard DD process before issuing Term Sheets to ensure reliability through loan closure.

CPI:  Tuesday’s report indicated CPI rose 0.4% for the month (vs 0.3% expected) and 3.2% for the year (vs 3.1%). Remember when we cheered the monthly increase dropping from 0.4% (September) to 0.1% in October? From November to February, we have seen 0.2%, 0.2%, 0.3%, 0.4%. The annualized rate has shot up past the Fed’s target of 2%. Energy and shelter account for 60% of that gain. Silver lining: food costs did not rise for the first time since April 2023 (flat grocery prices with restaurant food up barely 0.1%). Shelter costs are very gradually (but steadily) coming down. The annual rate was up 5.7%, the lowest since July 2022.

PPI: Today’s report was way up, 0.6% monthly, signaling possible ripple effects on consumer inflation in the coming months. Note that annual travel and leisure services costs rose 3.8% (no matter how many high-profile tech company layoff announcements are in the CNBC headlines, this sector continues to run hot and contribute to labor market tightness). Remember, the Fed is “data dependent” so this week’s data pushes out rate cut expectations. Thus, cuts at next week’s meeting or May 1 are now off the table as futures markets indicate 95% probability of sitting tight at both meetings.

Narrative: Over the past year we have gone from “higher for longer” to “lower but slower” to “soft landing” to the latest, “no landing” – meaning we are “there” now, stuck between a tight labor market and high rates. Some aspects of inflation are agnostic regardless of rates. Fed Chair Powell recently spoke of insurance for example. Natural disasters, major insurers pulling out of certain markets, trouble in the reinsurance markets and factors such as high auto repair costs (parts have become increasingly complex and expensive, even if there are the same number of incidents, each one costs exponentially more). One pundit wrote that America is becoming “uninsurable.” The economy may be “moving sideways” as disinflation stalls. Speaking of Powell, he took heat from Congress regarding the famous 2.0% inflation mandate. If it was 3.0%, he could be cutting rates now, right? During his testimony on Capitol Hill, Powell said that the 2.0% is critical for the economy and the Fed is not anywhere near changing that target. Then he said it five more times! He is pretty much painted himself into a corner (he seems to like being there), as that level of insistence during an election year pretty much ends that debate (for now). Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

Fed Chair Powell addressed upcoming regulatory changes regarding Bank capital requirements in his periodic congressional testimony this week. The upgraded changes were announced last year in the wake of the March 2023 sudden collapses of Silicon Valley Bank and First Regional Bank. Large regional banks would be required to retain more capital to protect against risk. Rising interest rates have devalued bank assets including commercial loan portfolios (along with office exposure) and substantial Treasury bond holdings. Powell, “I do expect there will be broad and material changes to the proposal.” Banks pushed back, telling policymakers the rules would “hurt Main Street” as banks would be forced to cut back on consumer credit and services. Some are saying that these rules intended to prevent another financial crisis could actually cause a crisis. That scenario assumes that less access to credit would accelerate drops in commercial real estate values and increase loan defaults in a spiral. Policymakers are wary of “fighting this battle” with the playbook that emerged from the “last battle” (the 2008 GFC). The revised regulations will be closely watched. Election year pressures on avowedly apolitical institutions like the Federal Reserve and FDIC may be distorting the process. Also, an upcoming Supreme Court decision may allow banks to litigate against Federal regulators in lower courts which could blunt the enforcement power of the FDIC and OCC.

Last year regulators released guidance urging banks to “work with good borrowers” on maturing loans aka “kick the can” or “pretend and extend.” Many loans that came due in 2023 received 1-year extensions (let’s do the math on when they come due shall we?). The Mortgage Bankers Association recently announced that 2024 CRE maturities have now ballooned from $659 billion (last year’s estimate) to $929 billion. That’s 20% of all outstanding US commercial real estate debt. Commercial banks are holding $441 billion of that total (note that the MBA did not break down US vs foreign bank loans).

Recent troubles at NY Credit Bank put the regional bank crisis issues back into the spotlight. NYCB took over Signature Bank’s loan portfolio after Signature’s March 2023 collapse. This came only 3 months after their December 2022 acquisition of Flagstar Bank. The sudden growth, rising rates, exposure to NY rent stabilized properties caused the stock price to plummet and liquidity concerns. This week’s 1 billion dollar cash infusion from private equity firms headed by ex-Treasury secretary Steve Mnuchin calmed investors (for now). Mnuchin’s group also is pushing for less “blend and extend” and a tougher stance on maturing loans.

Bottom Line: Bank troubles and CRE valuations are inexorably linked to the future path of interest rates which is dependent on inflation. Today’s jobs report indicated a still “warm but cooling” jobs market, lower than expected wage inflation and significant downward revisions of the hot December and January numbers. This week also saw weaker than expected Factory orders and a general “risk off” trade. The 10-year Treasury has dropped from 4.30 to 4.08 in the last 10 days. Next week’s CPI and PPI reports could be big market movers. Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

Yesterday’s release of the January Core PCE Index (the Fed’s preferred inflation gauge), showed a monthly increase of 0.4%. This comes on the heels of December’s 0.1% core reading. The recent trend of “bifurcated” supply/demand metrics continues. Goods prices were lower by 0.2% while services were up 0.6%. This closes out the January data releases. The big questions: will disinflation take hold in 2024, spurring the Fed to cut rates? Were January numbers skewed slightly higher due to year end/seasonality factors? The next two months of releases of the February/March data will be closely watched, starting with next Friday’s jobs report. Note that the Cleveland Fed’s “Inflation Nowcasting” site shows predictions of February core PCE of 0.23% and March 0.22%.

Expectations were put on hold the last month. Thirty days ago, the Fed futures market indicated a 94% chance of a rate cut at the May meeting. Today those chances are at 25%. The 10-year Treasury spiked from 3.87% to 4.25% in those 30 days. Note, however it’s rallying today down to 4.20% on manufacturing data. Purchase Managers Index is indicating contraction for the 16^th straight month. Best case scenario (aka today’s dialed back expectations) seems to be 3 (or 4) rate cuts this year starting in June. Multiple Fed officials have recently said “in the summertime” to telegraph a June start at the earliest. We may see more “telegraphing” by Fed officials as any moves during the heat of the 2024 election campaign are by definition, controversial.

Treasury supply issues were in focus this week as the biggest 5 year note auction ever ($64 billion of new issues) saw “tepid” demand. Rising budget deficits and slow inflation progress spurred bond giant PIMCO to predict that “term premiums” in long term treasury bonds (5, 10 and 30 years) may come back to levels seen in the late 1990s and early 2000s (the term premium is presently negative). This is a reminder that fixed rates (treasuries) may fluctuate independently from floating rates (Fed Funds, SOFR, Prime). Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

Optimism for early 2024 rate cuts has been tempered by recent data releases and Fed comments. Last week’s CPI and PPI price reports came in above expectations along with continuing unexpected strength in the jobs market (lower than expected weekly jobless claims for the past 2 weeks). Meanwhile the release of the Fed minutes yesterday revealed policy makers were optimistic but cautious. “Participants generally noted that they did not expect it would be appropriate to reduce the…fed funds rate until they had gained greater confidence that inflation was moving sustainably toward 2 percent.” They also mentioned that they view some of the recent data on lower inflation is “idiosyncratic” and could bounce back. They were also wary of cutting rates too early.

 

All this has changed futures markets rate cut expectations over the last month. May 2024 cut odds went from 85% likelihood (30 days ago) to 20% (today). The 10-year Treasury has spiked from 3.87% on Feb 1 to 4.33% today. What’s going on? It could be that the so called “last mile” from 3% CPI down to 2% will be bumpy and slow. Goods prices have come down as supply chains and scarcity premiums have abated, but labor/services costs continue to be sticky. That sector is subject to macro social and demographic trends including labor participation, baby boomer retirements, etc. On the other hand, it is also possible that the December and January data reports are skewed due to a boom in holiday shopping, annual pricing adjustments and other seasonal factors. And don’t forget the lagging shelter cost component (33% of CPI) is expected to drag the headline number down in coming months (we hope). Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

After the November/December rate rally that saw the 10-year Treasury drop from near 5.00% to 3.79%, 2024 started with a partial reversal as the 10-year spiked to 4.18% in mid-January. It seemed like markets had “gotten ahead of themselves” with the rally and some correction was in order. December’s PCE report showed strong consumer spending (up 0.7% in December), but the spending was not matched by income growth. Rising credit card balances and lower personal savings rates fueled the holiday splurge, implying it is ultimately unsustainable. Annual Core PCE showed a 2.9% increase, still above the Fed’s 2% target. The 3-month moving average is 1.5% annualized and the 6 month is 1.9%.

Yesterday’s Fed announcement left rates unchanged as expected, all the action is in the statement and Powell’s presser. The statement was simultaneously dovish (it removed language about the Fed’s willingness to keep raising rates) and tamping down expectations (no plans to cut rates with inflation running above the Fed’s target). The current data indicates that we might be there now, but the Fed is still haunted by the early 80s “whoops, we cut too soon and had to raise again” rollercoaster. So, Powell dutifully remarked that “rates are still too high” and that a March rate cut was not likely. Future markets adjusted and now indicate a 95% chance of a rate cut on May 1 (90 days from today but who is counting?). Powell indicated the Fed is “data dependent” and “meeting by meeting.” More semi dovish talk from Powell, “The committee intends to move carefully as we consider when to begin to dial back the restrictive stance that we have in place.”

This week’s data indicated that time is coming; higher jobless claims, higher worker productivity (employer wage dollars being stretched), lower ADP payroll growth, etc. These are signs of long awaited “labor slack” which is closely watched by the Fed. The 10-year Treasury has rallied from 4.13% to 3.85% this week. CMBS spreads are compressing as bond buyers return with fresh allocations and a bullish rate sentiment. All eyes will be on tomorrow’s January employment report. Will the “slack” continue? Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

George Smith used to enjoy reviewing the previous year’s interest rate predictions at year end. Last year’s Bloomberg survey of the top investment bank analysts indicated an average prediction of 3.48% for the 10-year Treasury at year end 2023. With one week to go the 10-year sits at 3.88% today, exactly where it closed at year end 2022. It dropped as low as 3.26% in April (flight to quality in the wake of the big regional bank failures) and then peaked at about 5.03% in October (as inflation seemed “entrenched” and “higher for longer” Fed speak spooked markets). It looks like Barclays and Deutsche Bank are pretty close with their predictions.

Speaking of the 10-year Treasury, Fed governor Goolsbee expressed “confusion” by market reaction to last week’s Fed meeting. He commented that markets “hear what they want to hear” and not “what the Fed Chair says.” Markets actually weren’t phased by his comments (these type of Fed comments lately are perceived as mandatory “more bark than bite” hawkish smoke screens). The futures market is predicting an 83% chance of a rate cut by the March 20 meeting (89 days from now but who’s counting?). As we say goodbye to a volatile year in capital markets, we wish everyone a safe and happy holiday season. Stay tuned…

 

END-2023 TREASURY YIELD FORECASTS
			10Y
Bank of America			3.25%
Barclays			3.75%
Citi			3.25%
Deutsche Bank			3.65%
Goldman Sachs			4.30%
JPMorgan			3.40%
Morgan Stanley			3.50%
MUFG			3.375%
NatWest Markets			3.35%
RBC			3.45%
Societe Generale			3.25%
TD			3.25%
2022 Closing Level			3.87%

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.

Yesterday’s Fed Policy Meeting had a self-congratulatory feeling as Fed Chair Powell remarked, “The era of this frantic labor shortage is behind us. Overall, the development of the labor market has been very positive. It’s been a good time for workers to find jobs and get solid wage increases.” Powell has always stressed the Fed’s altruistic mandate, especially after the pain caused by the rate hikes. He cheered the long-sought “labor market balance” and cited increased labor-forced participation as extremely positive. “Recent indicators suggest that growth in economic activity has slowed substantially and that higher rates are slowing investment.” He noted that the Fed is now seeing progress on inflation across the three main core areas. Translation: we don’t have to raise rates further. The Fed’s new “dot plot” of interest rate predictions indicates they expect 3 rate cuts in 2024 (the last dot plot in September predicted 1 rate cut in 2024). The Federal Reserve is willing to cut rates even if the U.S. economy doesn’t dip into a recession in 2024, Powell said.  “It could just be a sign that the economy is normalizing and doesn’t need the tight policy.” Powell feels the Fed will accomplish the rarely seen “soft landing.” Of course, he had to add the “disclaimer” to demonstrate his inner hawk. “We are prepared to tighten policy further if appropriate,” he said at the post-meeting press conference. That mandatory quote must be taped to his podium.

Did you ever wonder how to say, “Let’s Get This Party Started!” in Fed speak? Here you go. “The question of when it will become appropriate to begin dialing back the amount of policy restraint in place…and is clearly a discussion topic…out in the world and…for us at our meeting …I would say there’s a general expectation that this will be a topic for us looking ahead.” Bam! Equity and bond markets immediately went on an epic rally. Dow hit a new closing high (above 37,000) and the 10-year Treasury dropped to 3.91% (down from 4.30% on Monday). The 5-year went below 3.90%. The 3 rate cuts predicted in the dot plot are about half of what the market now expects. Fed Futures indicate the market expects 6 rate cuts in 2024. There are 8 Fed meetings next year. Assuming there is no rate cut at next month’s meeting, that’s about 25 bps per meeting. 2024 being an election year (have you heard?) may be pushing Powell to “telegraph” rate cuts in advance and possibly front-load them earlier in the year to avoid the appearance of political meddling. The dovish pivot is causing some to wonder. What does the Fed know? Stay tuned…

By David R. Pascale, Jr., Senior Vice President at George Smith Partners.