Pascale’s Perspective

This week’s data and treasury market reaction are significant for 2 reasons: (1) It’s been 2 weeks since headlines regarding the banking crisis and (2) Employment reports this week may be indicating loosening labor demand. In the last year, the Fed has become increasingly concerned about job openings vs unemployed workers as the usual survey data (JOLTS, etc.) showed a ratio as high as 2 to 1. As major corporate layoff announcements have been occurring multiple times a week and real time data from private job listings (indeed.com, Zip Recruiter, etc.) show plummeting job postings, many analysts feel that the Fed was looking at lagging data. The phrase “zombie job postings” and reports of skewed survey results imply that the official data is lagging. Monday’s data indicated continuing contracting in manufacturing (ISM). Tuesday saw job openings (officially) fall 700,000 to below 9.9 million- the lowest in 2 years and a lower than expected job creation number. Today’s jobless claims continued the narrative with higher applications both now and upwardly revised over the past few months (based on updated methodology). Will the Fed possibly realize that they have already raised rates enough to loosen the labor market? Tomorrow’s monthly major unemployment report might shed more light. 10 Year treasuries rallied down to 3.29%.

As systemic banking issues have receded from the headlines, the issues are not solved. The Real Estate Roundtable’s recent letter to the FDIC and the Federal Reserve highlights the issues and suggests some solutions. It notes that recent interest rate moves by the Fed have stressed bank balance sheets as treasuries and MBS are now worth less. There is $1.45 trillion in looming commercial and multifamily debt maturities in 2023-2025- banks and thrifts hold just over 50% of total CRE debt. The letter requests the establishment of a TDR (troubled debt restructuring) program that will encourage regulators to allow loan modifications during times of economic instability. This will avoid Banks being “forced” into foreclosing and/or putting sponsors into default due to restrictions on their ability to modify loan terms. Banks are also asking for increased deposit insurance which will put them on equal standing amongst depositors with the “TBTF” money center banks. The combination of increased depositor confidence and balance sheet flexibility could be part of a solution. Stay tuned…

The Silicon Valley Bank and Signature Bank collapses set off a week of wild volatility, market fear (risk-off), massive new rescue facilities from governments and money center banks, and the dust hasn’t settled. The events have also sharpened the divide between the “Too Big To Fail” money center banks and the regional banks. The TBTF banks have more stringent capital requirements and are in better shape to withstand volatility. The latest attempt (announced today) to stabilize First Republic Bank involves 11 major banks depositing $30 billion in FRB as a sign of confidence. This is on top of Sunday’s announcement of the Bank Term Funding Program (BTFP) which allows banks to borrow against their portfolio of secure bonds (Treasuries/MBS/Fannie and Freddie Securities) at par (the original price) and not today’s mark to market value (less than the original price due to rate increases). This is a critical facility as the Fed’s rapid rate increases have left many banks in a potentially illiquid position. Banks bought Treasuries in 2019-2022 while prices were high and yields were ultra low. Depositors poured money into banks during this low rate environment. The spike in Treasury yields over the past year drained deposits out of banks and into Treasuries, Money Market Funds, etc – and left Banks in a cash poor position while holding devalued collateral. This week has also seen a $50 billion rescue facility implemented by Switzerland’s central bank for Credit Suisse, a major international bank twice the size of SVB. Today has been the calmest day in markets since the SVB collapse last Friday…

What about next week’s Fed Meeting? Next week’s Fed meeting will present a conundrum for Powell and friends. Today is the one year anniversary of the first rate increase of this cycle of hikes. The Fed has spent a year tightening financial conditions, draining liquidity from the system, etc. Their intent was to pressure Main Street (employers, consumers, retailers, etc.), but their measures are now putting pressure on the financial system. Will the “cracks in the system” possibly spur the Fed to pause the increases at next Wednesday’s meeting? Maybe the focus should be on a suspension of Quantitative Tightening. The Fed is selling/rolling off $95 billion of bonds a month. Remember that the Fed was purchasing $80 billion of bonds per month last March. The selling devalues bonds while draining liquidity out of the system. The recent data (CPI as expected, PPI deflationary) may give Powell enough breathing room to “talk tough and pause.” Another possibility: Acknowledge financial market stress (“We’re monitoring it closely”), raise rates 25 bps and stop QT completely (or even start QE again?). Stay tuned…

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

This week, the 10-year treasury yield rose above the key psychological level of 4.00%. Hawkish statements by Fed policymakers indicate a resolve to not cut rates until 2024. Recent hotter-than-expected data(CPI, PCE, etc) has changed the narrative: inflation may be “stickier” than was assumed. This week also saw high CPI data from the 3 largest economies in Europe: England (10.1%), Germany (9.3%), and France (7.2%). This is driving up international bond yields. The latest market/futures/Fed talk consensus estimates are for 25 bp increases at the next three meetings and then (hopefully) a pause. That would put the Fed Funds rate, and SOFR, at around 5.40% at mid-year, aka the “Terminal Rate.” This month’s data is especially critical. The Fed is highly focused on labor/service costs and a(seemingly and stubbornly) tight job market as the main driver of inflation. This month’s data releases are critical (when aren’t they these days?) – Job openings 3/8, Employment report 3/10, CPI 3/14, PPI 3/15. The WSJ reported yesterday on signs of a cooling labor market in private-sector job postings. This trend has not yet appeared in official Labor Department data releases: the infamous “lagging indicators” may be at work here. Also, December and January data releases are skewed by “seasonal adjustments.” Therefore the March data releases (based on February’s data) may confirm some long-awaited “slack” in the labor market. As we approach the 1 year anniversary of the first Fed increase, the path forward remains murky. Stay tuned…

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

The Federal Reserve raised the Fed Funds rate by 0.25% today as markets expected. The target range is now 4.50-4.75% as the Fed has increased rates in 8 consecutive meetings beginning in March 2021. The rate is the highest since October 2007. Recent data indicating a slowdown in inflation has raised hopes that “the pause” may be occurring soon, perhaps after the next Fed meeting in March. The accompanying statement with the increase retained the language “ongoing increases in the target range” disappointed markets by implying multiple increases are planned. Fed Chair Powell’s post statement presser was closely watched. He acknowledged the slowdown,  “And while recent developments are encouraging, we will need substantially more evidence to be confident that inflation is on a sustained downward path.” He also said its “premature” to declare victory. Of course, Powell’s intent is to seem hawkish until the moment he cuts in order to keep markets from “getting ahead of the Fed.” It’s also important to note that positive “Real Interest Rates” are now just being achieved. As inflation is at 4.4% (using the annual core PCE from December), the Fed just barely hit positive territory at 4.50-4.75%. The divergence between market expectations and Powell’s rhetoric is stark – markets expect a 0.25% increase in March, followed by a pause at the May meeting, and possible rate cutting by 4Q 2023. Powell has repeatedly insisted that the Fed is not cutting this year. He did throw doves a bone during the presser with 2 statements: he acknowledged that “the disinflationary process has started”  – boom! The 10 year Treasury rallied from 3.51 to 3.39% immediately upon this statement. Then he remarked that he said it is “certainly possible” that the Fed Funds rate stays below 5% – meaning one more 0.25% increase before the pause. Futures markets predict an 85% chance of a 0.25% increase in March, with 15% predicting no rate cut. May futures indicate a 63% chance of a pause or cut at that time. Stay tuned…

2022 began with the 30-day floating index at 0.10% (now 4.32%) and the 10-year T at 1.51% (now 3.69%). Federal Reserve policy has dominated the capital markets. Speculation on future moves by the Fed is a huge factor in decision-making by all players in commercial real estate. Transaction volume started strong as the momentum from 2021’s huge year carried into Q1 2022. Volatility kicked in on January 26 with the Fed’s unexpected announcement that balance sheet reduction (aka Quantitative Tightening) would be a major part of Fed policy in 2022 (along with rate increases). Many borrowers rushed to lock in rates as the Treasury hovered around 2.00% in January-March. Then the Fed put the hammer down with 25 and 50 basis point increases in March and May – followed by 4 consecutive 75 basis point increases. Sales and loan volume plummeted as buyers, sellers, lenders, and equity providers were unable to price assets with any certainty. Lenders and investors are hoping for more clarity coming into the new year. Securitized lending volumes and investor appetite for the paper has waned. CMBS volume declined over 35% from 2021 levels. As one major originator said, “Only borrowers that have to transact are in the market.” Many originators are pushing 5 year loans as borrowers are reluctant to lock in long-term. The floating rate CLO market is in limbo. Many originators have not been able to securitize and are holding unsold pools on warehouse lines. Life companies had large origination volume in the first half of 2021 during the rush to lock in rates, with a considerable drop-off in the 2^nd half of the year. Credit unions and banks are increasingly cautious. Optimism for 2023 revolves around the possibility of the Fed engineering a “soft landing” and the anticipation of the “pivot” to lower rates which will unleash capital on the sidelines and rally securitized markets. Lenders and buyers of secondary market paper will come into the new year with fresh allocations. The US economy is showing incredible resiliency in these challenging times (GDP, unemployment, consumer sentiment) although there are also indicators of a slowdown going into 2023. In the contrarian world of Fed watching, that may be welcome news. Stay tuned… Happy Holidays to All!

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

Today’s announcement of a 50 bp rate increase topped off a year of rate moves unseen in recent history. The Fed increased rates 7 times this year including 4 consecutive 75 bp increases. The increase to 4.25% – 4.50% puts it at the highest level since December 2007, when Fed Chair Bernanke cut rates during the financial crisis.

What’s next? Today’s dot plot of predictions from Fed officials shows a “terminal rate” of 5.1% (up from September’s estimate of 4.6%). So, that’s “how high?…what about “how long?” – the dot plot indicates no rate cuts for all of 2023, with 1.0% in cuts during 2024. Note that would put the rate in December 2024 right back to today’s rate. Futures market assumptions are more optimistic. They indicate a likely 25 bp increase in February and March 2023 with the longed for “Fed pivot” starting in the summer. It seems that the end of the tightening is within sight. However, the Fed will keep up the hawkish rhetoric until “the job is done” in Powell’s words. He keeps reiterating that “the historical record cautions strongly against prematurely loosening policy”; referencing Fed Chair Volker’s premature rate cuts in the early 1980s, only to have to hike rates again even higher than before. The 10 year Treasury is right at 3.50% with 30 Day Term SOFR at 4.32%. Regarding yesterday’s cooler than expected CPI report, it is significant to note that services costs remain high with job openings exceeding available workers. That issue still isn’t “solved.” Stay tuned…

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

Today’s release of the October PCE report indicated that the key indicator, month-over-month core price increases, rose 0.2%. That’s in contrast to April (0.7%), June (0.6%), and the last 2 months at 0.5%. It’s just one month and not yet a trend, but 0.2% annualized is 2.4%. That’s “in the range” of the Fed’s 2.0% target inflation rate. Coming on the heels of yesterday’s sort of dovish comments from Fed Chair Powell, the 10-year Treasury rallied down to 3.54% this morning. It’s now almost 80 bps below the recent peak of 4.32% (October 21). One year ago today it was 1.33%. Markets are cheered by Powell’s comment that “it makes sense to moderate the pace of rate increases.” This is being interpreted as a likely 50 bps increase this month, followed by a couple more increases in the 25-50 bps range. He also cautioned that “we have a long way to go in restoring price stability,” mentioning that the terminal rate would have to be held for longer than previously assumed. Futures markets are now predicting a terminal rate of around 4.90% (which implies another 100 bps of increases). Powell drilled down on the core issue: tightness in the jobs market. The three categories of goods and services that make up the index are goods, housing, and services – with services being the largest. Good and housing prices are moderating while services costs climb.

Tightness in the job market: The Fed is watching the job openings per unemployed person ratio closely. It is presently at 1.7 to 1 (down from a high of 2 to 1 earlier). The Covid pandemic exacerbated this ratio. Powell pointed out that the “participation gap” has led to a shortfall of 3.5 million workers in the labor force. Covid related deaths, lingering long covid sickness, early retirements, and other factors probably account for 1.5 million of that total. Labor participation stats in tomorrow’s jobs report release will be closely watched as usual. Bottom line: The Fed can’t increase the workforce so it’s going to concentrate on decreasing job openings by tightening financial conditions. Powell seemed to be speaking to critics of his policy in Congress when he responded to a question: “We don’t think the world is going to be a better place if we take our time, and inflation becomes entrenched.” Stay tuned…

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

After last week’s big rally on CPI, Tuesday’s PPI added to the “inflation has peaked” hopes. Core PPI rose 5.4% annually and was actually flat month over month (vs expectations of 7.2% and 0.3%), and well off the March 2022 highs. The services component declined by 0.1%, the first decline since November 2020. Consumer durable goods (apparel, electronics) prices continue to soften as inventories pile up. Retailers indicate that consumers are downsizing and/or changing buying habits towards more value oriented. Many are predicting lower-than-expected holiday sales (while travel demand is strong). Interestingly, consumer credit card balances saw its highest annual jump in 20 years. This could be a sign the red hot consumer demand over the past few years is unsustainable: pandemic savings are running low and credit card rates are rising with the Fed increases. Signs that the job market may be slackening: the seemingly non-stop hiring by big tech has abated with layoffs by industry leaders. Weaker demand and job market slack are critical to cooling off price pressures.

Fed officials are making it clear that the “job is not done” – Yesterday morning SF Fed President Daly remarked that “a pause is off the table.” But “slowing rate hikes” is on the table. The consensus is based on comments and futures markets: a 50 bps increase on December 14, followed by 25 bps at the February and March meetings. A pause at that point would put the “terminal” Fed Funds rate at 4.75%. Daly indicated that the target is “4.75-5.25%.” Then what? The Fed intends to hold that rate for a while and let the cumulative effects of the rate hikes take effect. Daly also pointed out that as the inflation rate declines, the delta between a stable Fed funds rate and inflation will increase and (hopefully) further diminish price pressures. Keeping up the narrative: Before the December meeting, we will get October PCE, November jobs, and CPI. Stay tuned…

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

This morning’s October CPI report: Core CPI increased 0.3% for the month (0.5% expected), overall CPI is 0.4% (0.6% expected). Annual CPI is at 7.7% (7.9% expected and down from the June high of 9.1%). Relief rally: 10-Year Treasury dropped to 3.84%, down from a 4.12% opening; a big intraday move and below the psychologically significant 4.00% level. It’s interesting to note that the major fixed and floating rate lending indices are converging – 30 Day Term SOFR is 3.79%. The Dow jumped 850 points within hours. Fed futures “softened”:  85% chance of a 50 bp increase at next month’s meeting, 15% chance of a 75 bp increase. Yesterday it was 56% for 50 bps, 44% for 75 bps. One report does not “fix” inflation, but markets are ultra sensitive to trending data and anticipation. The rally is big as it assuages the fear that has emerged in recent weeks regarding the great Fed questions regarding the eventual terminal rate or peak rate: “How high and how long? Recent comments by Fed Chair Powell and other officials suggested the terminal rate may need to be 5.00% or higher to tame inflation. Today’s report provides a “hopeful path” to a lower peak and shorter time there.

Inside the numbers: Prices for “core goods” (homes, used cars, appliances, apparel) have been softening for months, while services costs have spiked. Today’s report indicated medical services prices fell 0.6%, benefitting from the “annual reset” methodology employed by the Labor Department. Another lagging indicator that should start showing softer price increases is shelter. Zillow, CoreLogic, RealPage and Apartment List have all indicated apartment rents (for new leases) softening nationwide over the past 2-3 months. It will take a couple more months for that to be figured into CPI, which counts “renters at large”- aka all tenants. Markets don’t want a repeat of the optimistic rallies as core CPI dropped steadily from April to June, but then leveled off in July and spiked in August and September- which sent rates soaring. Therefore, next month’s CPI report release on December 13, followed by the year’s final Fed meeting the next day is looming very large. Stay tuned…

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

First off, a 75 basis point increase for the 4^th straight meeting put the Fed Funds rate at 3.75% – 4.00%, the highest since 2008. Prime Rate is 7.00%, 30-Year fixed rate home loans are about 7.30% and 30-Day Term SOFR is 3.79%. Markets rallied on “dovish” comments in the initial statement: “In determining the pace of future increases, the Committee will take into account the cumulative tightening…. (and) the lags with which monetary policy affects inflation.” Many economists note that Fed actions take time to work through the economy. A scenario where the Fed watches and waits while lagging indicators catch up could forestall economy-crushing excessive rate increases, aka the “soft landing.” Hopes of “the pivot rally” jumped as the 10-Year Treasury yield dropped to 3.98 from 4.06 and the Dow rallied over 300 points in 30 minutes… until Fed Chair Powell’s remarks and responses to questions. His opening remarks seemed like a direct response to domestic and international pressure on the Fed to ease off on rate increases. He reiterated that the Fed’s number one job is price stability and that a sustained healthy labor market depends on that stability. The irony in that statement is that fighting inflation will require more slack in the labor market, i.e. higher unemployment. It’s as if the Fed needs to “break employment to save it.” The phrase that really moved markets was: “It’s very premature to think about pausing”, which he repeated for emphasis. Powell recognized that conditions have already tightened in housing, business investments, and other rate-sensitive sectors. He noted that goods prices should have come down faster and that prices for services are rising significantly. Yesterday’s ADP report for September indicated robust hiring continues in the services sector – especially hospitality and leisure.

Future Direction: Powell indicated that the Fed might “slow the pace” of rate cuts in December and February. But the data point that really shook the markets was his response to the big questions which are: “How high?” and “How long?” – regarding the “terminal rate” or peak and how long before the next rate cut. It seems like the answers are “higher” and “longer.” Powell said that there is now “significant uncertainty” amongst Fed policymakers about the “ultimate level” for the Fed Funds rate. This follows recent comments by Fed President Kashkari that a “terminal rate” in the 5% range may be needed to battle core PCE inflation. Recent assumptions had the terminal rate at about 4.6% and hopefully peaking for a few months. Powell and the Fed are now setting expectations for a longer battle. Rhetoric such as “Some ways to go” and the recent mantra “Restrictive territory… for some time” drove the message home.

In the weeds: Powell discussed employment metrics he is closely following: job quits, vacancies and labor participation. The Fed is watching for any sign of slack in the labor markets. He also discussed softening rental rates and the inherent housing cost lag in the CPI statistics. CPI continues to count rental costs based on all lease payments, not just newly signed lease costs. This may understate the effect of Fed rate increases on housing costs for months. He noted that this lag is considered when reading the data. The rallies dissipated into negative territory as markets digested Powell’s remarks – the 10-Year jumped to 4.11% and the Dow dropped 1.5%. Stay tuned…

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

The 2 Year Treasury and the 10 Year Treasury inverted in July and have remained “out of balance” to this day. That inversion is often seen as a harbinger of a recession. Today, the 3-Month Treasury is higher than the 10 Year Treasury – this has occurred only 7 times since 1967. Markets may be saying that the Fed has raised rates too fast, without allowing for enough lag time to gauge the effects (which can be felt for up to a year after any given rate hike). This week has seen earning disappointments from tech companies as companies pull back on advertising. The Case-Shiller index indicated home price gains are dropping at the fastest pace on record as mortgage payments average 75% higher than last year. The Fed’s demand destruction strategy is “working.” Recent quotes from Fed policy makers indicate some concern over raising rates too quickly over the next few months. Bonds have rallied – after hitting a multiyear high of 4.32% last Friday. The 10 Year is down to 4.00% as of tonight’s close. The latest hopes are quantified in the futures markets – a 75 basis point increase is nearly assured at next week’s Fed meeting (94% probability), but the December meeting futures show a 63% chance of a 50 basis point increase, and 37% at 75. This Friday’s PCE report looms large as the final major inflation data point before next week’s meeting. Stay tuned…

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

A perfect storm is continuing to hit treasury prices and therefore yields are rising. Markets study every data report hoping for some sign that inflationary pressures are easing/slowing/peaking, hoping for a “pivot” from the Fed. Recent economic data hasn’t provided that hope. The supply/demand metrics in the Treasury market are strained: record debt issuance and major buyers (Japan, China, Pension Funds) are buying less or sidelined. Also, most importantly, we are seeing heretofore untried Quantitative Tightening from The Fed. The central bank regularly purchased $80 billion per month during several extended periods since 2010, but is now selling Treasuries. The Fed was still purchasing Treasuries into March of this year. The process is now picking up as it took months for those recent purchases to “settle” – now the Fed is selling up to $95 billion per month. In fact, the Fed recently sold $37 billion in one week.

“Bid to cover” ratios are dropping in recent auctions, indicating fading demand. There are signs that liquidity in the Treasury market itself is starting to dry up, causing the normally calm Treasury Secretary Yellen to recently comment on her concerns. Recent Data: Last week’s CPI report continued the recent narrative that price increases are pivoting from goods to services. This is more concerning to the Fed as labor is a critical component of services. Example: travel is especially inflationary due to pent up demand for leisure combined with the return of business travel/conventions. Airline ticket prices and bookings are skyrocketing and the industry estimates there is a shortage of about one million workers in the segment. Note that apparel and appliances are seeing price and demand declines. Many retailers are overstocked as supply chains loosen and demand softens. Fed Speeches: Neil Kashkari referenced CPI reports in comments this week. He indicated that perhaps “headline” CPI has peaked but he is more concerned about core inflation (excluding food and energy). He indicated the Fed was resolute in its determination and if core inflation lingers into next year, commenting “But if we don’t see progress in underlying inflation or core inflation, I don’t see why I would advocate stopping at 4.5%, or 4.75%.” This caught markets attention – as the previously assumed “terminal rate” was about 4.25%-4.50%, and he’s talking about 5.0%. Fed Pivot Watch: Powell has made it very clear that the Fed is willing to tolerate unemployment and significant losses in stock markets without “blinking.” But recent developments like the British gilt crisis and Treasury market liquidity may be early indications of systematic financial risk which would (hopefully) be intolerable to the Fed. Stay tuned….

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