Thoughts From The Divide: Umbrellas

“You can then start lowering the policy rate just because inflation is lower”

While one wouldn’t expect Fed governor Waller to pop champagne and do a victory dance (or should we?), his latest speech was indicative of a celebratory mood. Victory wasn’t declared, but the war does seem to be progressing favorably. Having previously warned that something’s got to give, he said, speaking before the AEI, that “something appears to be giving, and it’s the pace of the economy”. Hardly good news for the rank and file perhaps, but Waller went on, “I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2 percent”. What’s more, “even without motor vehicles and sales at gas stations, retail sales barely increased in October, which may reflect a broad-based moderation in demand”. Hooray!? “The labor market is cooling off.” Excellent! “But the loosening of financial conditions is a reminder that many factors can affect these conditions and that policymakers must be careful about relying on such tightening to do our jobs”. Markets, suffused with holiday good cheer, were in no mood to think about Waller’s implied threat regarding financial conditions and moved to price further cuts early next year.

Admittedly, the euphoria may have been driven less by the content of the speech than by his Q&A responses. As Nick Timiraos shared in this tweet, in response to a question about the threshold for cuts, Waller reported that if “we feel confident that inflation is really down and on its way, that you can then start lowering the policy rate just because inflation is lower. It has nothing to do with trying to save the economy or recession. It’s just consistent with every policy rule I know from my academic life and as a policy maker. If inflation goes down, you would lower the policy rate. There’s just no reason to say you would keep it really high if inflation’s back to target, for example”. Some heavy lifting is being done by the “if” in that statement, but… while some investors may be optimistic seeing a 45% chance that there is no rain, others might take the glass half empty approach and still opt to bring an umbrella.

“What gives? Why would a bank hoard liquidity…?”

While we have been following the CRE dumpster fire for some time now (and hope we can be forgiven for abusing the dead horse), there were recent developments that got the hair on the back of our necks to stand up. This article from the FT asks the seemingly innocuous question, “Why are banks hoarding liquidity?” Indeed, why have all of the weathermen boarded up the windows on their homes? As the article explains, the banks are doing the seemingly incongruous thing of “offering higher-yielding cash products” some “yielding 5.6 per cent – to hold on to reserves that can only earn 5.4 per cent from the Fed. In other words, it’s unprofitable for the banks to hang on to these reserves.” The answer offered up is “the more-than-half-trillion dollar elephant in the room: unrealised losses on bond portfolios”. These losses are certainly not chump change, with banks such as Bank of America sitting on “$131bn of paper losses [don’t forget the Reddit wisdom!] in its held-to-maturity securities in the third quarter”. What’s more, “Banks are also being encouraged to rely less on their lender of next-to-last resort, the Federal Home Loan Banks”. Instead, as this article explains, there’s a new plan that would “ratchet up federal oversight” of the lending being done by FHLBs to troubled banks and “seek to direct banks toward the Federal Reserve’s discount window in times of extreme stress” (this hints that regulators might be fighting like cats in sacks behind the scenes).

Returning to the troubled state of US banking, what if there is also another potential source of unrealized losses… in the form of CRE? (no sh*t, Sherlock). As this article from the Real Deal notes, the paucity of deals in CRE is “obscuring” the value of real estate (and consequently the value of the debt attached to said real estate). Additionally, “many lenders do not want to take back these assets either. Nor do they want to write down the loans and reveal properties’ eroded value.” “The seller and lender are aligned in not doing a deal to impair the equity”. While this story is as old as lending, it does remind us that even the pain that has been felt is just a taste of what is to come unless the Fed does a swift about-turn. If we take to heart a quote from the late great Charlie Munger (RIP), that “A great business at a fair price is superior to a fair business at a great price”, we may need to hold off on any optimism. After all, who wants a fair business at a fair price? And that’s without considering the collateral effects of those paper losses hiding on bank balance sheets. Might bankers’ solid grasp of these issues explain their willingness to pay for reserves? Let’s just say that if we see our local weatherman toting an umbrella and wearing galoshes, we might be tempted to at least make sure our car windows are rolled up.

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