Jason's World

Last Thursday’s inflation report was supposed to be a cause for relief-inflation came in as slightly lower than expected, 3.2% to 3.3%. Before the report, I said that if inflation was higher than expected, then we would have seen market pandemonium like never before because people would be thinking about the Fed’s continued openness to further rate hikes. Luckily as Thursday passed, that did not happen, and we averted a full-blown crash.

But even though the two recent indicators show a cooling economy, as the Fed had expected, factors have nonetheless emerged to cast doubt on the soft-landing narrative that has dominated investors’ thinking since July.

The downgrade of the US Treasury yields by Moody’s has exerted upward pressure on treasury rates, which already have been pushed to 5-year highs by the Fed’s hiking cycle. Since all borrowing in the US-corporate, mortgage and municipal bonds-rise and fall with Treasury rates, this means that Americans will probably have to endure even higher borrowing costs than anticipated.

The fears of banking collapse that faded away in March have returned with a vengeance as Moody’s, in a new report, downgraded ten regional banks while either issuing warnings for or giving a negative outlook for 17 other banks. The largest bank that got downgraded, M&T bank, is roughly the size of Silicon Valley Bank. Worst of all, these warnings from Moody’s extended to some of the nation’s largest banks: U.S. Bancorp and Truist had their ratings put under review, while PNC had its outlook downgraded to negative. All  three banks are the top ten in the US in terms of total assets: Bancorp, PNC and Truist rank 7th, 8th and 9th respectively. Together they have nearly $1.8 trillion in assets; Signature, SVB and First Republic together had only around $500 billion in assets.

A lot more is at stake now than during the panic of March-April, and in some respects, this downgrade might be the harbinger of something truly terrible. To put that in perspective, the collapse of Lehman Brothers involved “only” $600 billion in assets (which would be $850 billion today). 

And the pressure on the banking industry may very well increase from here. Despite a trend of decreasing inflation, the Fed has maintained that it needs to see a sustained stabilization in inflation in order to begin pivoting to rate cuts. 

This will likely put many regional banks down under. Currently, regional banks hold about 70% of $1.4 trillion in outstanding commercial real estate loans that come due by the end of 2025. As the commercial real estate industry crashes and burns in the wake of the growing WFH trend, the high interest rate environment only adds fuel to the fire. Expect a wave of defaults as regional banks have no choice but to sell these loans at a much lower price to avoid the possibility of these loans dropping off their balance sheets completely. Something similar happened with SVB-it was forced to sell off devalued Treasury bonds as depositors came knocking on the door.

Looking forward, the biggest factor that decides whether we will see a earth-shattering crisis within the next few months is whether the Fed tones down its hawkishness. Right now, the Fed apparently seems to believe that a soft landing is certain. If the Fed shifts it’s tone and says that economic pressures combined with relatively normal inflation justify a permanent stop to hikes or even a pivot, it will likely reduce a lot of the worries that markets are experiencing, as shown in the negative performance of markets in the past two weeks. But given the fact that topline inflation remains above 3%, that is unlikely, even as the economy shows even more signs of cooling with job numbers coming below expectations for the second month in a row. If the economy is underperforming expectations now, you wouldn’t want to imagine what will happen if the Fed pushes the banking system over the edge.