Juggling Dynamite

The past year has seen the most aggressive Fed tightening cycle in at least 30 years (see the chart below as of March 30, 2023, courtesy of Isabelnet.com). Base effects matter a lot; coming off a decade of constant QE and near-zero interest rates, the “normalizing” of monetary conditions this cycle is particularly acute at a time when the world owes record amounts of debt.

US total household debt is at $16.5 trillion, including auto loans of $1.6 trillion, credit card debt at $986 billion, and student loans at $1.6 trillion (recall that interest on student loans has been suspended since 2020, but it is set to resume this year).

Auto loan and credit card interest rates just hit new record highs, with average interest rates of 24.5% on credit cards, 14% on used cars, and 9% on new vehicles (Kobeissi Letter data).

With prime rates at 6.7%, prime plus lines of credit are above 11% (nearly double from one year ago).

At current mortgage rates, US households need an income of $86,736 to qualify for the median-priced home, compared with $47,232 in February 2020. Affordability numbers are even worse in Canada.
And then there are the knock-out effects on levered investors/speculators who ballooned during the 2010-2022 easy money era, now in the take-back phase. Prices tumble as distressed sellers rise; see Housing is turning out to be a lousy shelter for investors:

Investors that snapped up apartment blocks with short-term, floating-rate debt are in especially hot water now. Research provider Green Street pointed out that privately held Houston real-estate investor Nitya Capital wants to sell 38% of its portfolio as it grapples with higher debt payments. Most of Nitya’s assets were bought at peak prices in 2021, when interest rates were at rock-bottom. Costlier debt wiped out cash flows on some of the landlord’s assets.

Commercial property prices are heading south in all sectors. As stress spreads among the lenders, see Shadow Banks Could Yet Cause Trouble:

As a recent TS Lombard note laid out, the level of real estate debt maturities in 2023 is expected to be high. This means asset managers may be forced to go to investors for more capital (which will be a tough negotiation at the moment) or sell property out of their portfolio to cover loans.

..It is possible that concerns about commercial real estate will start to expose other vulnerabilities — or at the very least asymmetries — in the financial system and shadow banks in particular.

Consider, for example, how rich non-bank asset managers such as Blackstone, Apollo, Carlyle and others became on both residential and commercial real estate in the wake of 2008. This was partly because they were able to make deals that more regulated banks couldn’t…But it’s safe to say that the combination of falling values, higher rates and a credit crunch is going to mean we’ll probably see some high-profile defaults.

On today’s episode of On The Margin, we welcome Darius Dale, Founder & CEO of 42 Macro, back to the show to discuss the recent liquidity measures in response to the banking turmoil over the past few weeks. With Markets rallying and investors piling back into the best-performing assets of the past two years, Darius urges caution. While the banking scare of recent weeks doesn’t resemble 2008, “don’t be a hero”. Darius walks through the current liquidity cycle and describes how that could quickly lead to a shift in the credit cycle. Here is a direct video link.

Bear markets can be psychologically trying as interim rallies may obfuscate ongoing downtrends. Markets are liquidity junkies and repeatedly anticipate that central banks will pause and return to easing credit conditions (typically a few months after a pause). As with tightening, however, the bulk of easing effects are not felt until many months after they’re implemented.

Equities historically don’t bottom until after a recession is recognized and central banks near the end of easing efforts. Amid all the daily noise, the NASDAQ is about the same level today as late 2020—27 months ago; the S&P 500 is where it was 24 months ago, and Canada’s TSX is at the same level as June 2021, 22 months ago.

Undoubtedly, central banks want inflation to fall back to their 2% target. But that does not mean they wait until it gets there before they start easing. In October 2007, credit stress caused the Fed to start easing with the inflation rate at 3.5%. When inflation reached 2% in November 2008, the funds’ rate had been cut by 425 basis points. In January 2001, inflation was at 3.7% when the Fed started to ease. When inflation fell to 2% in November 2001, the Fed had already cut 450 basis points. As usual, the year after the Fed started tightening is when panic broke loose in the economy and stock market.

The past year’s violent liquidity contraction is now compounding through the economy. US ISM manufacturing, employment and new orders, shown below since 2007, are officially in contraction (all sub 50).

Confirming the economic downturn, Treasury prices bottomed last October (yields peaked) and have risen since, with the first quarter of 2023 having the strongest government bond gains since the first quarter of 2020. The bullish Treasury trend continues today, with the Canadian 10-year yield at 2.88% from 3.77 last October and the US 10-year at 3.43 from 4.33%. As central banks move to pause and eventually start easing credit conditions again, later this year or early next, government bonds are due to rise further (their yields to fall).

The prize of investment discipline is collecting attractive cash yields and gains on the safest credits as equities, commodities, corporate debt, and real estate deflate back to lucrative entry points–always well worth the wait.