by Bryan Perry
April 4, 2023
A number of reasons are being touted for the market’s quarter-ending rebound last week, the primary one being the release of the personal consumption index (PCE) that came in fractionally lower than forecast. Reflecting prices in February, PCE inflation ran at an annual pace of 5.0% versus 5.3% in January. The lower reading shows that inflation was moving in the right direction as February ended, five weeks ago.
Although inflation grabs the headlines, I would argue that the main reason the market pivoted higher last week was action by the Bank Term Funding Program (BTFP), an emergency lending program created by the Federal Reserve in mid-March 2023 to provide emergency liquidity to U.S. depository institutions.
The Fed launched this program in a “by the way” announcement that reportedly pushed its balance sheet up by $500 billion. In the past three weeks, the Fed has done a 180-degree reversal, from shrinking its balance sheet through QT and instead injecting massive liquidity into the system. JPMorgan put out a note called “Flows & Liquidity – A Repeat of 2018/2019?” believing that Federal Reserve’s BTFP aid is likely to be massive, projecting that its max usage could be around $2 trillion. (Source: SWFInstitute 03/16/2023).
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The Federal Reserve (in Section 13(3)) has the singular power to permit Federal reserve banks to provide liquidity directly to non-bank commercial entities. The JPMorgan research team analyzed the uninsured deposits of the six U.S. banks with the highest ratio of uninsured deposits over total deposits. That number came out to be $460 billion. The more the usage of the BFTP, essentially that would increase the size of the Federal Reserve, thus creating more liquidity relief for the whole U.S. banking system.
This power is only available in times of crisis, when the Federal Reserve, by a vote of five governors, finds that “exigent and unusual circumstances” exist. Section 13(3) authority has been invoked only in unusual times of crisis, like the global financial crisis of 2008 and during the COVID-19 pandemic.
The BFTP program was set up to protect against future runs on deposits, but what about the looming problem with commercial office space debt held by banks? It is estimated there is about $5.5 trillion in commercial real estate debt, of which roughly $2 trillion is committed to multi-family housing projects, considered relatively safe, and around $3.5 trillion in all other sub-classes of commercial real estate, where banks have almost half the exposure, most of which (about 70%) is held by small banks.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
This situation very likely explains why the Russell 2000 is underperforming most other major indexes. Financial companies account for 15.7% of that index, most of which is represented by small banks. Healthcare is weighted at 15.7%, industrials account for 15.5%, and technology weighting sits at 14.1%.
The chart of the Russell 2000 ETF (IWM) shows a big break in the index, slicing below its key 200-day moving average on huge volume, which, in my view, will take time to repair.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Working at home took a toll on office usage. The latest Kastle Systems’ gauging of office vacancy in its 10-city barometer was at 48.4% as of March 22 – not a healthy development for the sector.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The concern with the hybrid work environment today is that this sub-50% office occupancy rate is the new norm, which is highly likely to drag down property prices, which brings rising pressure on landlords with billions in debt coming due in the next few years, likely at higher rates. While some borrowers will get loan extensions or modifications, a more expensive funding regime could force others to “hand back the keys,” said BofA Global’s Alan Todd, who leads the bank’s CMBS research effort, in a client note.
To help gauge borrower costs, the average coupon for office loans in multi-borrower, or “conduit,” commercial mortgage bond deals has almost doubled to 6.3% since 2021.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
At the median U.S. bank, commercial real-estate loans account for 38% of loan holdings, according to an analysis by KBW Research. The Federal Reserve recently said it would accept bonds and other assets at face value as collateral from banks, making bank runs less likely. Still, small and regional banks could run into trouble quickly if they have to sell commercial property loans to raise capital, said Richard Jones, a partner with the law firm Dechert LLP. In such a situation, banks would likely be required to reclassify loans as being held for sale. That means valuing them at their current worth rather than their loan value.
While the commercial office space loan risk is high on the list of inherent risks to banks’ balance sheets, the market sees it as something to think about months from now. At the present, and over the very near term, markets seem to only care about the huge injection of money and the view that the Fed, through the BFTP, has indeed pivoted, pausing on QT, flooding the system with fresh dollars to fix the problem they created. And stocks rallied big time on the news. Oh, how markets do love these liquidity injections.
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
Also In This Issue
A Look Ahead by Louis Navellier
The “Wall of Worry” is Crumbling, Brick by Brick
Income Mail by Bryan Perry
The Stock Market Loves Liquidity Injections
Growth Mail by Gary Alexander
The NASDAQ 100 Rose 20% in Q1: Danger or Opportunity
Global Mail by Ivan Martchev
Temporary Good News on the Banking Front
Sector Spotlight by Jason Bodner
Are We on The Edge of a Market Precipice?
View Full Archive
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Bryan Perry
SENIOR DIRECTOR
Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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