While many market participants are expecting a “soft” landing for the economy after more than a five per cent rise in interest rates, the evidence for a hard landing is mounting.
- Unemployment just rose from 3.4% to 3.8%
- The personal savings rate just rose by 3% with consumers anticipating harder times ahead.
- High yield bond defaults are up 1.6% to 3.2%
- Credit card delinquencies are up from 0.8% to 1.2%
- Auto delinquencies are up 5% to 7.3%
- Business confidence has been falling since late 2020.
- The bond yield curve is now steepening quickly; having been very inverted at -1.1%, it is now at only -45 bps.
The 10-year Treasury bond yield is now at a sixteen year high.
When bond yields go up because of higher interest rates, bond prices go down. When longer term bond yields go up by more than shorter term bond yields, it is known as “bear steepening.” This condition is dangerous to markets, because of the effects on mortgages and corporate loans, which become much more expensive. Long bond prices are much more sensitive to changes in yields than short dated bonds. For example, a ten-basis point move up in 30-year yields is as much as ten times more powerful on prices as the same increase in a two- or five-year bond yield. This means that entities that invest in long dated bonds like pension funds, insurance companies, or fragile banks can be vulnerable to much lower bond prices. Bear steepening can be dangerous when the economy is weakening; in Sept-Nov. 2000, May-June 2007, and Sept.-Nov. 2018 we saw, in all three cases, bear steepening marking the end of a bull market for stocks. However, in all three of those cases, inflation was much lower, which permitted the Federal Reserve to cut rates and stimulate the economy. The Fed is now telling us that higher rates today will not lead to more interest rate cuts tomorrow. In their September meeting, “higher rates for longer” was the theme as expectations over any near-term interest rate cuts were pushed out largely to 2025, due to the intractability of inflation.
Higher debt defaults seem inevitable as the lagged impact of higher interest rates flows through to consumers and businesses. While the market is currently expecting the Fed to stop raising rates when it gets to 5.45%, it is now entirely possible that we see more unanticipated rate hikes. Keep in mind that some $4 trillion of investment grade and high yield debt is being refinanced at much higher rates this and next year, while at the same time banks are tightening their lending standards.
As a result, commercial loan growth is now poised to go negative year-on-year.
Mortgage rates are still climbing, now at 7.41% These high rates, combined with banks’ increasing reluctance to lend, is leading to a drop in new home sales to a five-month low. New housing construction was down 11.3% in August, 1.7% below the previous year. But high rates are making their biggest impact in the commercial real estate market. There is a “wall of debt”- some $1.4 trillion of commercial real estate debt, which will be maturing through 2025. These loans will need to be refinanced at much higher interest rates, and are provided mostly by small regional or community banks. In all but the biggest 25 US banks, 67% of all loans are for commercial real estate. The impending credit crunch is likely to negatively impact access to credit by small and medium sized businesses, which leads to less hiring and less spending.
Oil prices have soared in the third quarter to new cycle highs, as markets consider the effects. The US strategic petroleum reserve is at lows, and overall total oil storage levels are very low. Crude oil prices may be heading even higher on supply concerns, and JP Morgan analysts are predicting $150 per barrel by next year. While our major inflation index, the “core” CPI, strips out food an energy from inflation, it should be noted that energy prices also have important indirect effects on inflation. High oil prices come at a time when consumers are already stretched. Student loan repayments of, on average, $400 per month per student must be repaid starting October first (after a Covid moratorium) and maxed-out credit cards are now subjected to an average 28% interest on a record $1.03 trillion total. These factors combined are leading to a drop in consumer expectations, as well as confidence in the present situation:
The much feared government shutdown has been reprieved for 45 days. Although Wall Street would not welcome the chaos that would ensue with a shutdown, what is truly feared is a downgrade of the US credit rating by either S&P or Moody’s. Last week, Moody’s signaled that a government shutdown would harm the country’s credit, while the former chairman of S&P’s sovereign rating committee said that the U.S. is in a weaker position now than when S&P downgraded its sovereign credit rating in 2011.
On a positive note, productivity among the US workforce is improving, and onshoring and infrastructure investment is robust. American and foreign manufacturers are onshoring to the US to avoid geopolitical risks and supply chain risks.
The federal government’s spending on public infrastructure is boosting demand for new construction equipment, up some 8.4% over the past year.
Federal deficits have become a preoccupation to the bond markets, in addition to inflation worries. The US funding deficit is a result of inflation, as the government must spend more on interest payments to service its debt. Record amounts of Treasury bond issuance is also exacerbating the bond selloff. The bond market is sending a clear message to Washington to cut the deficits. If the government does not act, bond yields will rise further and cause a recession and a credit crunch.
