Will These Red Flags Kill the Markets?

The Fed with an unforced error … what will tomorrow’s CPI bring? … huge government bond issuance… a bad consumer credit card record… inflation-adjusted household income is way down

Federal Reserve Bank of Philadelphia President Patrick Harker just paved the way for a market tantrum.

From Harker yesterday:

Absent any alarming new data between now and mid-September, I believe we may be at the point where we can be patient and hold rates steady and let the monetary policy actions we have taken do their work.

Now, I hope that’s true. But even if it is, why say it?

Harker just cemented the expectation of a September rate pause which, if disappointed, will now result in a Wall Street tantrum.

But Jeff, isn’t it practically a lock that the Fed will, in fact, hold rates steady?

Not if you ask Fed Governor Michelle Bowman. Here’s what she said on Saturday:

I also expect that additional rate increases will likely be needed to get inflation on a path down to the FOMC’s 2 percent target…

We should remain willing to raise the federal funds rate at a future meeting if the incoming data indicate that progress on inflation has stalled.

According to the CME Group’s FedWatch tool, the odds favor a rate pause in September, but the chance of another quarter-point hike comes in at nearly 15%. So, while a pause is likely, it’s not a lock.

If you’re unsure whether you’ll have time to take your 5-year-old to get ice cream as you’re running errands, is it wiser to dangle the ice cream as a possibility even though it might not happen, or wait until you’re certain you have time? Which is more likely to sidestep a potential meltdown?

Harker just floated a trip to Baskin-Robbins…and don’t think that Wall Street is more mature than a 5-year-old.

As to the potential for “alarming new data” as Harker called it, tomorrow brings the latest Consumer Price Index (CPI) numbers

Here in the Digest, we’ve analyzed a hypothetical in which the number might come in hotter than expected (due to a bad comparable month last July and higher oil prices in recent weeks). But our hypergrowth expert Luke Lango believes the more likely result is a cooler-than-expected number.

From Luke’s Daily Notes in Innovation Investor:

We are also growing increasingly optimistic on this Thursday’s July consumer price index report. We think it will be a major upside catalyst for stocks. 

Current estimates peg July CPI at 3.3%. We think that’s high.

Our proprietary model is targeting a CPI reading of 2.9%, with a range of 2.6% to 3.2%. Therefore, we think the odds favor a bullish surprise for July inflation numbers. 

If we do get that bullish surprise, that will send overextended Treasury yields sharply lower, which should boost stocks significantly.

A cooler number would be fantastic – especially now, in the wake of Harker’s comment. We’ll keep you updated.

Meanwhile, yesterday’s news of the Moody’s downgrades to U.S. banks puts commercial real estate directly in the spotlight

Regular Digest readers know that for months, we’ve been running a “commercial real estate watch” segment to monitor this critically important sector of the U.S. economy.

The same factors that resulted in a handful of banking failures this spring are creating cracks in the foundation of the $20-trillion commercial real estate sector.

Unfortunately, if commercial real estate suffers, so too will small banks. That’s because small banks account for 67% of commercial real estate lending.

Well, the ratings agency Moody’s just cut credit ratings of several small to mid-sized U.S. banks. It warned that the sector’s credit strength was running into headwinds related to funding risks and weaker profitability.

And what’s behind that?

You guessed it.

From Reuters:

“Many banks’ second-quarter results showed growing profitability pressures that will reduce their ability to generate internal capital,” Moody’s said in a note.

“This comes as a mild U.S. recession is on the horizon for early 2024 and asset quality looks set to decline, with particular risks in some banks’ commercial real estate (CRE) portfolios.”

Moody’s said elevated CRE exposures are a key risk due to high interest rates, declines in office demand as a result of remote work, and a reduction in the availability of CRE credit.

The worst of this pain is still ahead of us. That’s because $1.4 trillion in commercial real estate debt is coming due by the end of next year. It will have to be refinanced at today’s significantly higher interest rates.

Scour your portfolio for any commercial real estate exposure that’s especially vulnerable to refinancing and interest rate risk. More trouble is on the way for this sector.

Speaking of elevated rates, keep an eye on what’s happening in the government bond market

In our Monday Digest, we discussed why long-term government bonds yields could be headed higher.

In short, government spending is so out of control, with deficits so enormous, that the government will likely be forced to issue more bonds than normal to generate the funds to pay all these obligations.

The problem is that when you flood a market with an excessive quantity of something, that pushes prices down. And because bond yields and prices move in inverse fashion, lower bond prices mean higher bond yields. That’s not good for the average stock portfolio.

Moving this away from hypotheticals, is there evidence that the government is bringing more bonds to the market?

Yes – this is part of the reason why Fitch just downgraded the government’s credit rating.

From Bloomberg:

The US Treasury boosted the size of its quarterly bond sales for the first time in 2 1/2 years to help finance a surge in budget deficits so alarming it prompted Fitch Ratings to cut the government’s AAA credit rating a day earlier.

Here’s legendary investor Louis Navellier from yesterday’s issue of Accelerated Profits issue with more details:

The other factor that spooked investors was the Treasury Department’s plans to auction $1.0 trillion in Treasury securities in the third quarter. That’s up from the previously anticipated $733 billion.

So, it appears that the Treasury Department may have gotten ahead of itself, but that will ultimately be determined by the bid-to-cover ratios at the actual Treasury auctions.

Yesterday, we learned the government bumped that number again from $1 trillion number to $1.03 trillion. So, we’re talking a surprise 36% increase in the size of the initial bond issuance plan.

The “bid-to-cover” ratio, which Louis referenced, will reveal to what extent demand from buyers will “cover” the increased volume of new bonds. It’s likely everything will be fine (if not, we have serious problems). But even if demand is plentiful, the need to issue this increased volume of bonds is a troubling sign.

We’re seeing what happens when the government promises too many entitlements and spends vastly more than it generates. Of course, Treasury Assistant Secretary for Financial Markets Josh Frost said, “We see limited or no impact on yields or prices.”

Uh huh. And Jerome Powell saw nothing but “transitory inflation.”

Switching to U.S. consumers, aren’t these higher rates good for Americans since they translate into higher savings account yields?

Yes, for the handful of Americans who can save a meaningful amount of money each month. Which means “no” for most Americans.

From Bankrate:

Forty-nine percent of Americans have less or no savings than a year ago. And only 43 percent said they could cover an emergency of $1,000 or more using funds from their savings account.

For a different angle on this, yesterday, the New York Fed provided a report showing that Americans are now turning to credit cards to fund basic day-to-day living expenses. This has resulted in credit card debt setting a new all-time-high.

From CNBC:

Americans increasingly turned to their credit cards to make ends meet heading into the summer, sending aggregate balances over $1 trillion for the first time ever, the New York Federal Reserve reported Tuesday.

Total credit card indebtedness increased by $45 billion in the April-through-June period, an increase of more than 4%. That took the total amount owed to $1.03 trillion, the highest gross value in Fed data going back to 2003.

The increase in the category was the most notable area as total household debt edged higher by about $16 billion to $17.06 trillion, also a fresh record.

Now, the pushback to this is “but Jeff, the New York Fed study also reveals that credit card debt as a percentage of total deposits remains near historic lows.”

Fair.

Maybe Americans have tons of other deposits elsewhere. And maybe all this credit card spending is based on consumers really loving their travel reward points.

How can we get more insight?

A better test for consumer health is whether Americans are paying off their historically high credit card balances with ease

They’re not.

Back to CNBC:

As card use grew, so did the delinquency rate.

The Fed’s measure of credit card debt 30 or more days late climbed to 7.2% in the second quarter, up from 6.5% in Q1 and the highest rate since the first quarter of 2012 though close to the long-run normal, central bank officials said. Total debt delinquency edged higher to 3.18% from 3%.

Now, you might be latching onto the part of the quote above that references the delinquency rate being “close to the long-run normal.”

That’s fair. But if that’s the case, let’s look at the forces driving the delinquency rate and analyze the overall trend direction.

Back to CNBC:

…Household income adjusted for inflation and taxes is running some 9.1% below where it was in April 2020, putting additional pressure on consumers, according to SMB Nikko Securities.

“This is an issue because the sustainability of consumers’ pandemic debt-binge was partially predicated upon their incomes steadily rising,” Troy Ludtka, senior U.S. economist at SMBC Nikko, said in a client note.

“Instead, the opposite occurred, and now the rate at which borrowers are running late on their debt payments is back to pre-Covid levels. This could be the newest challenge facing embattled commercial banks.”

For months, we’ve been saying “watch out for when the U.S. consumer runs out of pandemic savings and when credit card debt grows too high.” We’re getting closer and closer to that reality.

By the way, don’t miss the reference to what this could mean for banks. In addition to challenges with commercial real estate, they’re now looking at weathering a beleaguered U.S. consumer.

Yes, keep trading stocks higher while bullishness is here. But be careful. We are not in an “all clear” market.

Have a good evening,

Jeff Remsburg

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