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Up in Smoke
David Haggith

As we slide into recession, will we burn up due to inflation first or war?

A few small things settled in a direction that could give Powell a chill that causes him to shift from battling inflation to driving it back up nice and hot, just as stock investors and bond investors are back to hoping he will do. Changes in the labor market make it appear labor may FINALLY be reaching that point where new jobs are not coming fast enough and old jobs ending more quickly to where the changes couldstart to push unemployment up. Still, I’ve pointed out a few head fakes along the way, and this could easily be another one. More data coming in on Friday could clarify the employment picture.

The S&P 500 set another record as investors switched right back to the old bad-news-is-good-news that they never seem to give up hope of for long. Today’s report of a slight crimp in the jobs market gave them another adrenaline rush as they started floating their hopes for a Fed rate cut in September. We’ve seen them wrong on those hopes for a year now.

Of course, if labor does start showing signs that it is putting in a turn for the worst, Powell’s labor mandate may override his inflation mandate in his mind. If he makes that choice because he thinks this year’s five months of rising inflation are just transitory, he could wind up taking us very quickly right back to where we started fighting inflation, taking us all back to experience the full burn all over again from square one. People would not be happy.

Fed-fired markets

So, let’s take a quick look at those things that both bond investors and stock investors appear to believe will change Powell’s choice back to providing the stimulus they are addicted to, even if it plunges us back into inflation. I’ll dive deeper into the details and what they mean this weekend for paid subscribers, but I want to give an overview here:

The big news of the day was the substantial slowdown in payroll growth—down to 152,000 jobs added in May. April was also revised lower to 188,000, but the May number is still a pretty fair drop from April, possibly indicating a new trend if we get another report like that (or just another head fake if we don’t). The number expected by economists was 175,000, so this report also came in well below expectations, making it easy to feel a downdraft in the labor market. Incidentally, nearly all hiring came from the sticky services sector, not from production of goods.

Yesterday, the downdraft in data seemed to spook the market, but today the addicts are back to just reaching for their desperate dose of hopium. Of course, a slowdown like this is exactly what one also expects if we’re already plunging into recession. The turn has to come sometime from all that Fed tightening, and the quick take I’d give on that is that the turn came for a move into recession well ahead of a turn to the end of inflation. So, we are entering a stagflationary recession, as always expected here. If that’s what investors like, so be it; but I think they are just pretending not to see the harms coming from the recession side. They are seeing only the part they want to see—today, anyway.

The Fed is probably not going to give that rate cut in September, even if this is a turn in the labor tide, because they will want to see the turn holding, too, before they shift policy. At least, three Fedheads have stated clearly it will take months of inflation data going back in the right direction to convince them to change policy to a rate cut.

What that means in a nutshell is that Fed is going to do as I’ve always said: continue to tighten us deep into a recession even as the recession is forming because it will be slow to see this “stealth recession,” cloaked as it has been by tight (and misleading) labor data that the Fed views as proof of a robust economy. The signs I’ve been presenting of late are that we are already sliding into recession and that the Fed does not see this. Secondly, inflation will, I’ve said, continue to burn up the Fed’s backside, pressing them forward with tight financial policy. So, the tightening will run past the start of the recession, which we are likely already entering.

I’ll dig more into the details in the Deeper Dive.

Dumb bonds

Apparently the gentlemen in markets do prefer dumb bonds. The bond market is far from being the smart money any longer, tumbling yields head over heels in the last couple of days. Today, that stabilized a little, but still ... 

Bond traders are tilting dovish again, piling into wagers that would benefit from a faster pace of Federal Reserve interest-rate cuts as Treasuries rally.

Here is and example of the market delirium that floats on a smoke ring of hopium:

“The next move that the Fed is going to make is ultimately going to be one that protects the strength of the labor market, rather than one that in which they need to be fighting inflation,” Kelsey Berro, fixed-income portfolio manager at JPMorgan Asset Management, told Bloomberg Television Tuesday. “We do think that inflation generally is under control.

You go ahead and think that. With more luck than Powell had last time he thought that, you’ll be right, and we’ll be fine. So, believe what you want. It is certainly what Powell wants and needs. But that doesn’t mean it has much basis.

You see, that will bring respite for Powell, who seems to care less about fighting inflation now than about helping the government finance Biden’s massive deficits. It is also good news to Powell from the banking-oversight side of his job because there was some bad news there today that could stand to benefit from bond yields falling back down (bond prices rising), which won’t happen if Powell keeps fighting inflation.

You see, the number of banks potentially deep underwater now due to the devalued Treasuries they hold in reserves as the nominal value of their reserves also falls, has expanded. 

Number Of 'Problem Banks' Climbs In 1st Quarter, New FDIC Report Finds

It has been more than a year since the regional banking crisis exposed vulnerabilities in the financial system. A new Federal Deposit Insurance Corporation (FDIC) report discovered that the banking sector is still grappling with ballooning unrealized losses, a high number of “problem” banks, and various challenges that could worsen from high inflation and interest rates.

So, if Powell’s hope and the market dope that is delivering deliriums all turns out to be true, that will be huge relief from another major banking crisis. Relief depends on Powell no longer keeping rates high. If yields drop, so that bond values rise, the whole loss of value in bank reserves held as Treasury bonds goes away; and so does some of the federal government’s credit-rating issues to a small degree. (More like the ratings don’t take another drop right away, than anything like they improve to what they once were in the good ol’ days.)

Officials confirmed that unrealized losses on available-for-sale and held-to-maturity securities rose by $39 billion to $517 billion. This, the report noted, represented the ninth consecutive quarter of “unusually high unrealized losses” since the Federal Reserve started raising interest rates in March 2022.

“Unrealized losses” mean there will be no loss of value at all if the banks can hold those bonds until mature and are paid off at face value. They do not have to mark those particular bonds down to market unless they have to sell them to thwart a bank run. Then they are worth whatever they are worth at that moment. We know that peril from last year.

And the problem is coming from real estate, particularly commercial real estate and this old familiar villains from the last big crisis—mortgage-backed securities:

An increase in unrealized losses on residential mortgage-backed securities accounted for most of the January-March jump.

The FDIC report further revealed that the number of problem banks totaled 63 in the first quarter, up from 52 in the fourth quarter of 2023….

“These issues could cause credit quality, earnings, and liquidity challenges for the industry,” the report stated. “In addition, deterioration in certain loan portfolios, particularly office properties and credit card loans, continues to warrant monitoring….”

The more than five dozen entities possess exposure to CRE greater than 300 percent of their total equity, the study found.

“This is a very serious development for our banking system as commercial real estate loans are repricing in a high interest-rate environment,” said Rebel Cole, Ph.D., a Lynn Eminent Scholar Chaired Professor of Finance at Florida Atlantic University’s College of Business.

“With commercial properties selling at serious discounts in the current market, banks eventually are going to be forced by regulators to write down those exposures.”

The Treasury bond part of Powells problem all goes away for Powell if he can just stop fighting inflation. He can’t do that easily if inflation is continues to slowly rise UNLESS his labor mandate kicks in because unemployment is rising, so he can say it was more important to save labor. Save labor, lose on inflation.

However, the MBS part of the problem likely does not because commercial real-estate defaults will continue, though maybe not as badly if interest drops. It’s just that a big part of the problem is that the assets, themselves, are losing value because people don’t want them. With restaurants going out of business, retail shutting down, people not working inside office buildings as much, the demand is seriously suffering.

All lubed up

Another wisp of reprieve for Powell came from oil, which has been repricing downward since OPEC+ met last week because, while OPEC held their production quotas where they are, they did say they would start to raise those quotas near the end of the year and into next year. (That is because they’ve had a hard time driving prices up to the $100 per barrel they love as other oil producers in the US and elsewhere rushed in to fill the void; so the price war has cost the OPEC+ forces some market share.)

If oil goes down, it won’t be adding so much pressure in the months to come to the price of everything. Still, it is a hope on shaky legs because wars all around the vaunted oil region continue to bomb away. Putin didn’t see the big gains from his recent efforts in Ukraine he thought he’d see because NATO arms stormed in and made a huge difference that is hurting him. That means that war will rage on for some time.

The wars Israel is engaged in are also heating up, not cooling down. News today said Israel’s leadership and the IDF are ready to move to a much hotter war with Lebanon in the days ahead if they need to, and it looks like the need to. Both sides are either doing or talking about doing a literal scorched-earth policy, such as burning down olive orchards to end people’s livelihoods. With the Houthis, who are playing a major part in those wars, attacking a US destroyer in the last few days, it doesn’t look like the the vast navies of the US and its allies have managed to secure Red Sea shipping routes, which hugely impact oil delivery.

So, anything could happen with oil still, as the region is up in smoke wherever you look.



Seeing the Great Recession Before it Hit

My path to writing this blog began as a personal journey. Prior to the start of this so-called “Great Recession,” my ex-wife had a family home that was an inheritance from her mother. I worked as a property manger at the time, and near the end of 2007, I could tell from rumblings in the industry that the U.S. housing market was on the verge of catastrophic collapse. I urged her to press her brothers to sell the family home before prices dropped. The house went on the market and sold right away — and just three months before Bear-Stearns and others crashed, taking the U.S. housing market down for the tumble. Her family sold at the peak of the market.

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