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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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Interest Rates, Deficits & Inflation

"The public again sees inflation as one of the top problems facing the nation, with 62% saying inflation is a very big problem for the country – only slightly down from the 65% who said this last year."

May 24, 2024  | Now that Goldman Sachs (GS) has finally given up on their call for a cut in fed funds this July, it seems appropriate to ponder the state of the capital markets as we approach mid-2024. When GS CEO David Solomon said that he sees no rate cuts in 2024, we think he’s got it about right. You see, the real question nobody dares state is that the Fed cannot control inflation without action by Congress to reduce the federal deficit. 

John Cochrane (aka “The Grumpy Economist”) wrote back in April 2022:

“Inflation’s return marks a tipping point. Demand has hit the brick wall of supply. Our economies are now producing all that they can. Moreover, this inflation is clearly rooted in excessively expansive fiscal policies. While supply shocks can raise the price of one thing relative to others, they do not raise all prices and wages together. A lot of wishful thinking will have to be abandoned, starting with the idea that governments can borrow or print as much money as they need to spray at every problem. Government spending must now come from current tax revenues or from credible future tax revenues, to support non-inflationary borrowing.”

Monetarism and fiscal theory agree, if you drop $5 trillion of cash on people and they only expect that some of it will be soaked up by future surpluses of tax revenue over spending, you get inflation.” 

If we take note of the fact that 1) Congress is unlikely to cut the federal deficit anytime soon and 2) US consumers show little fatigue despite constant predictions of default and deflation in consumer credit, then we think it is reasonable to push expectations of a cut in the target for Fed funds into Q1 2025.  This view is admittedly out of line with the Street narrative, but we note that people jumping the shark on rates are getting eaten alive. Charlie McElligott at Nomura (NMR):

“Rates continue to chop people up, where everybody’s favorite Steepener continues to bleed more bodies with Fed cuts continuing to get pushed-out on the timeline, as data softens but still remains 'good enough' and generally expansive…where it seem that the crowded nature of the trade on the multi-year Fed cutting cycle -view being near fully-reflected in price already…hence the trade seemingly won’t work until growth slows in a much more powerful fashion…”

One of the benefits of the current posture of the Fed is that headline market volatility has declined, but this may be a short-term pause. Given the enormous size of the Treasury’s General Account (TGA) at the Fed, the Treasury tail is now wagging the Fed dog. The fact that expectations for market volatility are low may simply be an indication of market confusion or perhaps even delusion. As concerns about inflation increase, equity market valuations rise apace. The chart below from FRED shows the Fed's balance sheet vs the VIX.

The vast pile of cash that the Treasury needs to make payments on its debt and other obligations interacts directly with bank reserves, impacting short-term liquidity and, some believe, ST asset prices.  The chart below shows the complex situation that the Fed must navigate with the TGA, Reverse Repurchase Agreements (RRPs) and bank reserves. Notice that the TGA reached $1.8 trillion during COVID.

As you can see, the vast flow of cash out of the TGA in Q4 2023, as well as the decline in RRPs, led to an increase in bank deposits and bank reserves. The Fed has recently floated the idea of restoring minimum reserve levels for some US banks and also pre-positioning collateral at the discount window in order to provide liquidity to the markets. But all of these expedients are a function of the federal budget deficit and the ebb and flow of cash into and out of the TGA.

Can the Fed get control of inflation without a reduction in the federal deficit? The short-answer is probably not. The fast flows of cash going into and out of the TGA are financed with debt, not tax revenues. Federal transfers are increasing demand and economic activity above the level consistent with price stability or perhaps even falling prices. Some economists argue about whether high interest rates are good or bad for inflation, but printing money to finance the federal deficit is not conducive to price stability. 

The real wild card in the equation in terms of inflation and future interest rates is commercial real estate, which continues to sink into a deflationary trap of historic proportions. The decline in value of CRE is destroying hundreds of billions of dollars in equity value accumulated over the past century. The FOMC is largely powerless to address the CRE debt deflation, which is a function of LT financing costs and changes in consumer and business behavior.

Starwood Real Estate Income Trust, which manages about $10 billion and is one of the largest real estate investment trusts around,” notes Maureen Farrell of The New York Times, “said on Thursday that it would buy back only 1 percent of the value of the fund’s assets every quarter, down from 5 percent earlier.”  But as we all know by now, hope is not a strategy.  The chart below from FRED shows the change in average prices for commercial real estate (CRE) over the past five years. Notice that we are almost 25% below average CRE valuations from 2021.

We suspect that the manager of SREIT, Starwood Property Trust, Inc. (STWD), will be forced to sell assets into a falling market sooner rather than later. Meanwhile, there are tens of billions of dollars worth of commercial real estate assets around the US that are headed for foreclosure and liquidation.

Of note, the first "AAA" portion of a commercial mortgage backed securities (CMBS) deal took a loss for the first time since 2008, Bloomberg reports. The American consumer may not yet be ready to roll over, but the accelerating debt deflation in commercial real estate may soon become the main focus of attention for the Fed, federal and state bank regulators and financial markets.

The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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