Déjà vu all over again?

Once More with Feeling

Problems in the Commercial Real Estate (CRE) market became so acute last week that holders of a virtually risk-free AAA rated class of bonds received less than 75 cents on every dollar invested. The consensus among sophisticated investors is that although one-fifth of all office space sits empty, and buildings in Seattle and Washington D.C sold last week at an 80% discount, all is well. Is the CRE problem manageable, or are we falling prey to Spanish philosopher George Santayana’s warning that “Those who cannot remember the past are condemned to repeat it”? After all, that is how analysts viewed the housing market in 2006 and 2007, just before the Global Financial Crisis (GFC).

While this is not the first instance of drastic price drops in CRE transactions, this is the first time since the GFC that investors holding the AAA-rated class of a commercial mortgage-backed bond took a big hit, and prices for the AA-rated down to the riskiest B-rated class of these bonds all went to zero., One-third of the $150 billion office loan market in commercial mortgage bonds were in trouble as of March, twice the number from a year ago. Meanwhile, the stock market sitting at all-time highs has completely written off the possibility of CRE-related problems. Investors cannot be blamed since banks’ total assets dwarf the outstanding CRE loans. Banks do appear to be positioned to absorb shocks from future defaults. Yet, based on the disaster in this $308 million dollar bond, any further CRE-related losses could cause stock market investors to take a step back and become defensive. The CRE market is back on our radar screen.

Where’s Maverick When You Need Him?

We had spoken weeks ago about the potential for geopolitical concerns about the incoming Taiwanese president. President Lai Ching-te represents a threat to mainland China’s assertion that the island is part of their national territory. President Lai was inaugurated a week ago Monday and declared that under his leadership, Taiwan would “neither yield nor provoke” China, and called for China to stop its military threats. Lai’s inauguration speech prompted China to immediately surround Taiwan with aircraft and a naval blockade—as an exercise, of course.

China has reason to be concerned. Lai won 40% of the vote in a three-way race as he positioned himself as the most pro-independence candidate. The president promised he would stand with his soldiers, and he put naval air and land units on alert. Thankfully, the drills are set to end after only two days, but Taiwan’s ego may be writing checks the island can’t cash; it is yet another potential flare-up that investors need to monitor because it could pull the U.S. into a conflict with China. If we begin to see commodity prices skyrocketing, it could be a tip-off that China is hoarding essentials in front of an invasion that could result in global sanctions against them.

Anchors Aweigh

Fed Governor Christopher Waller is often looked to as a thought leader of the Federal Open Market Committee (FOMC). It appears he is trying to steer FOMC voters and fixed-income investors to anchor their rate cut views around his own of one cut at the end of this year.  Additionally, he said that the FOMC “can rule out that inflation is reaccelerating”, “the probability of rate hikes is very low,” and that “the probability of recession seems to have disappeared.”

The minutes of the most recent FOMC meeting were released last Wednesday, and it mentioned that “various participants mentioned willingness to tighten policy further.” That view is quite different from Waller taking the prospect of rate hikes off the table. Importantly, the minutes were taken before the April CPI inflation report that showed some cooling when looking at the last three- and six-month annualized inflation rates. Those are the metrics that Waller focuses on to measure the momentum of inflation, and the latest data obviously made a strong impression on him.

Waller was able to successfully anchor investors forecasts, which were sitting at a 55% chance of two or more cuts early in the week to drop to under 40%. That caused shorter rates to rise more rapidly than longer-term bonds, which normally weighs on stock prices. It did not prevent the S&P 500 and the NASDAQ from closing at weekly all-time highs, but if short rates continue to rise, it will depress equities.

What to Look for This Week

1. Wednesday May 29, the Mortgage Banker Association releases its mortgage refinancing data at 7 am E.S.T. It has been racing higher, which is odd because one must wonder why homeowners with low mortgage rates would be refinancing at higher current rates.

2. The Private Consumption Expenditures Price Index inflation data is released Friday May 31 at 8:30 am E.S.T. It will be watched closely to see if the April data does show inflation cooling similar to the April CPI data. Fed Governor Waller will have more conviction in his view if there are no upward inflation surprises in the report.

3. Friday also has Personal Income and Real Personal Consumption data for April which will be scrutinized, but Saturday has the OPEC Oil meeting to kick off June. Crude oil has been falling, helping consumers pay less at the gas pump, but they will try to reverse that trend over the weekend.