Yesterday was an eventful day for markets. We started off with inflation data in Europe, followed by an earnings release by New York Community Bank that showed large provisions in their commercial real estate loan book, before moving onto the Fed’s Federal Open Market Committee meeting.
Volatility was high throughout the day with the Xover index (a proxy for European high yield) widening some 8bps, the S&P 500 down 1.6% and 10-year US Treasuries rallying 10bps.
Starting with inflation data, we had mixed numbers from the Eurozone. Both Germany and France showed a steeper decline than expected in headline CPI, which now stand at 2.9% and 3.1%, respectively. There is not a lot of detail in the preliminary releases, but we do note that services inflation showed a slight increase. We will get more data on this front later today when Eurostat publishes the aggregated Eurozone CPI data. Broadly speaking though, trends remain in place. Inflation is falling towards target, which should allow the ECB to cut rates relatively soon.
By mid-day in London, New York Community Bank surprised the market with much larger provisions linked to their commercial real estate (CRE) book, which resulted in a large dividend cut. The stock declined close to 40% at one stage, prompting the largest fall in the KBW Regional Bank Index since SVB faced a run on its deposits back in March. US Treasuries rallied and stocks sold off in a classic risk off day. Without going into the detail regarding the earnings release, our take on these headlines is that, from a micro point of view, banks with large exposures to US CRE and, in particular, offices will see an increase in provisions and non-performing loans and that is nothing new.
The bigger question for us has been whether this micro issue might mutate into a macro issue, which is what maybe could have happened had the crisis in March not been contained. Our impression is that this is unlikely. This is not to say we have seen the last negative headlines on US banks (or other banks) that have a large exposure to US CRE, and we will of course continue to monitor developments in the sector. But we do think three things became clear after the events in March 2023. Firstly, the vast majority of banks are in good shape and the system on an aggregated basis is in a strong position. Secondly, the Fed has the ability and willingness to act fast and stop contagion to healthy banks, which comprise the majority of the system. And lastly, European banks are largely isolated from US CRE issues.
Which brings us to the Fed and the FOMC meeting. Interestingly, there were no questions or comments about New York Community Bank, which highlights that this is far from a macro issue at this stage. The main headline was that Fed chair Jerome Powell explicitly pushed back against expectations for a March cut. We were expecting this to be the case (as detailed in this blog ) as the market seemed to have gotten a little bit ahead of itself. More importantly, in our opinion, is the fact that macro conditions are evolving in line with Fed expectations, allowing them to remove their tightening bias. Inflation is falling and growth is holding up, which was acknowledged in the statement by saying that growth and inflation were forming a “better balance”. The order of events is usually to move from a tightening bias to a neutral one and then to an easing bias. Yesterday, the Fed moved from a tightening to a neutral bias. They just need to gain “greater confidence that inflation is moving sustainably toward 2%” before adopting an easing bias to start cutting rates.
The Fed sounded confident that inflation is moving towards the target in the context of a controlled slowdown in the economy. “Let’s be honest, this is a good economy,” Powell said, which sums it up nicely. This should allow them to ease monetary policy by cutting rates and reducing the pace of QT while at the same time default rates should remain in check. In this scenario, both government bonds and credit should do well. Both components of fixed income returns, i.e. risk-free rates and spreads, might move lower in coming months. As always this is unlikely to be in a straight line, but with yields at elevated levels and the prospect of diminishing returns in cash as rates decline, we think that fixed income stands out as a very attractive proposition.