April 8, 2021 | The growing push-back against the Biden infrastructure plan and trillions more in deficit spending comes as the US economy is recovering by leaps and bounds. The mere fact of vaccination, effective or no, is probably worth several points of GDP simply by improving the national mood. The positive impact on consumers and some parts of the economy is massive and ongoing, even as other sectors struggle with deflation.
In many respects, it is April 2020 all-over-again. The FOMC bought us a year in the housing market with QE and low rates. Now we are back to square one with weak or even negative lending and bond issuance volumes. In terms of the economy, residential housing is not the problem. The low default rates in most 1-4s other than the government-insured sector suggest there is no credit issue in housing. The Fed is focused on employment and other sectors of the economy, but the bias remains deflationary outside of the overheated equity markets.
Some months ago, we predicted that the Democratic majority in the Senate was an illusion. The splinter in the ointment is a West Virginia Senator who is a Great Society Liberal, but has little in common with the socialist tendency presently calling the shots in Washington.
"Senator Manchin's (D-WV) Apr. 8 Washington Post opinion essay where he states his opposition to the use of budget reconciliation leaves us pessimistic regarding prospects for passage by Congress in 2021-22 of a $2+ trillion broadly defined infrastructure plan that was outlined in the Administration’s American Jobs Act," writes Byron Callan of Capital Alpha Partners.
The fact that President Joe Biden is already signaling weakness by putting the corporate tax rate out for negotiation illustrates the flimsiness of the progressive agenda. As Republicans regain confidence, we fully expect to see one of the half dozen marginal Senate Democrats cross the aisle -- but probably not Manchin. If the Republicans can delay another month or so, the rising economy may well shred any remaining argument in favor of fiscal stimulus and give them back the majority in the Senate.
Meanwhile in Foggy Bottom, the FOMC says there will be no change in ST interest rates nor in QE, but the markets are calling bull-feathers. Earlier this year, the FOMC lost control of the bond market when the 10-year T note spiked. Note, however, that yields on the benchmark 10-year Treasury note started working higher last Summer and Fall.
In fact, the rate spike in February 2021 marked the acceleration of an existing trend higher in rising interest rates. Notice, for example, that mortgage bonds were comfortably in the green this week until the Federal Reserve's latest buying operation ended, then prices slipped and yields rose. Many analysts seem to ignore the fact that the Fed may not be able to end QE because it has become an important part of the bond market.
The FOMC faces a possible net addition of another $1 trillion in spending and borrowing in 2021. Also, there are a number of federal trust funds that are now running negative in terms of net cash flows, increasing the funding burden on the Treasury. For every dollar of trust fund release, the Treasury must raise $2 in cash. A scenario such as 2018, when the FOMC thought it could end QE and raise target rates is impossible today w/o a major change in federal spending by Congress.
Meanwhile in the world of real estate finance, the results are, well, lumpy as you might expect. We described some recent observations in our last missive (“Update: Commercial, Residential Loans & MSRs”), mainly that urban commercial real estate is moribund and is unlikely to bounce back to previous valuations. Even a successful economic recovery measured by national statistics could see valuations for New York office buildings cut in half because of new, lower levels of utilization and NOI.
The loud gnashing of teeth you hear in the background is the sound of progressive cadres bemoaning the fact of the building economic recovery. In the residential housing market, for example, the number of households using loan forbearance is falling fast, rendering the appeal of pro-consumer policy moves in doubt. If there is no crisis, then who needs a bailout?
The announcement by the Consumer Financial Protection Bureau, for example, that it is considering a nationwide foreclosure moratorium for ALL residential loans angered members of the mortgage community. But troubled loans may not be a big deal if consumers continue to leave forbearance successfully at the current rate. The CFPB announcement is just more of the same progressive politics of regulatory extortion and abuse.
The CFPB does not actually have the legal authority to impose a national moratorium on loan foreclosures, but the mortgage industry is unwilling to fight – so far. For that matter, the Centers for Disease Control does not have the legal authority to impose a national moratorium on evictions of renters. But as the financial situation facing landlords becomes ever more dire, even progressives may need to pay attention to the details.
The basic problem with spending on “infrastructure” is the same as the problem with affordable housing. Everybody wants it, but infrastructure and housing are expensive loss leaders – especially in blue states like New York where feeding layers of corruption are required for any public task. Building in New York City costs in excess of $600/psf not including the cost of the land, which is also ridiculously expensive. Think $5k psf all-in cost including land for New York City construction. How does one make this affordable?
The truth of the matter is that inflation in living costs and asset valuations has rendered major metros too expensive for even affluent households. Since the FOMC refuses to allow any deflation in asset prices, consumers get no relief. But the fact of the COVID pandemic has added a powerful downward bias to some, but not all, sectors of the commercial real estate sector. For now, the buoyant stock market provides a welcome distraction, but the commercial real estate sector is an open wound that will remain for years to come.
Earlier this week, Jim Cramer on CNBC's Mad Money provided a fascinating commentary on why stocks go up. He remarked on the fact that merely mentioning a stock, regardless of the news content, causes the price to rise. The fact of a brokerage firm issuing a hold on a stock causes the price to go up. And most tellingly, Cramer noted that the spasmodic upward thrusts in stock prices do not cause sellers to enter the market. In the world of quantitative easing, all boats rise on a sea of fiat paper dollars. The trees grow to the sky, for now.
Our big worry is that activity in the corporate bond market remains muted, this along with flat to down commercial lending that will be confirmed by bank earnings next week. As those bright lights on the FOMC debate whether the central bank should start to manipulate the entire Treasury yield curve, the market is reacting in ways that are not altogether encouraging. We do note, however that mortgage related issuance is rebounding, confirming our anecdotal observation that issuers are still seeing strong volumes in 1-4s despite a 50bp increase in 30-year mortgage rates.
The BIG question is what happens to the bond markets if the Biden Administration continues to grow federal deficits. A bond selloff could cascade into the equity markets and cause a major mishap a la the recent mess with Archegos, a family office that accumulated insane leverage through bilateral swaps with banks. Ultimately the Fed’s low interest rate policies created the circumstances for Archegos and other spread trade frauds such as Wirecard and Greensill, to name but two high profile cases.
At the present time, the consumer side of the US economy is booming along with stocks and residential mortgages. The rest of the economic landscape is littered with assets and industries that are in varying stages of distress and showing accelerating levels of deflation. Eventually these deflationary black holes may start to matter in the thinking of investors.
An equity market selloff could have substantial negative repercussions for the global markets and cause some financial institutions to take major losses on hidden derivatives positions. Yet the bigger risk is that a market break could shred the little credibility possessed by the Biden Administration and Treasury Secretary Janet Yellen, leaving the US entirely exposed to the vagaries of the markets. If the Biden infrastructure plan fails, Americans face a Lame Duck government less that a year into Biden’s first term. Stay tuned.