It’s a good time for disaster movies…Civil WarThe Day After TomorrowArmageddon and, of course, in the theatres right now, Godzilla vs. King Kong.  Fun on the big screen, not so much in real life.  Have you seen Godzilla vs. King Kong?  A guilty pleasure (like eating ice cream out of the carton) to be sure.  As a total sidebar, I actually loved the first one from the late ‘50s with guys in monster suits and where a Japanese actor would go on and on perorating about the existential risk of nuclear power while in the dubbed version, all he said was, “Run!” (curious factoid, 7.5% of the theatergoers apparently thought it was a documentary…okay, I made that up, but it could be).  

No one has to embrace the frisson of a scary movie, just don’t go.  However, we are stuck with the real life equivalent in financial markets right now:   inflation versus recession (or stagflation).  

The Feds’ confusing and confused meetings and Fed head chatter about inflation and recession brings disaster scenarios to mind, doesn’t it?  The Fed clearly is enjoying a rock and hard place, Charybdis and Scylla, Godzilla and King Kong moment with really bad things threatening on both sides of the debate.  The wrong decision here could be the stuff of its own disaster movie.

Let’s put aside the yammering of our glorious political elites who reflexively yell for lower interest rates now.  They, of the reptilian brain, only see Fed decisions through the lens of what the voters, the folks, instinctively want and they surely want lower interest rates right now.  Our pols are pretty sure that pontificating about the fact that interest rates are too high is an electioneering winner.  The assumption, of course, is that, damn the merits, the bulk of the voters can be fooled at least through early November and any costs associated with artificially reducing interest rates (think Turkey for a minute) will  remain clouded by opacity; unappreciated.  Negative externalities anyone?  

But, are interest rates too high, too low, or just right from the perspective of the real business of government which is (supposedly) nurturing a healthy economy?  I want to talk about the debate, not the answer.  What is the Fed thinking about when they think about Fed funds?  

First, any debate on interest rate change has to take a view of the lag effect.  It doesn’t get talked about enough.  We don’t really know what the lag is between Fed funds moving and the impact on the real world.  We don’t know how much time we should expect to pass between accelerants and acceleration (and vice versa) but we know that the lag is real.  Then there is the question of whether the accommodative fiscal policy is more powerful than monetary contraction.  Both have lags, but which wins this race?  Gotta take a view.  

What’s the case for accommodation?  What’s the case for a more restrictive policy?  

The case for sitting still must begin with the observation that a five handle on Fed funds and a ten year that may soon uninvert does, unburdened by facts or much analytics, look restrictive…but really it is not.  From a blackboard point of view, if you think the real cost of short term money over the longtime is 2% and long term inflation is roughly 2% then a 4% Fed funds rate and a ten year slightly above that looks pretty much right.  Moreover, if the Fed tosses the long-held 2% base case for inflation on the midden heap of history and embraces a brand spanking new 3% base case for acceptable inflation, then there’s surely no reason to cut.  (The Fed, of course, is shying away from any admission that the base case might change, as it looks embarrassingly like the financial equivalent of 1938’s “peace for our time,” but that doesn’t mean they aren’t going there.) 

The economy is doing swell.  Gross domestic product is expanding, unemployment is historically low, the consumer remains relatively enthusiastic and the stock market continues to trend upward.  While some sentiment indices are flashing caution and consumer debt is growing concerningly, there’s not much evidence in the data right now suggesting a real slowdown, let alone a hard landing.  We’ve lived with a 5% Fed funds rate for the majority of the last 60 years, so why fix it if it ain’t broke?  

To lower interest rates in an economy that is expanding and robust seems a bit out of touch, doesn’t it?  According to my research assistant, Professor Google, it has happened rarely in the past 70-ish years.  Isn’t cutting interest rates in a growing economy like pouring gasoline on the fire?  

Moreover, as we’ve mused before in this column, Chairman Powell would prefer his legacy to be Volkerish and not Burnsian.  Right now, it’s very far from clear whether inflation will recommence trending downward or whether it might reaccelerate.  Based on recent data, it looks simply stubbornly intent on staying where it is for the foreseeable future.  Finishing this commentary up on Data Dump Friday, there is, in fact, more than a whiff of stagflation in the air; growth is meh and inflation simply won’t go away.  That’s a prescription for staying the course.  

If, based on the macro, the equities for either accommodation or restriction are roughly balanced.  There remains a case for fresh accommodation and a pretty strong one at that, in one perhaps obscure, to many, corners of the data.  There are two market segments in our economy that are extremely sensitive to Fed funds that are in trouble.  Both are large and struggling the broad based collapse and either is capable of doing real damage to the broader economy.  As we’ve argued in the past, once the match is lit, a new conflagration is possible.  

What we’re talking here is commercial real estate and the balance sheets of small to mid-market corporates.  

Best guess is that between 30-40% of the debt held by enterprises in these two market segments is floating.  Much of this debt was taken on board when SOFR or its predecessor, LIBOR, was close to the zero bound.  Now over 500 bps higher than its low water mark, there is enormous stress on these enterprises (and that’s, putting aside for the second, inflationary impact on costs which have skyrocketed during the past several years and the fact that easy revenue growth is largely behind us).  Note this is materially different from the GRC and actually worse.  Back then, the stress was the terminal point, at refinancing.  Today the stress is May with on-the-run expenses, the interest cost, materially higher than when this debt was contracted.  Note also that rate caps continue to burn off.  No one knows how or at what pace, but that will make this problem even harder to deal with.  Moreover, a significant amount of this debt is coming due very soon.  A significant amount of the assets supporting this debt are now wildly mispriced and cannot avoid the necessity of significant restructuring (that is a euphemism for lots and lots of new equity).   

I wrote a column a few weeks back suggesting that it’s possible that commercial real estate and its first cousin the corporate market could be the match that lights the conflagration (Could We Bring It All Down?).  Of course, I wrote two weeks later that I could be entirely wrong and Goldilocks may be in the house but call me a pessimist, I have a decided bias toward the doom-loop scenario.  

Assessing the tripwire characteristics of mispriced corporate and CRE debt in large measure depends on one’s view of the higher for longer narrative.  At least in the CRE market the current take is that while there is a lot of noise around inflation, inflation is still coming down.  If not coming down really soon, it’s coming down moderately soon.  Whether it’s phantasmagorical or not, the whole notion that if interest rates come down eventually, we can relax for the moment, seems to be an ascendancy, witness the modest bull market in issuance in SASB and conduit securitization.  

That’s just wrong.  

I’ve got no particular insight (make that actually no insight at all) into how those who occupy the heights of power view the relative risks of reigniting inflation by suppressing Fed funds versus the risk of causing a recession and the possible multiplier effect on recession risk of ongoing interest shocks in the CRE and corporate marketplace.  It’s a tough call.  Can we kick the can down the road?  Can we skirt the abyss?  Can we keep doing it if interest rates remain elevated for many quarters to come?   Maybe the residents of the heights think that we’ll find a way to fix this down in the trenches, in those market segments where the interest rate problem is most acute, that we’ll all muddle through like last time.  Deals will be cobbled together.  Lenders, shy of ownership of these assets and shy of the responsibility for taking businesses down will find a way to pretend all is well long enough for well to arrive.  I’m not buying that this extend and pretend strategy is going to work this time.  

I’m betting that the current interest rate environment is our reality for many, many quarters, possibly years.  I return to the observation that Mr. Volcker, who literally destroyed the economy, is an honored member of the pantheon of economic Gods and Mr. Burns has been consigned to one of Mr. Dante’s lower rings.  Political noise is almost a neutral factor here because no matter what the Fed does, they will be blamed by half the country.  There’s really no political safe harbor for the Fed.  Moreover, the data is unconvincing and if we remain data driven, a compelling case for up or down is simply not there.  

In that troubled landscape, legacy trumps all and because of that, I don’t see rate relief on the table any time soon.  Those who talk about a potential rate increase in the next year are not any longer only denizens of the loony fringe.  That means that while economic activity should continue at a moderately high level for the balance of this year, there is real trouble in the floating rate markets.  The Fed and our fiscal masters will pay their money and take their chances.  They’ll run the risk that a disaster in the commercial real estate and small corporate sectors will not cause broader contagion.  Good bet?  Bad bet?  

Get ready.