I continue to be surprised around how well the major equity indexes are holding up.
Charles Schwab (SCHW) strategist Liz Ann Sonders noted Tuesday that "Hedge funds currently are sitting with largest net short position in S&P 500 futures since late 2011," which Real Money's James "Rev Shark" DePorre then observed was a major reason explaining "why this market won't pull back." That is likely one factor why the indexes are maintaining their buoyancy, even before Wednesday's CPI reading.
However, there is a major divergence between where equities say the economy is going and the direction the credit markets are pointing to right now. Bloomberg noted Tuesday that the ICE BofA MOVE Index spiked to its highest level since the 2008 Great Recession during the recent Silicon Valley Bank and Signature Bank implosions. This index is a gauge for expected swings in Treasury bonds using one-month options.
Meanwhile, stock volatility moved only to the levels of last November during the second and third largest bank failures in American history -- and the VIX is now below the 20 level once again. The MOVE index remains elevated at over double its average over the past decade, which the Bloomberg article notes is the widest gap between stock and bond volatility levels in 15 years.
We also experienced the widest inversion between the 3-Month and 10-Year Treasury yields on Tuesday. This is a major headwind to the banking sector whose industry is largely built on the premise of borrowing short term and lending long term.
The Mortgage Bankers Association recently reported that banks lost $301 per mortgage loan issued in 2022, compared to a profit of $2,339 a year before. Banks are also now having to compete for deposits for the first time in recent memory. I am sure I am not the only one being bombarded by emails from financial institutions imploring me to move my savings to pick up yields of 4% plus.
Realistically, one also has to be increasingly concerned about the commercial real estate market. There is a likely possibility for rising defaults, which would impact an already beleaguered regional banking system. Some $1.5 trillion in commercial real estate debt is scheduled to come due before 2025 and regional banks supply some 70% of the credit to this part of the economy.
Recent analysis by Morgan Stanley projects that commercial real estate values could drop 40% from peak to trough. Data provider Green Street estimates that commercial real estate values in March were down 15% overall from the same month a year before.
Obviously, commercial estate loans coming to maturity on collateral that has lower valuations that has to be refinanced at higher rates is going to lead to higher write-downs and defaults throughout the banking system. This will force banks to increase reserves, raise credit criteria and reduce lending to the small business sector and focus on the most creditworthy customers. The classic credit crunch that happens in recessions. This is one key reason that small business optimism has fallen over the past year as interest rates have risen sharply and is likely to continue to do so.
The credit and stock markets are telling investors very different things about the direction of the economy. Unfortunately, I think the latter is likely to turn out correct and I continue to position my portfolio accordingly to this more pessimistic view.