Stocks generally ended January higher, except for the small caps of the Russell 2000. Each benchmark index listed below ended January higher, except the small caps of the Russell 2000. The market seemed to be still basking in the afterglow of the late 2023 rally and prospects for lower interest rates in 2024. While some mega-cap tech firms only met their high earnings forecasts, enough exceeded expectations to bolster the overall market sentiment. The U.S. 10-year treasury yields rose following a robust January payrolls report, indicating substantial job gains and wage growth.

The most market-shaping events in January were favorable economic data, the January Fed meeting, and news of New York Community Bancorp (NYCB) reporting significant Commercial Real Estate (CRE) loan losses.

The economy remains resilient despite ongoing conflicts in Ukraine and the Middle East. Fourth-quarter gross domestic product (GDP) expanded at an annualized rate of 3.3%, with consumer spending, a major GDP contributor, at 2.8%. Commodity prices, despite Middle East turmoil, show limited stress, but potential supply chain issues could lead to stubborn inflation. (1)

The Federal Reserve essentially tightened monetary policy last week, though it took a few days for markets to begin to catch on.

At its January meeting, the Fed left rates unchanged, and during the presser, Powell all but took a March rate cut off the table, signaling the market to simmer down about upcoming rate cuts. Chair Powell said the Fed needs “greater confidence” that 2% inflation is forthcoming. The economy has tolerated these higher rates, and unemployment is still below 4%. The “If it’s working, don’t fix it” rationale signaled shallower and later cuts than the market assumed coming into the new year. With unemployment below 4% and the economy growing steadily, the Fed suggested a cautious approach to rate cuts in the new year was warranted.

If there was any doubt about what the Fed was signaling, Powell’s February 2nd appearance on 60 Minutes erased it.  With inflation trending downward, the economy growing steadily, and jobs still plentiful, Powell dismissed the likelihood of a rate cut in March as “unlikely” and revealed his view that the first-rate cut would not occur until mid-year.

Given that Fed policymakers dosed the economy with rapid and large rate increases to slow the economy and bring inflation to heal, the economy has yet to yield to a recession. This economic resilience appears to be causing the Fed to rethink its “neutral rate of interest” target. In Federal Reserve speak, the neutral interest rate refers to the level of the federal funds rate (the rate at which banks lend to each other overnight) that neither stimulates nor constrains economic growth. It is often seen as the interest rate level consistent with full employment and stable inflation over the medium term. Neel Kashkari, President and CEO of the Federal Reserve Bank of Minneapolis, published a paper on February 5th titled “Policy has Tightened a Lot. How Tight Is It?

Kashkari concludes his paper with, “It is possible, at least during the post-pandemic recovery period, that the policy stance that represents neutral has increased. The implication of this is that, I believe, it gives the FOMC time to assess upcoming economic data before starting to lower the federal funds rate, with less risk that too-tight policy will derail the economic recovery.”

Kashkari followed up the release of his essay with an interview on CNBC on Feb 7th.  In the interview, he expressed that employment conditions should influence rate decisions, and continuing strength in the labor market will indicate slower-than-expected rate cuts. Being pressed on as expectations for the number of rate cuts in 2024, he suggested 2-3. He also made an interesting observation about higher productivity, perhaps due to advancements in innovation from artificial intelligence (AI), leading to productivity gains and non-inflationary growth. Under that scenario, a higher neutral rate would be prescribed.

The takeaway is the neutral interest rate can vary over time and is influenced by various factors such as productivity growth, demographics, and the economy’s overall health. It is also not directly observable and is subject to estimation and revision by economists and policymakers based on economic data and analysis. Until now, Fed policymakers have suggested a 2.5% Federal rate as neutral; as Mr. Kashkari, they may reassess that today’s rates are not as restrictive as previously thought and decide that the neutral rate is higher, perhaps in the neighborhood of 3.5 -4%. And since all rates are priced off the Federal Funds rate, the market may have to reset expectations for higher rates across the credit spectrum.

Regarding Commercial Real Estate (CRE), Powell downplayed the possibility of a banking crisis similar to 2008-2009 but acknowledged potential challenges for smaller banks due to CRE issues. In late January, New York Community Bancorp (NYCB) saw its stock price halve due to mounting losses in Commercial Real Estate (CRE) loans. The bank’s CRE borrowers faced challenges from high-interest rates and low occupancies. Adding to the complexity was NYCB’s acquisition of assets from Signature Bank, which had failed the previous March, triggering heightened regulatory capital requirements by surpassing the $100 billion assets threshold. Concerns over NYCB’s issues spread throughout the regional bank sector, causing a decline in sympathy.

Despite signs of economic normalization, persistent issues remain in interest-rate-sensitive sectors. CRE loan losses pose a credit risk to banks, while the ongoing yield curve inversion presents a significant obstacle to net interest margin. Anticipated high bond issuance by the Treasury and increasing bank capital reserve requirements further impede a full return to normalcy in the banking sector. These factors collectively indicate challenges for the traditionally CRE- and small business-funded regional banking sector.

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This material contains an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources.

The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward-looking and should not be viewed as an indication of future results.

Tim Waterworth

More about the author: Tim Waterworth

Tim is licensed as a Registered Representative with Kestra Investment Services, LLC, and an Investment Advisor Representative with Kestra Advisory Services, LLC. He holds himself to a fiduciary standard, which means he is obligated to put the best interests of his clients first.