Key Points

A series of recent market news indicates that the negative effects of restrictive monetary policy and high interest rates are gradually emerging. The Federal Reserve continues to tread carefully in balancing the relationship between insufficient tightening and excessive tightening.

Since the Federal Reserve initiated this round of interest rate hikes in March 2022, it has stopped raising rates since September 2023, but the timing of the first rate cut has been repeatedly postponed. A series of recent market news indicates that the negative effects of restrictive monetary policy and high interest rates are gradually emerging. The Federal Reserve continues to tread carefully in balancing the relationship between insufficient tightening and excessive tightening.

Japan's fifth-largest bank suffers from unrealized losses in bond investments

In March 2023, Silicon Valley Bank in the United States went bankrupt and was liquidated due to the tightening of the Federal Reserve and the surge in U.S. Treasury yields, resulting in huge unrealized losses in bond investments. More than a year later, Japan's fifth-largest bank, Norinchukin Bank, unfortunately "stepped on a mine" for the same reason.

This century-old institution, founded in 1923, mainly serves agricultural, fishery, and forestry cooperatives in Japan. On June 19, 2024, the bank suddenly announced to the outside world that it is planning to gradually sell about 10 trillion yen (about $63 billion) of U.S. and European sovereign debt (government bonds) before March 31, 2025, to stop loss combination investment transactions and consider diversified investments.

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The bank's financial report for the fiscal year 2023 (from April 1, 2023, to March 31, 2024) shows that in its securities investment portfolio, yen assets account for 24%, U.S. dollars account for 57%, euros account for 16%, and other currencies account for 9%. Among them, those within one year account for 36%, those from one year to five years account for 16%, those from five years to ten years account for 31%, and bonds exceeding ten years account for 17%. Since the Federal Reserve's aggressive interest rate hikes in this round from fiscal years 2021 to 2023, the unrealized losses in the bank's bond investments were 334.3 billion, 1.73 trillion, and 2.19 trillion yen, respectively. This is due to Norinchukin Bank, like most institutional investors, misjudging the trend of overseas interest rates. It was originally thought that the Federal Reserve and the European Central Bank would soon cut interest rates, but the opposite happened. Especially due to the continuous inversion of short and long-term interest rates, the unrealized losses in investments in U.S. short-term bonds are greater than those in long-term bond investments.

Since 1999, to cope with deflation and economic stagnation after the collapse of asset bubbles, the Bank of Japan has implemented a series of unconventional monetary policy measures. This has forced Japanese financial institutions to significantly increase the use of overseas assets and seek higher-return investment opportunities. According to statistics from the Bank of Japan, by the end of 2023, the proportion of foreign securities held by domestic banks in Japan accounted for 27.8% of their securities assets, an increase of 15.5 percentage points from the average of 1994-1999. It is believed that the situation of overseas investment "failure" like Norinchukin Bank should not be an isolated case among Japanese institutional investors.

This is almost identical to the European sovereign debt crisis from 2010 to 2012. At that time, after the 2007 U.S. subprime mortgage crisis gradually evolved into a global financial tsunami and a world economic recession by the end of 2008, countries unanimously adopted fiscal and monetary expansionary counter-crisis measures. As a result, the U.S. economy and finance quickly stabilized and rebounded, while the five southern European countries (Portugal, Italy, Ireland, Greece, Spain, collectively known as PIIGS) were deeply mired in government debt. At the end of 2009, the exposure of the Greek government's financial fraud scandal triggered the Greek debt crisis. Subsequently, the crisis repeatedly spread to the other four southern European countries, evolving into the European sovereign debt crisis from 2010.

The repeated postponement of the timing of the Federal Reserve's first interest rate cut this time also exerts considerable pressure on the U.S. financial system itself. According to statistics from the Federal Deposit Insurance Corporation (FDIC), as of the end of the first quarter of 2024, all U.S. banks had unrealized securities investment losses of $516.5 billion, marking nine consecutive quarters of huge unrealized losses. The unrealized loss for the quarter increased by $3.89 billion, while the unrealized loss for the previous quarter decreased by $20.63 billion. This mainly reflects the unexpected resilience of the economy and inflation, the reassessment of the Federal Reserve's tightening expectations, and the impact of the upward movement of U.S. Treasury yields. During the same period, the yields on 2-year and 10-year U.S. Treasury bonds rose by 36 and 32 basis points, respectively, while the previous quarter saw decreases of 80 and 71 basis points, respectively.The recent detonation of investment products with the highest credit rating highlights hidden worries in commercial real estate

Recently, a report released by a U.S. bank showed that investors in the AAA-rated portion of a loan (Commercial Mortgage-Backed Securities, CMBS) supported by a UK shopping center have rarely suffered losses. At the same time, a report from Barclays Bank showed that buyers of the AAA portion of a $308 million note supported by a mortgage loan on a building in Midtown Broadway, Manhattan, also suffered losses. This is the first time that bonds supported by commercial real estate with the highest rating have suffered such losses since the 2008 financial crisis.

The aforementioned rare detonation events indicate that there may be some serious problems in the financial systems of Europe and the United States, and even the highest credit-rated investments are no longer safe. At the same time, the detonation of the aforementioned CMBS is closely related to commercial real estate, indicating that the decline in the value of commercial real estate in Europe and the United States may be more serious than the market expects. Fitch Ratings once released an analysis report warning that the value of U.S. office buildings may experience a sharp decline exceeding the collapse of the real estate market in 2008. So far, the value of office buildings has fallen by about 40%, but the U.S. commercial real estate market is still far from bottoming out. Moody's expects that the market value of U.S. commercial real estate may evaporate $250 billion by 2026.

Since the 2007 subprime mortgage crisis, the overall risk exposure of the U.S. banking industry to real estate loans has decreased, but the exposure to commercial real estate loans has increased, and U.S. small domestic chartered banks have performed particularly outstandingly in this regard. According to statistics from the Federal Reserve, by the end of May 2024, real estate loans accounted for 45.1% of all loans and lease assets of U.S. banks, a decrease of 10.5 percentage points from the end of 2007; among real estate loans, commercial real estate loans accounted for 53.6%, an increase of 9.5 percentage points. During the same period, U.S. small domestic chartered banks accounted for 67.2% of all commercial real estate loans of U.S. banks, an increase of 14.3 percentage points.

After the COVID-19 pandemic, many office workers chose to work from home, leading to an increase in the vacancy rate of commercial real estate. According to a recent report from Moody's, in the first quarter of 2024, the vacancy rate of office buildings in the United States reached a record high of 19.8%, compared to an average of about 17% before the pandemic, and it is expected to further rise to 24% by 2026. Under normal circumstances, debt extension is a routine operation, but the current 30-year real estate mortgage interest rate is around 7%, slightly higher than 3% before the rate hike. With high interest rates and a sluggish commercial real estate rental market, owners have to default on debt, and banks are also forced to bear an increase in commercial real estate loan losses.

By the first quarter of 2024, the delinquency rate of commercial real estate loans of all U.S. banks was 1.18%, which has increased for six consecutive quarters and is the highest since the third quarter of 2015. Given that U.S. small domestic chartered banks account for nearly 70% of the share of all banks' commercial real estate loans, they will be more sensitive to fluctuations in the commercial real estate market. In addition, according to the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) disclosed by the Federal Reserve, in the bank reports for October 2023 and January 2024, the demand for all commercial real estate loan categories was weak in the second half of 2023, and standards were tightened.

The performance detonation and stock price collapse of the New York Community Bank at the beginning of 2024 is just the tip of the iceberg. At the end of 2021, the bank's total commercial real estate loans were $10.9 billion; after acquiring Flagstar Bank at the end of 2022, the loans at the end of the year rose to $22.8 billion; after acquiring Signature Bank at the end of 2023, the loans at the end of the year further rose to $38.6 billion. On January 31, local time, the New York Community Bank disclosed that due to the surge in loan losses, it plans to reduce dividends to replenish capital, triggering a plunge in its stock price. This once made the market panic, thinking that the Silicon Valley Bank incident would come back.

The Federal Reserve, which is "walking on a tightrope" between fighting inflation and preventing risks, released the 2024 Spring Financial Stability Report in early May. The report pointed out that according to the survey results of 25 contacts, the impact of rising inflation and monetary policy tightening is still the most concerned risk. This risk ranked second in the recent top four financial risks in the 2022 Spring Report, but has been at the top since the 2022 Autumn Report. Respondents pointed out that a renewed acceleration of inflation may keep interest rates higher for a longer period than previously expected. At the same time, several contacts hinted that the Federal Reserve may lag behind the curve in cutting interest rates, or may not act quickly enough in the event of a sudden economic downturn.

The pressure on the real estate market, especially commercial real estate, was mentioned again and again. This risk has been among the top four risks since the 2023 Spring Report, and the latest ranking is third. Respondents continue to see the upward trend in interest rates as the main resistance for the industry, and point out that the maturity barriers in the next few years may bring refinancing risks, bringing further downward pressure on prices and valuations. The exposure to commercial real estate risks may have a negative impact on the banking system, and the vulnerability of small and regional banks in the United States is particularly high (see Chart 5).In addition, respondents are also concerned about the possibility of a re-emergence of stress in the banking sector. This risk has consistently ranked among the top four recent risks since the spring 2023 report, currently ranking fourth. Respondents pointed out that, in addition to the risk exposure in commercial real estate, interest rates may remain at higher levels for a longer period than previously expected, which could be a catalyst for a new round of outflows of potential deposits.

In fact, the Federal Reserve is also very worried about the risk of over-tightening. The Federal Reserve has repeatedly made it clear that a return of inflation to 2% is not a threshold for rate cuts. Both a sustained decline in inflation and unexpected weakness in employment could trigger rate cuts. In March 2024, when the Federal Reserve updated its dot plot, it significantly revised up its forecast for U.S. economic growth in 2024 from 1.4% to 2.1%, higher than its estimated potential growth rate of 1.8%, but maintained its forecast of three rate cuts within the year unchanged until it was reduced to one in the dot plot update in June. The Federal Reserve's care for the financial market is evident. This is the confidence behind the U.S. stock market's repeated new highs and the counter-trend rise in housing prices despite the pressure of tightening.

As a result, the Federal Reserve had to admit in the aforementioned spring report that U.S. asset valuations have further risen to a higher level relative to the fundamentals of major asset categories. Among them, stock prices have grown faster than expected earnings, pushing forward price-to-earnings ratios to the upper limit of historical distribution; corporate bond spreads have narrowed and are currently at a low level relative to the long-term average; residential property prices remain high relative to fundamentals.

The wealth effect of rising asset valuations in the stock and housing markets is replacing the excess savings formed by giving money to households during the pandemic, which are gradually being depleted, and continues to support strong U.S. personal consumption expenditure, further boosting the expansion of the U.S. economy. According to the forecasts of the International Monetary Fund (IMF), the World Bank, and the Organization for Economic Cooperation and Development (OECD) in June, the forecasted U.S. economic growth rates for 2024 are 2.6%, 2.5%, and 2.3%, respectively, all higher than the Federal Reserve's forecast and above the Federal Reserve's estimated potential growth rate, and all pointing to a "no landing" U.S. economy. If this is the case, U.S. inflation and employment resilience will exceed expectations.

On June 27th local time, the IMF concluded its summary remarks after the fourth article consultation with the United States, suggesting that, given the significant upside risks to inflation, rate cuts should only be cautiously considered when there is clearer evidence that inflation is sustainably returning to the 2% target. In addition, if the upcoming inflation data heats up in the next few months, it may be necessary to seriously consider eliminating the easing bias in the Federal Reserve's communication, and even further rate hikes may be considered. Earlier, Federal Reserve Governor Bowman also spoke out, stating that it is not appropriate to cut rates now, and he is still willing to raise rates if inflation continues to be high.

According to the FDIC statistics, in the first quarter of 2024, there were 63 banks with total assets of $82.1 billion on the "problem bank list." These problem banks are all small banks, which increased by 11 banks and $15.8 billion from the fourth quarter of 2023. However, the FDIC also stated that this issue is not a cause for concern, as the number of "problem banks" only accounts for 1.4% of the total number of banks, which is within the normal range of 1% to 2% during non-crisis periods. In addition, the aforementioned delinquency rate of commercial real estate loans of all U.S. banks, although continuously climbing, is still within the normal range of 1% to 2% during non-crisis periods. In this sense, the Federal Reserve can still harbor the illusion of waiting for the right timing, which also means that the impact of high interest rates on the U.S. economy and finance will last longer. However, given the lag in policy transmission, it may be too late to cut rates when the economy suddenly declines.

Listening to the intermittent sounds of glaciers cracking beneath our feet, it is estimated that the Federal Reserve is now torn between gains and losses: cutting rates too early risks an economic "no landing" and the risk of a second round of inflation; cutting rates too late risks an economic "hard landing" and the bursting of bubbles.