Why a Recession Could Be Good for the Bond Market, the Banking Sector, and the Real Estate Market

On July 26, the Federal Reserve Board (FRB) raised interest rates by another .25%. Interest rates are in the 5.25-5.5% range which is the highest they have been since 2001. The FRB has indicated more interest rate hikes may be needed to address inflationary concerns.

Rising interest rates and continuing interest rate uncertainty have had a profound impact on the municipal market. Mutual fund outflows have been significant since mutual fund shares decrease in value as interest rates rise. Investors have fled bond investments because all bonds lose value as interest rates increase. It will take interest rates stabilizing or decreasing to reverse this trend.

Low demand has, in turn, had a big impact on the volume of bond issuance. Volume is dramatically down not only due to weak demand but also because of the high cost of funds. Unless a borrower has debt coming due or is in dire need of funds, the rising interest rate environment has disincentivized borrowing in the bond market.

Interest rate hikes and uncertainty have caused many medium-sized banks to become insolvent on their books. Their assets of loans and fixed rate investments have lowered in value with rising rates. Their liabilities have been increasing due to pressure to increase deposit interest rates. Three such banks have already gone out of business. These failures resulted in the withdrawal by depositors of significant funds from medium-sized banks, creating liquidity challenges. In response the FRB has initiated a new program to provide liquidity to banks, and to date, about $102 billion in loans have been made under this program. Only a reversal of interest rate increases would solve this insolvency issue, as well as the loss of depositors to the big banks.

The real estate market has many sectors. But overall rising rates and uncertainty about future rates has had a mixed impact in the industry. Property buyers and sellers are having a very hard time reaching agreement on value and purchase price due to this uncertainty. Buyers are having problems obtaining loan amounts and terms which facilitate purchases. Office markets are stagnating. Multifamily is struggling and beginning to slow down. The industrial and hospitality sectors have had sustained growth.

In addition, as long as there is uncertainty about whether interest rates will continue to rise, the above trends will continue. The FRB must be satisfied that inflation has been conquered, but it remains unclear when this will be. Notwithstanding rising interest rates, the economy has proven to be very robust, unemployment remains low, GDP is growing at a rate of 2.4%, and consumers continue to spend. Inflation has come down, but it is unclear how and when it will decrease from the current approximately 3-4.5% rate, depending on how it’s calculated, to the 2% or so target.

It seems that for the FRB to believe it has tamed inflation and for inflation to actually be under control, there may need to be a recession. Unfortunately, it will likely take a recession to lay the basis for normalizing the bond market. A recession should eliminate interest rate uncertainty and create the conditions for declining interest rates. Once interest rates reverse course in a clear and decisive manner, the bond market will be able to stabilize, bank solvency will resolve itself, and the real estate industry should stabilize. Absent a recession, the FRB would have to be sufficiently confident that it has conquered inflation to decrease interest rates. It is not clear if and when this might occur.

Whether and when a recession may take place are uncertain. However, ironically it seems clear that a recession (while creating a set of its own issues) would be helpful in addressing serious issues undermining the healthy functioning of the bond market, real estate market, and banking sector. Until there is, at a minimum, interest rate stability, these destabilizing impacts will continue.