Interest rates up, more banks going down

December 6, 2009
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Editor’s note: This is the first of a two-part report on financial markets in 2010.

With 2010 just around the corner, the Business Journal asked Mitch Stapley, chief fixed income officer for Fifth Third Asset Management, to peer into his crystal ball and talk about a variety of financial matters for the coming year. Here is the first installment of that conversation.

Business Journal: Where do you think interest rates will go next year?

Mitch Stapley: We’ve got the Fed on hold for, you know, forever, and forever probably ends in the fourth quarter of 2010. Sometime late next year, the Fed is going to begin to normalize rates. Where we need to kind of be moving toward is the notion that when they begin to raise rates — which at the short end of the curve are essentially zero today — they’re not going to be raising rates at a very controlled 25 basis points at a crack pace.

You can expect to see rates go up by 50 basis points, 75 basis points at a whack. When these do begin to go up, expect them to go up pretty dramatically as the Fed really tries to renormalize the curve. That’s not an issue for today; it’s an issue for late next year.

BJ: Will credit for small businesses loosen next year?

MS: I think you’re going to see that. There are a couple of things going on. You’re seeing banks rebuilding balance sheets, courtesy of the very steep yield curve that we’ve got going on out there right now.

As earnings go up, as we move through this credit cycle, and as the losses are recognized and capital is rebuilt, we believe that you’re going to see lending begin to pick up more or less in pace with an improvement in the overall economy — the overall appetite for risk taking. So we think bank lending probably begins to turn up in the middle part of next year.

BJ: Where do you think the banking industry is going next year?

MS: I think the good-news part is you’ve got this very, very steep yield curve. So you basically can borrow short and lend long and make a lot of money, basically risk free. That’s a good-news story.

The reality is, though, you’re still going to see the banking industry confronting issues with loan losses. Specifically, they’ll be focused more in the commercial real estate sector market. That’s just going to take some additional time — 12 to 18 months — to work all the way through.

But the good thing is these issues have been identified; you’ve seen them coming. It wasn’t like the downturn in the residential real estate market. It certainly wasn’t like what precipitated all this — the derivative securities that the banks were holding on their balance sheets. When that stuff blew up, it essentially had taken the markets by surprise.

People have been talking about commercial real estate. People have been looking at it and making predictions of a downturn. You’ve been able to have a market that is functioning and coming back. So if you needed to reduce positions or do whatever you could — I’m not saying you can eliminate all your exposure — I think you can understand it. You’ve been able to quantify it, and if you really wanted to get rid of it, you were able to sell it and get out of it.

It will be an issue, but again it’s one of those that, with a long enough lead time, we’ve been able to get the banking system in probably as good a shape as we could have it in to handle this. The problem has hit us, but it came with enough warning that we’ve actually been able to do something about it.

BJ: Do you see more banks closing next year?

MS: That probably continues well into next year — just an awful lot of the same kind of banks like we’ve seen so far. We’ll see more small banks continue to be under pressure. I think the problem you’ve got right now is there is such a pipeline of small and mid-sized banks with issues out there, and the capacity that the Feds have in really dealing with them is pushed past the breaking point.

It’s not that there aren’t more banks to close out there today. It (the FDIC) literally does not have the manpower to manually go through and handle all of the banks that they need to deal with. So they’ll have them on life support to keep them going until they can get to them. The reality is the process is going to take probably close to a year before we really begin to see a wind-down.

BJ: Is the stock market too far removed from the everyday economy?

MS: I think it is. I think this is one of those special times where this stock market is reflecting a couple of things. It reflects markets that are bouncing back in an extremely oversold condition that we’ve experienced over basically the last year, and we’re punching out the lows. Some of the bounce-back that we’re seeing today is just the markets beginning to function, credit being available, and the market is coming back with that.

I think the biggest thing in the jump in share prices is the massive amount of liquidity in government loans, government guarantees and asset purchases that have occurred — not only here in the United States, but on a global basis. The most compelling bit of information you’ve got out there is the global economy is valued at $60 trillion. It generates $60 trillion worth of goods and services in a year.

We have globally injected into the financial markets to stabilize the Great Recession of 2008 from becoming the Great Depression, to about $12 trillion. So one-fifth of a year’s worth of economic productivity has been committed to containing that economic contagion.

When you see a bounce of 70 percent in the emerging market, when you see a 50 percent jump in high-yield bonds, when you see what’s happening with commodities like gold and the market’s risk-based assets, it is rallying today based on that. It’s not so much a reflection of what’s going to happen in another six months, but a very real reflection of what an awful lot of liquidity flooding into the system can do to risk-based asset prices.

Next week: A look at the status of the U.S. dollar, consumer spending and the fixed-income market for 2010.

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