Market Snapshot | March 2023
Transcript of the video:
Liz Ann Sonders: Hi everyone. Welcome to the March Market Snapshot. Perhaps obvious. I want to talk about the turmoil among banks in the wake of two key regional bank failures last week, most notably in the one that's been in the news Silicon Valley Bank, which we’ll call SVB. And then more recently this week, concerns about Credit Suisse and potential contagion.
[Table for History of financial crises is displayed]
Now, I'll start with this table. That is a look at the history of significant financial crises back to the mid 1970s, we show the dates, whether there was an accompanying recession and or a bear market and what the reaction function was on the part of the Federal Reserve. Now, I don't want to dive deep into history. We don't have time for that on this video. You can look at this table at your leisure. I just want it as backdrop. So let's focus on the present.
So let's start with a little bit of a backdrop for the present. The Fed's monetary policy tightening cycle over the past year is the most aggressive in more than 40 years, and it involves both the massive increase in the Fed funds rate off of what had been 0% rates, but also shrinkage of what had become the Fed's behemoth $9 trillion securities portfolio. After years of quantitative easing, which we know of as QE.
Now, if you incorporate both quantitative tightening or QT the shrinking of the balance sheet with the rise in the Fed funds rate and as shown here,
[High/Low Chart for As policy tightened, bank deposits plunged is displayed]
It's something called the proxy funds rate. It was created by the San Francisco Fed and you can see that has soared while at the same time banks’ depositors have been looking for higher yields in areas like money market funds. And as a result, you can see the commensurate plunge in U.S. bank deposits, which has been epic.
So back to SVB. What happened? Now for those who might have been blissfully out of touch regarding the news of the past week, here's a very quick snapshot. The pandemic and the commensurate epic monetary and fiscal policy response to the pandemic led to a surge in money supply, a surge in liquidity, tech startups, venture capital, of course, were key beneficiaries of that. And in turn, that led to a massive surge in deposits at SVB. That was a favored bank of that world, particularly from startups, tech and biotech startups, as well as the venture capital world. Now, in order to boost yields on those deposits, SVB loaded up on longer-term government bonds without hedging the interest rate risk. Oops.
Now given in addition the 2018 rollback of some Dodd-Frank regulations, including upping the size of banks in terms of their size that were subject to stress tests from $50 billion to $250 billion. As a result of that rollback. SVP was not subject to stress tests, including in the event of a sharp spike in interest rates. Double oops.
Now, at the same time that the tech sector, of course, and related VCs have been under extreme pressure, and because SVB had such a concentration in that area, that meant their exposure and downfall was really a function of two different things.
[High/Low Chart for Deepest yield curve inversion since early-1980s is displayed is displayed]
Now you also had the extreme inversion of the yield curve, shown here, deep in inverted territory, and that just helps as a backdrop to illustrate what happened with SVB. More than 95% of that bank's deposit base were accounts not FDIC insured. In fact, that ranked them 99 out of the top 100 banks, that's not a good ranking; while more than 55% of their assets were invested in long term government bonds, that ranked them number one out of the top 100 banks. Also not a good thing. Now they ended up with unrealized losses on that portfolio, but they also had the concentrated industry exposure problem.
So you had a run on the bank began when many of their depositors needed immediate cash and then there was some kind of fire having been shouted in the proverbial crowded building by a couple of key stakeholders via social media. As a result, SVB was forced to realize their portfolio losses and then the lack of new deposits and or lending opportunities coming in highlighted basically the fragility of a model like SVB’s.
Now the effects these days of lightning-fast news flows, especially via social media. We all know banking that can be done instantaneously via mobile devices. The bank’s collapse happened with lightning speed. Now it was the second largest bank failure in history, second only to Washington Mutual's during the global financial crisis.
And because of its size and how quickly it happened, it triggered the emergency meeting over this past weekend, the March 10th weekend among Fed Treasury and FDIC officials, ultimately resulting in what we could think of as a double-barreled guarantee for all of SVB’s depositors, not just those that were FDIC insured. And the Fed created a new emergency term funding program for high quality assets across the banking system as a way hopefully to stem the tide of possible additional bank runs.
Now, in terms of the FDIC backstop, the joint declaration that came out over last week and highlighted that and here I'll do quotes, "Any losses to the deposit insurance fund to support uninsured depositors will be recovered by a special assessment on banks as required by law," unquote. In other words, this is not being funded by taxpayers, at least not in any direct way. And that is why some pundits, though certainly not all, are pushing back against this being labeled a bailout, given that neither equity nor bond holders are being bailed out, nor is the banks management just the depositors. And that is a key difference between now and the 2008 crisis.
So even if this is not systemic like ‘08 and as much as we would all like to put the SVB debacle in the rearview mirror, we're not yet through this crisis. As I record this video, market is in some turmoil again due to the concerns about the viability and contagion risks associated with Credit Suisse, as I mentioned, which of course is a potentially larger problem for the global banking system and or global economy relative to this fairly small domestic footprint of SVB.
Now, we have no color on how this situation will unfold. The news is coming in rapidly, but it's not a stretch to say that volatility in uncertainty will persist for now, and it certainly elevates the concern about whether these are idiosyncratic issues or a more serious global crisis. It also suggests event risk clearly remains a factor for markets and volatility.
[High/Low Chart for Market’s volatile expectations about rates is displayed]
Now, this brings us to the subject of the Fed. We've got the next FOMC meeting next week. It concludes on March 22nd. Expectations for what the Fed does from here, including the terminal rate that's the expected Fed funds rate once the Fed stops, have been all over the place this week, As shown here as recently as March 8th, the yellow line, two days before SVB failed, the market expected the Fed to bring the Fed funds rate to nearly 5.7%, with essentially all rate cuts priced out of this year’s expectation. Now, fast forward to the day I'm taping this and the terminal rate expectation, as you can see in the red line, has plunged to below 5% with rate cuts again priced in by the end of this year.
Now, we don't know what the Fed will do at the March meeting other than knowing that expectations are volatile. But we think neither a 50-basis point hike that was priced in just prior to the SVB failure nor a rate cut are in the cards. That basically leaves the possibility of either no hike (or a pause) or 25 basis points worth of a hike.
Now, the recent labor market report was mixed, as frankly was the latest CPI report. Even though core inflation remains a bit out of the Fed's comfort zone for now. Then more recently, we got weakness in retail sales this week, a lower-than-expected producer price index. That could support a pause by the Fed. The reality, however, for those trying to gain what the Fed is likely to do is that news about the banking system, especially in the wake of the concerns about Credit Suisse over the next week, will likely be important factors in the Fed's ultimate decision.
This is a fluid situation, but it's not a stretch to say these are unlikely to be contained and isolated problems for the simple reason that we are only starting to wring out the excesses of the post global financial crisis era of easy money and ample liquidity.
[List of Takeaways is displayed]
So let me finish with just a quick summary of the takeaways. There's a well-worn phrase about Fed tightening cycles and that the Fed tightens until something breaks. Well, looks like something has broken. Again, the most significant tightening cycle in 40 years has led to a plunge in bank deposits. You've had recent triple digit yield curve inversion and the related credit crunch clearly signaling recession. Our view certainly hasn't changed on that front.
The Fed right now is in a bit of a pickle as they marry the competing forces of monetary policy and financial stability that leaves uncertainty heading into next week's meeting. The net result is I think we should expect more volatility and that suggests heed the benefits of diversification, rebalancing and stay focused on quality. This is not a time to take undue risk.
Thanks for listening in what is a very volatile time for markets. Thank you.
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