Last Wednesday, the yield on a 2-Year Treasury climbed to 5.07% - its highest level since before the financial crisis, as Chairman Powell, in congressional testimony, pondered reaccelerating the pace of monetary tightening.  By Friday, it had fallen back to 4.6%, partly in response to mild wage readings in the February jobs report, but primarily because of the collapse of Silicon Valley Bank or SVB - the second largest banking failure in U.S. history.

The demise of SVB does not reflect general weakness in the U.S. economy or in the banking system. Rather SVB’s unusual mix of assets and liabilities made it particularly vulnerable to the Fed’s recent aggressive tightening.  However, it does carry with it some contagion risk to other financial institutions which markets will, no doubt, try to ferret out in the week ahead.  Moreover, it illustrates the damage that is inevitable when a central bank first encourages financial speculation by an extended period of negative real rates and then demands that the whole economy go “cold turkey” with excessive tightening.

Investors in the week ahead will be watching this story unfold along with a key reading on February inflation.  So far, SVB does not appear to represent a “breaking point” for an economy that has displayed remarkable resilience in recent months.  However, it may could represent a “braking point” for the Fed, taking a 50-basis point hike off the table for next week’s FOMC meeting and raising the possibility of an early end to the now year-old tightening cycle.

On Sunday evening, the U.S. Treasury, Federal Reserve and FDIC released a joint statement guaranteeing that ALL depositors in SVB would be made whole and have full access to their funds as of Monday, March 13th.  They also announced a similar systematic risk exception for Signature Bank, the 29th largest U.S. bank in terms of  assets, which New York authorities shut down on Sunday.  In addition, the Federal Reserve announced a new lending facility, the Bank Term Funding Program, offering loans to banks, savings associations, credit unions and other eligible depository institutions, with high-quality securities being accepted as collateral and valued at par.  

These actions may be sufficient to stem some of the current turmoil in global markets emanating from smaller U.S. banks.  However, it should be noted that these problems were largely set up by over-easy Fed policy for many years and are now being triggered by excessive tightening.  In light of this reality it is possible that the Fed will now halt its tightening cycle.  We should have a much better handle on this possibility later this week.

The Demise of Silicon Valley Bank

The story of Silicon Valley Bank has been well covered in the news media in recent days.  However, it is worth reviewing why it was almost uniquely exposed to the Fed’s tightening.

As of the end of last year, Silicon Valley Bank was 16^th largest U.S. bank [1], with $209 billion in assets.  However, it only had 16 domestic branches and had more than quadrupled its client deposits over the past five years by catering to startup companies and the venture capital firms that fund them [2].  This explosive growth led to three associated vulnerabilities.  

• First, 93% of their deposits were corporate, (rather than from individual investors), compared to a median of 34% among the largest 10 U.S. banks [3]. As a consequence, 84% of their deposits exceeded the FDIC $250,000 limit and were thus uninsured.  This meant that, unlike the average commercial bank, SVB was very vulnerable to a traditional bank run, which occurs when depositors, on mass, withdraw their money for fear that they won’t be able to get it later.
• Second, largely as a result of their explosive growth, the majority of SVB’s assets were in high-quality fixed income securities rather than in loans.  While this reduced the credit risk of their asset base, it left them vulnerable to a sharp rise in interest rates, particularly if they had to sell these assets and book losses in a higher interest rate environment.
• Third, venture capital investment has slowed in recent quarters, reflecting a general tech downturn.  This has forced startup companies to burn through cash more quickly, reducing deposits – a significant problem for a bank with so much of its deposit base coming from this sector.

These vulnerabilities go a long way towards explaining the sudden collapse of SVB and also provides some reassurance about the health of the banking system as a whole.  Most banks have far more diversified deposit bases and, as noted by my colleague, Mike Cembalest last week [4], none of the major banks have anything like the same exposure if all their fixed income assets were marked to market to reflect current interest rates.

Beyond this, a profusion of bank regulations since the Great Financial Crisis, while sometimes clumsy, have generally contributed to increased bank capital, while economic momentum, as witnessed by last Friday’s jobs report, remains relatively strong.  

That being said, we have transitioned from a long era of over-easy money to one of aggressive Fed tightening and 2023 will likely produce many other unpleasant and disruptive examples of the economic toll from such a sudden, sharp change in the cost of borrowing money.

The Jobs Report: Not too Hot

The Silicon Valley Bank debacle overshadowed Friday’s jobs report.  However, labor market data also give the Federal Reserve some reason to back off from their recent hawkish rhetoric.

In particular, while non-farm payrolls grew by a stronger-than-expected 311,000 jobs, this number looks less impressive when combined with a downward revision of 34,000 to gains for the prior two months. Moreover, the unemployment rate rose from 3.4% in January to 3.6% in February, as the labor force expanded by a healthy 419,000.  Most importantly, average hourly earnings rose by just 0.2% month-over-month and 4.6% year-over-year.  If, as we expect will be revealed in next Tuesday’s CPI report, consumer prices rose by 6.1% year-over-year in February, this will mark the 23^rd consecutive month in which year-over-year wage gains have failed to keep pace with CPI inflation.

This is important, as it undermines the argument that wages are pushing inflation higher.  Indeed, on the CPI report itself, it is worth noting that 6.1% year-over-year in February would be down from 6.3% year-over-year in January and from a peak of 8.9% year-over-year last June.  We expect this number to keep dropping to roughly 4% year-over-year by June of this year and then move sideways for the rest of the year due to sticky shelter inflation.  Thereafter, it should resume its decline, reaching levels in line with the Fed’s objective of 2% consumption deflator inflation by the end of 2024. 

The Fed’s Path from Here

This is actually a very natural path for inflation to take.  Even as inflation falls, the pace of decline will naturally be impeded by workers demanding partial compensation for past inflation and businesses trying to partially restore eroded margins.  So long as inflation is receding in a steady and predictable manner, little economic damage is caused by the slowness of its decline.  It seems very hard to justify triggering a recession just to accelerate this process, although in recent months the Federal Reserve has seemed hell-bent on doing just that.  The demise of SVB may cool their ardor.    

In his congressional testimony last Tuesday and Wednesday, Fed Chairman, Jay Powell, noted that he believed that “…the ultimate level of interest rates is likely to be higher than previously anticipated.” and that “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

Short-term interest rates rose in response to these words.  By the close of business on Wednesday, futures markets were pricing in a 72% probability of a 50-basis point hike in March, with further 25-basis points hikes in May and June and even a 40% shot of a July hike.  This would have boosted the federal funds rate from its current 4.50%-4.75% range to a corridor of 5.75%-6.00% by late summer.

48 hours later, in response to the turmoil surrounding Silicon Valley Bank and cooler wage inflation in the February jobs report, futures markets had backed off with a 68% chance of just a 25-basis point move in March, followed by a similar move in May and a probable final 25-basis point hike in June, pushing the “terminal” federal funds rate to a range of 5.25%-5.50%.

Moreover, markets don’t expect “terminal” to remain “terminal” for too long.  Despite repeated Fed pronouncements that they would like to hold rates at a high level for some time, the futures market is pricing in rate cuts starting in November of this year, with the federal funds rate being cut six times between this summer and December 2024.

In making this prediction, markets are actually closely matching the intentions of Fed officials as revealed in their December “dot plot”.  I know of nothing in economic literature that could justify such a policy of deliberately overshooting on monetary tightening and then easing.  Rather, the experience of recent decades shows that, while monetary policy is very ineffective at regulating the pace of economic growth and inflation, it is quite potent in fueling financial bubbles and then bursting them, rippling through to economic disruption in the short run and diverting capital from its most productive uses in the long run.  Silicon Valley Bank can now take its place in the long gallery of rogues and victims fostered by over-active monetary policy.

However, for investors, it is important to look through current volatility and consider its aftermath.  As the Federal Reserve works with other regulators this week to try to repair the damage from the SVB collapse and prevent contagion, they may well lose some of their appetite for further tightening.  While we do still expect some further Fed tightening, as the economy slows and the actions of a divided Congress do little to bolster the economy or dampen financial market volatility, the Fed could feel forced to ease earlier and more than currently anticipated, in sharp contrast to Chairman Powell’s comments last week.  This should set up a slow-growth, low-inflation and low-interest-rate environment for the middle of this decade, and ultimately provide support for both stocks and bonds after a very difficult 2022 and volatile start to this year.

[1] Federal Reserve report on Large Commercial Banks as of Dec 31^st, 2022

[2] Silicon Valley Bank, Q1’23 mid-quarter performance update.

[3] J.P.Morgan North American Equity Research, Large Cap Banks, March 10 2023.

[4] Eye on the Market, Michael Cembalest, March 10^th, 2023

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