The Fed’s “long and variable lag”

The SVB meltdown was perhaps the first piece of tangible evidence of the cumulative effect of the US Federal Reserve’s aggressive policy tightening cycle. It was higher interest rates which reduced the value of SVB’s longer-term Treasury bond and mortgage-backed-securities (MBS) portfolio and which, together with accelerated depositor withdrawals, catalyzed SVB’s ultimate closure. This was one of the clearest examples of asset and liability mismatching as short-term customer deposits (i.e., liabilities) were withdrawn, and SVB didn’t have sufficient liquidity in their portfolio of Treasuries and MBS (i.e., assets) without taking large losses on those securities.    

Fed, FDIC, and Treasury department respond

After taking SVB into receivership, US regulators shut down Signature Bank, a New York-based lender with heavy exposure to the cryptocurrency industry. Further, to stem any potential issues in the banking sector more broadly, the Fed, FDIC, and Treasury department rolled out emergency measures, including a program to backstop all deposits—even those in excess of the standard $250,000 per depositor. Regulators also introduced a new funding facility to address liquidity concerns. The magnitude of the regulator’s efforts should not be underestimated. In effect, the policy response created a “double safety net” that would 1) remove the incentive for any depositors to shift dollars and 2) provide substantial, temporary liquidity via the Fed’s “lender of last resort” facilities that provide significant backstops to banks to fund withdrawals of any depositor who wanted to leave.

Full deposit insurance significantly reduces the incentive for people to shift from one bank to another now that it’s clear an effective deposit guarantee will be put in place if deemed necessary. And the combined power of the Fed’s new facility, the Bank Term Funding Program (BTFP), and its existing discount window provides banks a haven to temporarily exchange their underwater securities at par for cash. This capability breaks the linkages of the “weak funding/realized security losses/capital inadequacy” trifecta since banks will not have to sell their securities at a loss under funding duress.

And yet, despite regulator’s efforts, it’s clear that two rapid bank failures have raised the risk of deposit flight from more lenders, as holders of large, concentrated deposits seek to move their money from regional banks to larger, more systemically important institutions considered “too big to fail.” The regulators’ announcement on Sunday, we believe, should help reduce the incentive to move deposits but we’ll only know the accuracy of that belief in time. Our conversations with bank CEO’s over the last 72 hours suggests deposits are moving from bank to bank, but nothing on the scale that should be considered structurally worrisome to the industry.  

How vulnerable is the US banking sector? 

One of the key issues that has weighed on investor sentiment over much of the past year has been the elasticity of bank deposits to higher available interest rates elsewhere. Higher available rates fuel more competition for deposits and raises a question about the resilience of bank profit margins. Add in concerns about liquidity, and Wall Street analysts are now re-underwriting profit assumptions for the entire sector. In fact, several banks are now expected to generate a much lower level of profitability as their deposit bases are assumed to have shrunk considerably. It was that profit recalculation that materialized in bank equity prices on Monday–the regional bank index was down 12%.

In this environment, we believe the banks that can successfully navigate the volatility are those with strong, diversified, and stable deposit franchises, healthy balance sheets, and company-specific advantages. To be sure, we expect more volatility in share prices and credit spreads in the banking sector over the coming days. Some smaller, regional lenders are already coming under severe stock price pressure and larger global banks are also getting punished as investors digest the regulatory measures. If the actions taken on Sunday night stem the crisis of confidence, which we believe they will, volatility across the broader financial sector and market should be contained in coming days. 

Will the banking issues affect US monetary policy? 

The failure of two banks and growing concerns about systemic instability are likely to affect US monetary policy in our opinion. The next Federal Open Market Committee meeting is scheduled for March 21–22, and we believe the banking turmoil provides a good argument for the Fed to slow rate hikes. Previous expectations of a 50-basis-point rate hike are unlikely to play out, in our view, unless there’s evidence of extreme inflation or a very rapid resolution of the banking issues. Depending on how stable the financial system looks in a week, we expect the Fed to either raise rates by 25 basis points or take a pause and allow the dust to settle. Market pricing over the last several days, since the banking crisis began, would suggest other investors agree.  

The US 2-year Treasury yield, the best proxy for monetary policy expectations, fell from above 5% on March 8, to 4.2% Monday afternoon. Implied in this move is the potential end to the Fed’s year-long hiking cycle, with the upper end of the Fed Funds range likely just touching 5%. Concerns just one week ago were that the range would reach 6%. How quickly things change. 

Why own bonds? Monday is why

Recently, we’ve received a lot of questions about owning bonds today, amid a Fed hiking cycle. The short answer is always 1) risk management and 2) rates will reverse at some point. We saw both those reasons play out during this recent bank crisis. In a flight to safety, and in an effort to reprice Fed policy, bonds have rallied and rates have fallen. The 2-year move is noted above and the benchmark 10-year Treasury yield fell from above 4% to now 3.6%. This fall in yields resulted in 0.3%-1% price appreciation in fixed income Monday, depending on the type of bond (i.e., muni or taxable). As we’ve noted often recently, we see core fixed income as attractive in 2023 given their substantially higher yields (vs. the last several years) and the potential for rates to move lower once the Fed’s hiking cycle is considered finished. Time will tell, but we may have just checked that box.