The Federal Reserve has released a postmortem on the failure of Silicon Valley Bank (SVB). The report points to mismanagement, supervisory failures, and a digital-era bank run fueled by a social media frenzy as the reasons for SVB’s failure. However, the report fails to attribute, as a contributing factor, the systemic risk in the banking system due to the Federal Reserve’s monetary policy moves. SVB, like many other banks, purchased treasury bonds and mortgage-backed securities at high prices at pandemic low yields. After flooding the economy with money, the Federal Reserve rapidly raised interest rates to combat inflation. The reversal in policy made the market value of SVB’s investment holdings worth less, turning its’s balance sheet upside down along with the balance sheets of many other regional and community banks. The Federal Reserve’s failure to acknowledge the duration risk (See Duration Risk Explainer below) it put into the banking system raises questions about it being in denial as to how its policies have contributed to destabilizing the banking system.
Over the past few decades, the nature of the economy has changed, from capital-intensive plant and equipment industries dominating the economic landscape to digitally-intensive companies comprising a higher percentage of the economy’s output and investment market capitalization. Because of this evolution, the Federal Reserve’s primary policy tool, manipulating interest rates, has become a blunt instrument. Today, interest-rate policy primarily affects the sectors of the economy that need to borrow and those that lend. Companies and consumers that don’t need to borrow are insulated from higher interest rates, and those companies and consumers that rely on borrowing can be financially bludgeoned by rate increases. Real estate investment trusts (REITs) are heavy borrowers, and as their current financing arrangements come to term, they face refinancing at significantly higher rates. Regional banks, which finance many commercial real estate projects, also suffer from deposit flight as depositors fear their banks may become financially unstable and are wooed away by the higher yields available from money market mutual funds. Fewer deposits mean less money to lend, translating into credit contraction throughout the economy.
This dynamic resurfaced at the end of April when First Republic became the second-largest bank failure in U.S. History. The bank’s Q1 earnings report revealed that deposit outflows were much more than expected, and the bank’s balance sheet was upside down. Over the following weekend, the bank was seized by regulators and auctioned off to JP Morgan Chase Bank. The First Republic seizure resurfaced market concerns about systemic risk. Though deposits may be considered safe, the deposits are still flowing out of banks. As long as depositors can get a ~4% higher yield by transferring to a money market fund, it is hard to imagine the deposit outflows will ebb, and the longer funds flow out of banks, the more severe the ensuing credit contraction will become. The good news is that this is nowhere near as dire as the banking crisis of 2008, and the Federal Reserve can reverse the situation by changing policy. The Fed may acknowledge the banking instability risks and pause further rate hikes to give the rate increase already made time to slow the economy and inflation. In addition, the Fed may need to consider adjusting its 2% inflation target. Prominent economists have made the case to raise it in the past.
The Fed meets May 2 & 3, and despite financial instability issues within the banking system, the markets have a 25-basis point Federal Funds Rate hike priced in. The Fed is caught between a rock and a hard place. To get inflation to its 2% target, the Fed must remain hawkish, but continuing to raise rates increases the risk of further instability in the banking system. As in all recent prior meetings, market participants will hang on to every word looking for a sign of the Fed’s intentions and signals of an upcoming pause or pivot. A hint that the Fed intends to pause at the June meeting could cheer markets, but “more data showing slowing needed” may dampen it.
The Fed monitors economic data for signs that their policy measures are slowing the economy and alleviating inflationary pressures. Tight labor markets with supply and demand imbalances have been a primary focus, with jobless claims a key indicator of continuing underlying economic strength. Though the labor market has shown signs of loosening over the past few reports, the most recent report firmed. Contradicting the jobs report, GDP data came in below expectation, with a 1.1% annualized increase. Core personal consumption expenditures (PCE) inflation indicator came in line with expectations, supporting the Fed staying the course. For those keeping score, that’s a split message, with Hawks edging out Doves 2 to 1.
Adding to the outlook for near-term volatility is the simmering debt ceiling debate. The U.S. debt ceiling is a limit set by Congress on the amount of debt the federal government can legally incur. When the government approaches this limit, Congress must vote to increase it in order to prevent a default on the nation’s financial obligations. The process of increasing the debt ceiling limit is highly politicized, with each political party using it as a bargaining chip to advance their own agendas. In general, Republicans tend to use the debt ceiling as leverage to demand spending cuts and other conservative policy changes, while Democrats may use it as a means to secure more government spending or progressive policy initiatives.
The political theatrics surrounding the debt ceiling often involve tense negotiations between the president and congressional leaders, as well as public statements and media appearances aimed at rallying support for one side or the other. In some cases, lawmakers may even threaten to let the government default on its debt if their demands are unmet, which can roil markets. Overall, the process of increasing the U.S. debt ceiling is a complex and often contentious affair that eventually gets resolved until the next time.
Currently, we have down-weighted investment allocation to financials and are holding more short-term US government money market and floating-rate securities. The yields are relatively high, and the stability of these positions will take some volatility out of a portfolio and serve as storage for dry powder. We continue to lean into companies that don’t need to borrow, with very little debt on their balance sheets, strong cash flows, and growing dividends. However, they still work within the broader economy, which is much more likely to be slowed because of a credit contraction.
We may not always be able to control the circumstances of a given situation. But we always have the freedom to choose how we respond. The choices we make – and how we make them – often determine how well we survive or thrive in the situation. Remind yourself about the facts of the market, revisit your financial plan, and focus on what you can control and the things that matter most to you. Reconnecting your decision-making to your goals and values can lead to solutions that make life more fulfilling.
If you’d like to review your financial plan or have questions, make an appointment to talk to us. We are here and available, so please don’t hesitate to reach out.
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Tim
Duration Risk Explainer
Duration risk is the risk that an investor faces when investing in bonds due to changes in interest rates. Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. Specifically, it measures the weighted average time until the bond’s cash flows are received by the investor. When interest rates change, the price of a bond will change in the opposite direction. The longer the duration of the bond, the more sensitive its price will be to changes in interest rates. This means that if interest rates rise, the price of a bond with a longer duration will fall more than the price of a bond with a shorter duration.
Banks have regulatory capital reserve requirements about the amount and type of securities they must hold to protect their depositors. Duration risk is the risk that a bank may face if it needs to sell a bond before its maturity to meet depositors’ withdrawal requests. Banks are also subject to credit risk. That is the risk that borrowers default on the loans the bank made to them.
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This material contains an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward-looking and should not be viewed as an indication of future results.
