Just when beachgoers in Amity Island thought it was safe to go back into the water, the man-eating great white shark returned, complete with a menacing soundtrack. At the start of the year, global investors felt more positive and started to dip their toes into the equity markets again. The up-beat sentiment was based on expectations that interest rates were set to peak soon following a period of aggressive policy rate hikes from central banks around the world. In the US, the markets were poised for a last rate hike or two in the short-term before the start of a rate-cutting cycle by the Federal Reserve Bank later in the year. The European Central Bank was slower to start hiking rates as inflation remained stubbornly high and interest rates were set to still be aggressively hiked but the market was firmly focussed on taking its cue from the Federal Reserve. By the end of January, investors were knee-deep in the market waters with a positive gain in the S&P 500 index of 6.2%. That’s when the feint sounds started… dunn dunn … dunn dunn.
The Fed raised rates by 25 basis points as expected on the 1st of February and the Bank of England and the European Central Bank each hiked rates on the 2nd of February by 50 basis points, also as expected. The tone of the Fed, however, became more hawkish. Inflation was sticky, the labour market was very strong (with wage price inflation pressures) and the consumer was still in a good space – as reflected in indicators such as retail sales. Suddenly, interest rates would need to go higher and stay higher for longer. The S&P 500 lost 2.6% in February and continued weaker in early March… dunn dunn … dunn dunn.
It was too much to expect that the aggressive hiking in policy rates by central banks would simply be absorbed by economies without incident and tolerated until rates started falling once more. On the 10th of March the Silicon Valley Bank (“SVB”) in California failed following a run on the bank by depositors. The cryptocurrency-focused bank, Silvergate Capital, also from California, had failed just days before after it experienced a run on deposits. The failure of SVB, the 16th largest bank in the US, became the second largest bank failure in US banking history after the collapse of Washington Memorial during the Global Financial Crisis.
SVB’s failure was a result of the rapid rise in interest rates that substantially reduced the value of their long-dated bond investments and the capital of the bank. A sale of some of those bond holdings created a $1.8bn loss and to improve its capital position, the bank was forced to go to the market to raise more funds. A $2.25bn capital raise was launched in the equity market by Goldman Sachs on the 8th of March but investors were already spooked. Concerned depositors started pulling their funds from the bank, the share price of SVB collapsed, the market capitalisation of the bank fell by $160bn in a day and SVB was unable to raise the capital that it required. To maintain the integrity of the financial system, the Federal Deposit Insurance Corporation (“FDIC”) stepped in to place the bank in receivership and guarantee the bank’s deposits. The FDIC typically insures depositors to a maximum of $250,000 but on this occasion they guaranteed the full amount of all deposits to avoid any contagion in the rest of the financial system and to support the technology companies and venture capital companies that made up a large part of SVB’s clientele.
Questions will no doubt be asked about why the FDIC chose to bail out the full value of deposits (rather than the $250,000 cap) and why the SVB CEO sold significant amounts of stock just days before the bank collapse. However, questions were definitely asked of the rest of the global banking sector in the aftermath of the SVB failure. Signature Bank experienced a run on its deposits and the FDIC had to step in once more as the US’ third largest bank failure was inked into the history books just beneath SVB. Banking shares around the world took a knock as investors considered whether other banks might meet the same fate and whether this was going to be a replay of the Global Financial Crisis (“GFC”) and the associated Great Recession.
The market also began to seriously question whether or not the Federal Reserve would continue hiking rates in such an uncertain environment. Previous expectations of further Federal Reserve hiking, including a 50-basis point hike at the 22 March meeting, were quickly revised. Suddenly, the policy pivot was back in play! A modest hike, if at all, was pencilled in for the March Fed meeting with rate cuts starting to be priced in for the latter part of 2023. US Treasury yields fell sharply with the two-year treasury yield falling over 100 basis points in three trading days. The gold price spiked higher and cryptocurrency values fell sharply in the wake of the Silvergate Capital closure. Such was the market concern, that President Biden was prompted to hit the weekend press podium to allay the fears of bank depositors and pronounce that the US banking system was safe. Smaller banks did continue to see outflows in the early part of the week following the SVB failure but that trend slowed down as the week progressed.
There is no expectation at this point that another global financial crisis is in the making. This does not, however, imply that there won’t be further isolated bank failures, particularly of banks catering for niche markets (such as cryptocurrencies and venture capital). Credit Suisse lost a quarter of its value on 15 March to add to banking sector concerns but the institution has had its own particular problems for some time. Banking regulation and capital requirements could come under further scrutiny in the near-term but much of the heavy-lifting has already been done post the GFC. In 2009/2010 a global regulatory framework (Basel III) was put in place to provide for more resilient banks and banking systems with prescribed liquidity risk measurements, standards and monitoring systems. Banks are regularly subjected to stress tests under this framework and these evaluate what will happen to their capital under different macroeconomic scenarios. Banks who fail the stress test have to revisit their capital structures to support the integrity of the whole financial system. Basel III is currently evolving into Basel IV as banking regulation and capital adequacy and liquidity is continuously reviewed and updated.
The larger US banks have already experienced inflows of funds as depositors at smaller institutions have opted to switch to the relative safety of a banking major considered “too big to fail” (Bank of America, JP Morgan, Wells Fargo). The banking failures of this past week have completely muddied the policy waters and added more uncertainty to the future direction of interest rates. The market has been hanging on to every central banker soundbite, every inflation print, every GDP release, every labour market report and any snippet that might hint at a change in policy direction or a change in the magnitude of policy moves. Traditionally bad news (low/weak growth, higher unemployment) has been good news for the markets in that expectations for the Fed’s policy pivot are brought closer. The bad news of the bank failures has changed market expectations to an earlier pivot but the inflation problem is not yet beaten. The latest US headline CPI printed at 6.0%, down from 9.1% at its June 2022 peak but still a far cry from the 2.0% target. The Fed will not want to suddenly stop talking tough on inflation but it may see more of an economic slowdown following its policy tightening to date and from any slowdown in bank lending that might take place as banks adopt a more cautious stance following the recent bank failures. The Fed has promised to be data-dependent in the application of its policy and so it may well opt to be cautious at its next meeting and be restrained on further hiking for now. Don’t expect the Fed to let up on its inflation fight if we get past these banking concerns but for now the policy pivot is back in play for 2023. Market volatility and uncertainty may tick up a notch and any periods of market weakness will be an opportunity to buy those expensive stocks that you always wanted at a cheaper price. That won’t be the time to be making wholesale changes to your quality investment portfolio. Feverishly splashing in the water will only attract that 20-foot Carcharodon Carcharias again and the unnerving sound of alternating E and F notes.