2023 has continued to be volatile for the markets and the economy. Inflation continues to cool, and FED monetary policy is now breaking things. Despite the volatility, the financial markets for broader indexes are up; with the narrower DJIA 30 position index falling.
- S&P 500 + 2.42%
- NASDAQ +11.97%
- DJIA -3.85%
- Bloomberg US Aggregate Bond Index +2.90%
These figures alone would allow you feel that the 11 weeks of results support the notion that markets have changed direction from 2022. What you don’t garner from the results:
- Silicon Valley Bank, Silvergate Capital Corp, and Signature Bank collapsed. First Republic Bank received a rescue infusion of $30billion from other large banks. Sounds like 2008. Signature Bank’s troubles are directly tied to their exposure to the crypto currency industry (not entirely surprising). For the other banks, they are collectively being strained by depositor outflows and treasury bond portfolios losing value.
- The FED has been raising rates for a full year now. Inflation has fallen from its peak 6/22. The FED (until last week) was likely to increase interest rates by another +/- 1% more hikes between now and end of 2023. Excessive in my opinion, but I don’t get a vote. The FED will need to change their thinking (and likely will) with their meeting on Tues & Wed. Why? A byproduct of raising interest rates is that bond values fall. This even happens to the most secure bonds known as “treasury bonds.” Banks invest very large parts of their portfolios into treasury bonds when they collect deposits from their customers. When interest rates are stable or falling, there isn’t a problem. When interest rates are rising that means that when a bank customer shows up to withdraw funds from their account that the bank can be forced to sell some of their bond portfolio if their cash on hand has been depleted. Selling those bonds to meet demands when their value is depressed, causes losses and you end up with banks failing. Sadly, when bank customers get nervous it creates a “run on the bank,” and customers line up to withdraw their funds. This is probably the first time in history that these runs happened at such a fast pace. I attribute this to social media and the flow of news at a lightening pace. While larger banks are not immune to the same loss of bond values in their portfolios, they are inherently “larger” and have other lines of business that can support this strain better. For this reason, it’s important to understand that this present-day situation is condition of poor liquidity (in otherwise quite conservative bond investments). Compared to poor solvency of 2008 when banks and shadow banks (Countrywide Loans) were passing out mortgages to anyone with a pulse. Then those loans were repackaged into investment grade vehicles and sold to sophisticated investors (sovereign wealth funds), institutional investors (pensions) and retails investors. There is still a problem today due to the FED policy over the past 12 months, however, it’s not based on unsound mortgage underwriting practices and regulation of an era now long-gone. This is a very different condition and one that the FED can reverse if they will stop raising rates and ultimately cut them.
Look back at the index results (above) and you’d think how is this possible? It’s because the markets have started to recognize that the FED was closer to the end of their rate hikes than in mid-cycle. This was true up until some January data was released and Fed Chair Powell came out and started talking again and put negative pressure on the markets. But WAIT!!!! Hey Fed Powell….you just crushed 4 regional banks with your interest rate policy, what are you going to do now? “I’m going to Disney World!” was not his response. So, what did he say? With Treasury Secretary Janet Yellen by his side, they spoke to congress and effectively stated that all depositors’ funds will be covered by the FDIC. The historical limit for protection has been up to $250,000 per account holder but as we’ve seen in 2022, they can move the goal posts at will. This did calm the markets, but I anticipate that for the smaller & regional bank sector it will be more time before this sector calms down. The broader market can (and has) looked past this.
How has the market looked past this? The S&P & NASDAQ both rose last week, and it appears to me that the market views inflation as being on a cooling trajectory is the larger story. Keep in mind the market could have viewed the collapse of those regional banks as an economic melt-down. Again….S&P & NASDAQ up this past week. Why? The markets believe that the FED playbook must wrap up their rate hike cycle; or else they will add more strain to the banking system. As I noted earlier, one of their mandates is price stability. Crushing bond portfolios, collapsing banks, and creating panic….is not in Webster’s definition of “stability.” More specifically this week the rate hike projection was up to a 50-basis point increase (2 rate hikes). Now it’s down to 1 hike or 25 basis points. Further, prior to this past week, it was projected that by the end of this year Fed Funds would reach 5.56% (1% higher than they are now). After the reginal banks stress of this past week, the futures markets are projecting that Fed Funds will end 2023 at 3.73% which is 3 rate cuts by year end. This is why the markets are showing a trend higher; the markets are responding favorably to the likely end of rate increases and then cuts into year end.
I suggest that if there are additional banks fail, the markets can reverse course. The 4 regional banks noted above are in the recovery room, the FDIC has stepped in to do their job and private deposit infusion has given one of them support. Takeovers/Mergers may transpire and that would be the market doing what it’s supposed to do. There can/may be more banks that are strained, and it would be equally understandable if this happened based on current FED policy. Another 4 banks (example) faltering will create a nervousness and would test the market trajectory. Yet, this is an opportunity for the FED to acknowledge that price stability is part of their mandate, and the data suggests that the rate level is constrictive enough. Their words won’t be a direct as mine but that type of theme in Powell’s statement will give the markets added comfort.