Regulators' prompt response and the creation of a new lending facility should limit broader market fallout from recent bank failures, notes Chief Investment Officer Larry Adam.
It is often said that the Federal Reserve (Fed) tightens until something breaks. In fact, history is peppered with examples of financial accidents caused by past Fed tightening cycles – Orange County’s default (1994), the collapse of Long Term Capital (1998), the bursting tech bubble (2000) and the housing crash (2008). That is why the market has been concerned about the Fed, particularly as it has raised interest rates at the fastest pace in over 40 years and the full impact – which occurs with a lag – has yet to be seen. Last week’s sudden collapse of Silvergate Capital and Friday’s failure of Silicon Valley Bank sent shockwaves through the markets, driving the S&P 500 down -4.5%, sending US Treasury yields sharply lower, and wiping out nearly $300 billion market capitalization in the S&P 500 financial sector. The biggest question for investors: are the recent failures manageable events or is there a significant risk of financial contagion that could have downside economic implications?
Before we delve into these questions, let’s review what led to demise of Silvergate Capital and SVB Financial, the parent of Silicon Valley Bank. The two banks had a lot in common:
Silicon Valley Bank was taken over by the FDIC on Friday, leaving many tech companies and start-ups scrambling to make payroll and wondering about the fate of their uninsured deposits (above the FDIC’s $250,000 threshold) over the weekend. In addition, the third bank in a week, Signature Bank, failed yesterday.
The failure of SVB is a true game changer for the Fed and could change not only the narrative from the central bank but has the potential for changing the path as well as the direction of interest rates, depending on how these events play out in the coming days, weeks, and months. For now, the probability of a March increase in the federal funds rate is less certain than it was last week and the end result will depend on the evolution of this crisis up until the Federal Open Market Committee (FOMC) meeting on March 21-22. Despite current uncertainty, we still believe that the Fed will raise rates by 25bps next week as bringing down inflationary pressures remain a priority.
Although the characteristics of the failed banks are highly particular to their niche markets as we mentioned above and should not create systemwide contagion, bank runs are unpredictable. However, the central bank, that is, the Fed, remains as the “lender of last resort” and will be ready to backstop any potential run against the banking system. The Fed has already created the BTLP program to inject liquidity for banks that need it and will continue to assess the risks to the system and provide resources as the system needs them.
For the US economy, the potential effects are less clear, as they will depend on how the current crisis evolves over time and what the Fed decides to do with interest rates. We will continue to monitor the events and make the necessary changes to our forecast.
The collapse of Silicon Valley Bank and the new Bank Term Lending program are game changers. The creation of the Bank Term Lending Program should relax concerns about broader financial contagion. However, it also shows that the Fed is becoming increasingly concerned about financial stability risks in the wake of the three bank failures over the last week.
While Chairman Powell opened the door for a potential 50 basis point rate hike during his testimony to Congress last week, the recent strains in the financial sector have taken this off the table for now. Market expectations for the peak fed funds rate continue to whip around—climbing to a cycle high of 5.7% after Powell’s hawkish testimony early last week to ~5.1% as of this morning. Rate cuts by year end are once again a possibility. While past crises have historically led to easier monetary policy, the Fed does not have the same flexibility today with inflation remaining elevated. But it does tell you that the Fed will need to tread carefully from here.
Meanwhile, the SVB crisis sparked a huge flight to quality across the entire yield curve, sending the 2-year Treasury yield down ~90 basis points from a peak above 5% last week and the 10-year to 2-year spread reversing some of its extreme inversion. These moves highly suggest that the market thinks the Fed may be done and a recession could be nearing. This does not bode well for lower-quality credits like high yield bonds. Our preference remains for higher quality bonds. It also suggests that the cyclical peak for yields is likely in.
Patience remains a virtue as we reiterate our 4,400 2023 year-end target on the S&P 500 that has held through multiple narrative shifts in the first quarter. The year started with a soft-landing narrative with the Fed pausing and eventually cutting, then to a no landing with heightened inflation and higher rates and now to a banking crisis. While we’ve held steady with our 4,400 target, this most recent narrative shift does not cause us to change our long-term optimistic view on the equity market. Why?
The recent failure of three banks is an unfortunate result of the rapid rise in interest rates to combat the unprecedented rise we have seen in inflation. The quick response from regulators and the creation of a lending facility should limit the contagion fall-out to the broader economy and financial markets. The silver lining may be that the Fed moves more slowly in raising interest rates and may potentially end its tightening cycle earlier which should be a positive for the economy and both the fixed income and equity markets. As this is a very fluid situation, we will continue to provide necessary updates as needed.
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