Weekly Update 3/17/2023: Markets Swing on Fed Odds and Bank Issues
- Consumer and producer price data released
- Saudi airline to purchase Boeing jets
- Accenture reports earnings
- Accenture reports earnings
In the Valley
Hard to believe but two weeks ago, most people outside the financial world did not know a certain California bank even existed. “When you’re not working, what do you do to de-stress?” was the question posed to Greg Becker, CEO of Silicon Valley Bank (SVB), on March 7 at an investor conference. “Cycling is my advice,” he replied. “Living in Northern California and being on the peninsula. That’s just—I think it’s the best bike-riding cycling in the world, period.” Three days later the bank, which had $173 billion in customer deposits at the end of last year, was put in receivership by the regulators. The failure was the largest since the demise of Washington Mutual in 2008. The cause of SVB’s collapse is pretty straightforward—the duration of its assets was mismatched with its liabilities. For a bank, this violates cardinal rule #2 (#1 being don’t get robbed). When interest rates began to rise in earnest last year, the bank realized that its investments in safe securities did not shield them from a potential run on the bank if depositors started to pull out their funds, which is exactly what happened. And this was not an overnight problem, as a check of the firm’s financial statements shows the ballooning unrealized losses from holding these instruments as 2022 progressed. Theoretically, this could have carried on for many more quarters, but as the economic slowdown hit the tech sector harder and harder, private equity and venture capital firms needed cash to cover payroll and other bills since money from investors was drying up. Initially, SVB tried to raise capital by issuing more equity but quickly found out that that was not going to work. From the Bloomberg opinion desk of Joe Weisenthal comes these wise words: “Tech and Silicon Valley is all about the boom times. Move fast. Grow fast. Pour money into winners. Scale up. But growing fast is actually not unambiguously great for a bank. If you acquire too many costly customers and have no capacity to profit from them except by taking some significant risk, then you're in trouble…. Tech investing is all about maximizing upside, while banking is (or at least should be) all about avoiding downside. So, to the extent that there's some risk out there that's been encouraged it's in facilitating this nexus of hot, boom-bust, fast-moving tech money with banking, which should be kind of boring.”
The situation was made more extreme by the fact that these depositors often had accounts which were far above the Federal Depository Insurance Corporation (FDIC) limit of $250,000. In fact, $152 billion of the $173 billion in deposits were thus uninsured. That calls into question the underwriting discipline of various venture capital firms, but that topic is a discussion for another day. Regardless, that triggered the FDIC, the Treasury Department and the Federal Reserve to come up with an emergency plan. Signaling that this was a “systemic risk exception” to backstop uninsured deposits, regulators decided to guarantee ALL deposits. Was this a bailout? Technically, no. Shareholders and certain debtholders would not be protected, and any losses to the Deposit Insurance Fund to cover uninsured deposits would be recovered by a special assessment charged to all banks.
The biggest risk is a domino effect happening similar to after Lehman Brothers failed in 2008. Other banks who invested in bonds are facing the same type of risks given that interest rates are much higher than two years ago. In response, the Federal Reserve established the Bank Term Funding Program. Banks holding “safe assets” such as Treasury bonds or government-backstopped mortgage bonds, can bring them to the Fed at par in exchange for a loan of cash up to a year in duration. The key is receiving 100 cents on the dollar for every bond that may be currently trading at 90 cents, 80 cents or below. Banks can use the cash to grant customers’ requests for their deposit money if a “run” on that bank should arise.
Lehman moment redux?
What made the collapse of Lehman Brothers in 2008 such a pivotal moment during the financial crisis was not what many think. It was not a large investment bank when compared to Goldman Sachs or Morgan Stanley. It was not a large insurer like AIG which was a crucial player in complex financial derivatives. The biggest factor was that it was allowed to fail because nobody wanted to buy it. That lack of confidence is at the center of the current volatility surrounding many bank shares. Credit Suisse Group AG saw its shares pummeled on Wednesday after several years of scandals, leadership changes and legal issues. But the trigger for the pullback of Switzerland’s second-largest lender was that its biggest shareholder ruled out increasing its stake due to regulatory constraints. Other banks like JP Morgan, Bank of America and Citigroup have pared their direct exposures to the bank to limit counter-party exposure. Like Lehman, it has become a leper even though it has access to Swiss central bank lending facilities (unlike Lehman or SVB) and has enough liquid assets to pay back half of its liabilities in deposits and loans from other banks. European banks are required by regulators to model their expected gains or losses from changes in the market values of their assets and liabilities due to rate shocks. For Credit Suisse, its worst loss would be 1.8 billion francs, from a parallel upward shift in rate curves. That amounts to just 3.6% of its capital base; the level at which its regulator would start to get worried is 15%. However, none of this matters if clients and investors do not believe that it can weather the storm.
The Christmas classic movie, It’s a Wonderful Life, is a perfect example of how banking works. It’s all based on faith. When the townsfolk of Bedford Falls gathered in the lobby of Bailey Building and Loan to get their money out, George Bailey explains it all: “You’re thinking of the place all wrong, as if I have the money bank in a safe. The money’s not here,” says George. “Your money’s in Joe’s house… and a hundred others. You’re lending them the money to build and then they’re going to pay it back to you the best they can.” Behemoths like Credit Suisse and Goldman and Bank of America do a lot of other things like asset management, underwriting to bring companies public, negotiate mergers and acquisitions. But at the end of the day, it comes down to the counterparty having faith in what they do. When that faith is gone, it can bring down firms large and small. The sharks seem to be circling First Republic Bank currently even with a consortium of banks trying to rescue it. When these events happen on a global scale, it becomes a Lehman moment.
By Thursday, Credit Suisse said it would tap its central bank for 50 billion francs ($54 billion) and launch an offer to buy its own distressed debt. "The transactions are consistent with our proactive approach to managing our overall liability composition and optimizing interest expense and allow us to take advantage of current trading levels to repurchase debt at attractive prices," said a spokesperson for the bank. The shares rebounded initially before bouncing around between small gains and losses during the day only to finish flat on the day. Chairman Ammar Al Khudairy of Saudi National Bank reiterated to CNBC on Thursday that it did not want to exceed an ownership threshold of 9.9%, but also said the pressure Credit Suisse was unwarranted. If the market returns faith in the institution, it will rise but a crisis of confidence is at hand, and it may take more measures by the company or central bank to restore trust. Until that happens, a cloud of uncertainty will reign, and we would not be surprised to see other financial institutions be “targeted.” This remains a fluid situation where headline risk will play a role in the next day’s trading.
The Fed quandary
Over the past few years, we have seen the Fed, for lack of a better term and to keep it simple, just throw money at the problem. Interest rates would be cut, lines of credit would be expanded, and everyone would breathe a sigh of relief. However, the Fed has an inflation problem. It simply cannot cut rates and wait for applause. The consumer price index (CPI), excluding food and energy, rose 0.5% last month and 5.5% from a year earlier, according to the Bureau of Labor Statistics. The overall CPI rose 0.4% in February and 6% from a year earlier with over 70% of that rise due to shelter costs. Stripping out energy and housing, a metric Fed Chairman Powell has singled out as key for their policy, services prices were up 0.5%, the most since September. The good news is that egg prices did decline by the largest amount since the early months of the pandemic! With inflation running still “hot”, it is going to be very hard for the Fed to throw money at the banking issue.
Producer prices and retail sales
According to the Bureau of Labor Statistics, the producer price index (PPI) declined in February after downward revisions to the prior month. Prices rose 4.6% from a year earlier and, excluding the volatile food and energy sectors, the core PPI was unchanged from a month earlier translating to a 4.4% annual rise which was below expectations. The decline reflected decreases in both goods and services—eggs prices declined in the wholesale channel, too!
Retail sales fell in February after a strong report in January. That presents a mixed picture as consumers still seem to be spending but are unsure how bad inflation is going to get. The Commerce Department reported that, excluding gasoline and autos, retail sales were flat. Eight out of 13 categories fell last month, led by furniture and department stores. Vehicle sales shrank by 1.8% and sales at restaurants and bars fell 2.2%, the most in over a year. So-called control group sales, which are used to calculate gross domestic product and exclude food services, auto dealers, building materials and gasoline stores, rose 0.5% versus the expectation of a 0.2% decline and a 1.7% rise in January. “Even as higher borrowing costs and elevated prices are a constraint for consumers, pent-up demand, a still-strong labor market and gradually easing inflation appear to be supporting household spending,” Rubeela Farooqi, chief US economist at High Frequency Economics said in a note. “However, as the labor market softens in response to restrictive monetary policy, consumer attitudes are likely to turn more cautious over time.”
Bank of America Institute economists state that many households have savings and checking account balances substantially higher across income cohorts than they did before the pandemic. For example, for lower-income households, with annual income below $50,000, savings are still nearly 50% above the 2019 average. Thus, it looks as though many Americans will have the wherewithal to keep spending as long as jobs continue to be plentiful. Initial jobless claims released yesterday by the Labor Department shows applications for unemployment benefits fell by the most since July of last year. The figure fell by 20,000 to 192,000 in the week ended March 11, below the median estimate in a Bloomberg survey of economists which called for a figure of 205,000. Week-to-week claims can be volatile as reporting quirks in some states and weather can play havoc on the data. The four-week moving average smooths out some of this bumpiness. It, too, edged down this week to 196,500.
Odds
The European Central Bank (ECB) raised rates by half a percentage point yesterday seemingly brushing aside the brewing banking concerns as it presses ahead with its inflation fight. Its key rate would rise to 3%, the highest level since 2008. The hike follows consecutive half-point rate increases last month and last December. Underlying inflation in the eurozone rose to a fresh record of 5.6% in February. It did not completely ignore the market volatility stating it is “monitoring current market tensions closely and stands ready to respond as necessary.” ECB President Christine Lagarde and her colleagues did not offer guidance on future moves for their key rate saying it will be data dependent. However, she made a point to stress that just because there was no guidance, that did not mean that the ECB is wavering on its commitment to bring down inflation. She also emphasized that the ECB is confident that European banks have strong supervision, strong capital and strong liquidity positions with exposures that are not concentrated. The euro swung between gains and losses on Thursday morning.
What are the odds that the Fed will make a move of its own with the federal funds rate target? The probability has been all over the place. Based on Thursday’s FedWatch Tool, last month the odds of a 25 basis point (0.25%) increase were 84.9%. Last Thursday, the odds of a 50 basis point rise were over 60%. By this Thursday morning, odds were 0% for a 50 basis point move, 67% for 25 basis points and 33% for no move at all. Talk about volatile markets! Like the weather, it is sure to continue to change right up until the Federal Open Market Committee meeting conclusion next Wednesday, March 22.
What is our take? The threat of a contagion is never non-zero. With the failure of SVB, it becomes prominent in the minds of investors and traders. However, that does not mean the banking system is unsound. While rumors may sway sentiment, the undeniable present fact is that the economy is facing a scale of inflation it has not seen in over 40 years. Even with numerous pundits repeatedly criticizing the Fed’s moves as too aggressive and too restrictive, the Fed continued because it knows what happens if they do not succeed in their mission of bringing the level of goods and services back down to a manageable level. The alternative is much more future rate hikes and the associated pain, volatility and declines in the economy and the equity markets—plus the enormous opportunity cost of the missed opportunity to nip it in the bud when they could. Since the end of 1982, when the Fed switched to using its funds rate as its main policy tool rather than aggregate money supply, it has conducted 12 dovish turns (meaning cuts in interest rates). On average, the Fed benchmark rate was 414 basis points above headline CPI, and 379 basis points above core CPI, in the month it switched to rate cuts. Currently, we’re 125 basis points below headline CPI, and 100 below core.
Yes, Fed policy does work with long and variable lags. Yes, if the current situation evolves into a bona fide financial crisis, they will have to act. And, yes, the Fed has been wrong before. But the bottom line is this is how capitalism works, where some will succeed while others fail. There is no room for charity in market trading pits. The Bank Term Funding Program has ring fenced U.S. banks from the type of problems SVB developed. Central banks have not forgotten the global financial crisis which was over a decade ago but feels like it wasn’t that long ago. The markets also know that with the fed funds level target range currently at 4.50%-4.75%, there are 450 to 475 basis points of room available to cut if things go south in a hurry. But unless another tangible Lehman moment arrives, the employment numbers and inflation data continue to point to rate increases likely continuing next week. Are we much closer to the so-called terminal rate than we were twelve months ago (when rates were 0%)? Definitely. Soon, the market is going to shift away from the terminal rate guessing game to what quarter the economy will exhibit the type of inflation figures that will satisfy the Fed. That may take a recession, or it may not but, like the ECB, the Fed will be data dependent and market participants would be well cautioned to believe that. Stay tuned.
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