The Panic Seems to Be Running Out of Steam

In my post from earlier this week “What the SVB Collapse Means for Investors,” I noted the situation was very fluid. Here, I provide an update on what’s been happening since.

As expected, the sudden failure of SVB rattled global capital markets. Fears of instability quickly spread domestically (to First Republic and other regional banks) and internationally (to Europe where Credit Suisse was forced to receive a cash infusion from the Swiss central bank). Reassuringly, the nation’s top money center banks were relatively calm and were seen by many as benefiting from the stress of their smaller rivals (as deposits move from small to larger banks). Regulators have been quick to provide liquidity to smaller banks (over $160 billion according to yesterday’s initial release), reassure depositors that their cash balances are safe, and the panic seems to be running out of steam—though it’s too early to know for certain.

Over the past week, investors dramatically changed their expectations of future Fed actions. Instead of hiking rates to 5.25% or more, the market is now pricing in a 1% reduction in overnight rates by the end of the year. As a result, bond yields collapsed across the curve with the largest declines occurring in shorter dated maturities (the two-year US Treasury fell more than 50 basis points). At the same time, US stocks reacted to every headline in a volatile up-and-down pattern and ended the week up modestly (as of Friday morning). Energy prices and commodities generally fell during the week.

Although the situation is still fluid, investors should be focusing on several key areas:

The Economy

It remains to be seen how badly the overall economy will be damaged by recent events. This was not a credit or solvency crisis (as we experienced in 2008). Although lending standards have been tightening, they are not at extremes, and solvent borrowers continue to have access to capital. At the same time, falling rates and lower energy costs should benefit consumers, homebuyers and most energy dependent sectors of the economy. Current GDP forecasts expect continued growth in the first half of the year. If correct, the headlines of the past week may prove to have limited economic impact beyond the institutions directly involved.

Federal Reserve

We believe the Fed will be keen to rebuild its damaged credibility as a bank regulator. Although the process can take years, coming regulatory changes will be significant. The unintended consequences to the past week will need to be addressed, including:

• After last week’s actions, we have unknowingly created a two-tiered banking system with large “systemically important” banks (where deposits of any size are guaranteed) and small and mid-sized banks (where deposits are probably, but not explicitly, guaranteed). This may have the unintended consequence of encouraging deposits to move to the large “too-big-to-fail” institutions. Ironically, this movement, if it is allowed to continue, has the potential to destabilize smaller banks and encourage more criticism of the Fed’s regulatory record—the opposite of regulators’ previously stated intentions.
• To slow deposit flight, smaller banks will be forced to increase the rates they pay to customers. Although this is long overdue, the larger, systemically important banks will not face the same pressures—again increasing the pressure on smaller banks.
• The Fed’s new liquidity facilities have put an unintended spotlight on the banks that utilized them. Unlike 2008, when all banks were forced to draw liquidity (whether they needed it or not) to avoid any negative market signals, the newly established programs are highlighting which banks may be under pressure.
• We expect smaller banks to face enhanced liquidity stress testing and capital requirements. In addition, all banks are likely to face significantly higher FDIC fees.

Needless to say, there is going to be a significant debate in Congress over the future state of US banking. Much more to come.

In the meantime, it’s unclear how dramatically the Fed will alter its previously stated plans. Prior to SVB, the Fed had stated its intention to separate its balance sheet and interest rate tools. In fact, Chair Powell was clear in asserting that the Fed had the tools to deal with market disruptions away from its interest rate policies. We expect inflation to continue to moderate through the summer months. As such it is likely that the Fed will slow or even pause its rate hiking cycle in the next few meetings. Its balance sheet, on the other hand, will increase as much as needed to provide liquidity to stressed banks. The impact of this increase may be much less than prior easing cycles. Unlike past Quantitative Easing (“QE”) cycles, the Fed will not be absorbing losses (should interest rates rise). Those losses will remain with the banks, albeit recognized slowly as held-to-maturity securities mature.

Putting It All Together

Markets always seem to assume the future will resemble the past. While history is important only if you look, we believe that if you look, you will see that the current situation is very different from the Great Financial Crisis. Liquidity is required for a well-running economy and financial market, and the Fed has the tools to provide liquidity, and we believe it will do so. If adequate liquidity is maintained, the current rate environment, coupled with moderating inflation and reasonable global growth, provides a solid backdrop for credit markets and secular growth companies.