I, too, as anyone who is even fractionally enthralled by financial news, not to mention every breathing publication out there, am wondering what is next? Where do we go from here? How would Chairman Powell and the FED proceed from the unfortunate occurrences of the past two weeks? What about equities, Bonds? These are just some of the questions in a long list of unfathomable concerns every retail or institutional investor has. This post is my humble attempt to not only contextualize everything, but also opine as to what I think might happen.
When the news broke about Silicon Valley Bank, I wanted to see how the markets reacted, and what better way to ascertain the collective emotions of the entire market than our age old favorite the "VIX index." The tumultuous news of SVB caused the VIX to hit new highs since October last year (as shown below):
Source: Wall Street Journal (Mar 13, 2023)
The markets have been on a roller-coaster ride because of the Keynesian approach the government took during the pandemic, and the consequential turmoil due to inflation, skyrocketing energy prices, and billions of greenbacks that citizens had access to and saved up. Without having SVB in the picture, market participants were already at a loss as to what the terminal rate would be, where the economy was headed, and most importantly, whether or not the FED would be able to tame inflation and drag it down to 2%- not to even mention the entire conversation on soft, hard or no landing. Investors were getting bewildered with every report that came out; If CPI report came within the confines of acceptability, retail numbers came in higher, if energy prices were coming down, the labor market continued to show its resiliency. No one had an inkling, let alone knew, what was going to happen, but that didn't stop pundits from prognosticating. The banking crisis has further exasperated the tumult that investors were already having a hard time navigating.
The SVB crises, in my humble opinion, was the culmination of high interest rates, poor risk management, and misuse of uninsured deposits for venture debt, along with I am certain myriad of other issues. Everyone adores easy money and low interest rates for obvious reasons, but few tend to understand what high interest rates mean, not in terms of tightening the money supply, but also in relation to the banks' liabilities vis-à-vis the deposits. Without taking a deep dive into the banking business model, banks have deposits that they need to make sure they can match when consumers come asking for them, in SVB's case, they invested heavily- before the rate hikes- in long-term bonds with low yields, and with rate hikes, the demand for their holdings went down because which sane and risk avert investor would buy long-term bonds- even the ones with virtually low risk such as the US treasuries- with low yields when the bonds started trading at higher rates due to the hikes. So when it came to the depositors asking for their money, SVB couldn't match the demand and had to sell their AFS securities (with low yields) at steep discount resulting in losses worth billions. Additionally, SVB's attempt to raise $1.8 billion seemed to have also struck a nerve with the markets, and resulted in the infamous "run on the bank."
SVB, as it turns out, because of their symbiotic relation with VCs and Silicon Valley, was also taking a stab at venture debt. They were lending dollars to venture capitalists for their funds as a quid pro quo for their [VC's] portfolios of companies banking with SVB. This was highly unusual, and some might even say should be illegal, for a bank because the money they used for these loans were the billions of uninsured deposits they had on their balance sheet. What SVB should have done was marked their holdings to the market on a regular basis and rebalanced their portfolio according to the FED's quantitative tightening and the macro environment. What does that mean? It means that they should have sold their holdings with low yields and swapped them with high yielding short-term investments, this would have saved them billions not just in case of their market value but also because when depositors were attempting to withdraw their money, SVB would have been able to sell their short-term investments relatively quickly and at a fair price as well as match the demand one-to-one, this was quite aptly referred to as "duration mismatch," by Chamath and the group on their weekly All-In podcast.
So why wasn't the banking crisis contained when SVB was put into receivership, and especially after when the government backstopped and guaranteed their deposits? Well, I think, that was more related to human nature than capital markets and the heartbeat of the economy. The potentiality of SVB's customers loosing their money lead to the deluge of withdrawals from other regional banks such as Signature (which was also put into receivership) and First Republic. All wasn't lost for the banking industry, though, as Bank of America saw $15 billion in deposits in the wake of all the withdrawals from regional banks; BofA, I am positive, was not the only one, as other major banks such as JPM, Citi, and Wells Fargo must have had their own exponential increases throughout the course of this predicament. First Republic was arrested from SVB and Signature's fate, and had an influx of $30 billion deposits from major banks in order to restore confidence in the bank meeting its obligations and the overall visage of the banking industry.
The crisis that started with a relatively infant bank, when compared to other major international, and too-big-to-fail banks, quickly spread across the globe as Credit Suisse came under enormous pressure, and as of the publication of this post, has been acquired by UBS for effectively pennies on the dollars. But, will this acquisition- effectively led by the Swiss government- coupled with US authorities' efforts and various facilities that have been established be enough to shore the risk in markets?
I have always thought that the best measure of the collective risk in the market is best defined by yields on various US treasuries i.e., 2- and10-year notes. Short-term yields have cratered since the whole banking debacle, and investors are rushing to not only park their cash, but also park it securely. The 2-year yield curve (as shown below) clearly shows how bad the situation is now, the yield slumped from over 500 bps to 384 bps over the course of the last two weeks; I am not even going to get into the inversion and the spread between 2- and 10-year treasuries.
Source: CNBC (March 13, 2023)
The bond market is vividly telling us that the market is expecting the FED to either bring their rate hikes to an abrupt stop or that there are only one or maybe two 25 bps hikes in the books and that the FED might even have to initiate a reduction in the fed funds rate by the end of this year. The demand for short-term bonds have skyrocketed and those that had them in their portfolio will without a doubt either intend to keep them on the books as the potential of future yields being lower than current ones have escalated or, given the current enormous demand, they can choose to sell them for a hefty profit. What happens when the demand for a security kisses the sky? That's right, the trading spread has increasingly widened, making it harder to trade short-term securities such as the 2-year treasuries. We can see what this means for the bonds, but what does it entail for the equities' market? That remains to be seen, but personal hypothesis is that stocks will decline as the risk of recession looms high and as the emigration of funds into the bonds market continues, at least up until the FOMC's meeting next week.
Stocks closed in a relatively good place this past week due to the helping hand extended by the major banks to First Republic, but the market's sentiment towards the ginormous merger of UBS and Credit Suisse will be on full display in pre-trading and normal session on Monday; I doubt it will have the effect that the governments and regulators are anticipating, don't get me wrong, it will have an impact but miniscule in nature and not nearly the seismic event that they might be hoping for. Markets and investors have grown wary and I don't believe that this will be enough to cool the markets down. FOMC meetings have grown in importance ever since the rate hikes began, but the meeting next week is of an exponential importance. Everyone will be fixated on what the FED does in terms of its policy rate and on what the future plans are for rate hikes and the economy as a whole.
FED and Chairman Powell are in a precarious situation to say the least. If they stop the rate hikes, they risk kickstarting the economy, which given the retail numbers and tight labor market, won't be much of an issue, but if they do continue to hike, the risks may further permeate to banks worldwide and other sectors of the financial markets as well. The bond market has already priced in a reduction by the end of this year, and if the FED acts in a contrarian manner, it might spook the markets further. I think that the FED will have to tiptoe and make sure they don't knock over anymore dominoes with their missteps; I further believe that they will have to raise the rates at next week's meeting, at least 25 bps- given the CPI, along with core inflation, PCE, retail numbers, and last but not least, the labor market.
Lets leave the technicalities aside and briefly discuss the morality of it all because, to some, this feels eerily similar to the "bailouts" of 2008. Allow me to excuse you, dear reader, of the notion that this is in any shape or form similar to what happened in 2008; for starters, banks are in far better financial shape than they were back during the financial crisis, and to all those asking where the $600 billion facility is being funded from, well, that is the result of last decade of banks depositing their funds into the Federal Reserve. The creditors, bond holders, and stock owners have all lost every last cent they had in SVB, and the average joe is not at all footing the bill this time around. But, I would be remiss if I didn't mention the obvious byproduct, or maybe side-effect, of all the backstops and mergers that are happening now in order to stem any doubts in the markets: Maybe the fact that governments are scrambling all of their resources to shield the banks and turmoil from reaching to the far reaches of the markets might lead to people becoming more complacent and taking on even more risky bets because of the omnipotent presence of the government's protection behind the curtains.
We can all maneuver with conjecture, but the fact of the matter is that we are players of a very dangerous game, and there will always be winners and losers, the trick is to not boast too much when we win and to chin up when we loose. As far as the markets and morality of it all is concerned, time will tell, but I will say this, as humans, I wouldn't put too much faith in ourselves.
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