First cracks appear from rapid Fed tightening
In March ‘22 the Fed finally got the Fed Funds Rate off the 25 bps floor with a 25 bps rate hike. By then, inflation had already averaged over 6% for the prior 6 months. From that initial hike, the Fed bulldozed its way all the way up to 4.75% with it’s latest 25 bps rate hike coming in Jan ‘23. FOMC skipped Feb ‘23 and is about to resume rate deliberations with meetings this week.
Until 1.5 weeks ago, the Fed’s steep hike curve was digested, with a lot of heartburn, by markets. Stocks fell, bonds adjusted and borrower’s started to feel pinched by rates that no longer made many purchases feasible. But the world of finance kept chugging along. Then the floodgates blew open. Starting around March 9th, Silicon Valley Bank (SVB), the bank of the tech world, had an old-fashioned run on its deposit, forcing itself into the hands of the FDIC for the weekend while its future was mulled over. Unfortunately that future ended with bankruptcy. While that played out, we saw some interesting moral hazard moves of guaranteeing deposits by the gov’t, a move meant to calm depositors.
Signature Bank, another alternative lending institution focused on crypto currency, met a similar fate as SVB with a rapid run of deposits over a similar time frame. First Republic Bank, a bank catering to wealthy individuals and a neighbor to SVB in the Bay Area, got caught up in the contagion risk of SVB and nearly went bankrupt itself. If it weren’t for a consortia of banks willing to lends $30B of deposit, and the gov’t willing to provide a loan based on its securities portfolio being valued at par, the bank would done by now. Even today, First Republic’s future is extremely precarious with bankruptcy a very real outcome.
Finally, Credit Suisse, a major player in global finance, emerged as the first European victim as the deposit crisis crossed the Atlantic Ocean. UBS, another Swiss lender, stepped up to purchase its rival in a quick-fire $3.2B buy-out intended to “stabilize” the financial system. The full effect of this move is yet to be understood. Nor can we know how much the gov’t intervened with own set of safety-net guarantees to make this happen.
The craziness behind these events outlined above is the speed. In the span of 1.5 weeks, nearly four large-ish banks met their demise. Many attribute it to twitter rumors and the speed of smart phone money transfers. Others blame it on the fact most of these banks were only willing to offer borrower’s less than 0.5% on their deposits at a time when treasuries and money market yields exceeded 4%. The more obvious culprit, depositor jitteriness stemming from large write-down of long-dated securities. These assets were acquired a year or two ago when deposits were swelling from easy gov’t money and no yield was available to bank except for at the longer-end of the yield curve. Banks bought these securities, the Fed’s rate hikes destroyed their value, and now the banking system is turned on its head for any depositor sitting on more than the FDIC limit of $250k. Frightened deposits have pulled money from smaller regional banks and diverted funds into large “safe” banks like JP Morgan, Bank of America and Wells Fargo known for their massive size and implicit gov’t backing.
Sorry for the long story-telling, but this really creates an intriguing set-up for this week’s Fed hike decision. On the one hand, inflation is still at 6%, labor markets are very tight with unemployment at 3.6%, and consumer spending is still strong. The Fed Funds at 4.75% is still below inflation at 6%. Until these levels cross, there’s a good chance inflation won’t be tamed. Contrast these data points to a banking system teetering in a major way and you’re left wondering what the heck the Fed will do. Dropping rates with inflation still elevated was the classic mistake of the 1970’s that led to painfully persistent inflation in the many years ahead. Powell can’t be oblivious to the fault of his predecessors even as the banking system in his own backyard threatens to fall apart. The bill for easy money, for far too long, seems to be finally coming due.