For those of you who would prefer to listen:
This was a consequential week on Wall Street. SVB Financial, the parent company of Silicon Valley Bank, officially filed chapter 11. In the end, there were no buyers for the bank. Fears spread about contagion. Another bank, just up Highway 101 became the next focus. First Republic received a $30 Billion lifeline from the biggest banks on Wall Street. One could argue, the $30 Billion was merely a return of the deposits that fled the bank last week. It’s been a gut-wrenching go. The US financial system is being tested again.
I was in Dallas this week for Barron’s annual Independent Summit. The timing couldn’t have been better. Leaders in the Registered Investment Advisory industry from coast-to-coast came together to discuss the state of the Market, the industry, and the future. We are all trying to make sense of it all.
What happened with Silicon Valley Bank looked like an isolated incident. At least at first glance. The issue was not bad loans. It was more like an old fashion 1930s liquidity crisis, taking place in the Digital Age.
Panic set in on that fateful Thursday. Customers swarmed in, demanding cash at once. In response, Silicon Valley Bank could not convert loans and securities (including cryptocurrencies) into cash fast enough. It was a run on the bank, in digital form. That’s never happened before. The Government had to shut SVB down last Friday to prevent a crisis.
Compounding the problem was a similar situation over the weekend with Signature Bank of New York. That stoked even more fear. They were shutdown too. Importantly, all depositors are being made whole. Everyone is getting their money back.
This was not a bailout of those banks. They failed. It was more of a firebreak drawn for the rest of the industry. This could’ve been a much bigger problem as these banks held working capital for companies. They had payrolls to meet and vendors to pay. It could have easily cascaded into a much bigger problem at once. But other problems did arise.
First Republic is reportedly exploring additional options to improve its liquidity, including a potential sale. The bank saw significant outflows following the collapse of Silicon Valley Bank. Rating agency Standard & Poor’s cut its credit rating to junk based on outflow risks and general pressures on profitability. First Republic has long been considered amongst the highest-quality financial institutions. This situation sure has rattled confidence.
Back to the Digital run on the bank: That’s a new phenomenon. It’s dangerous too. What can start as a small, isolated situation can lead to panic quite quickly. $42 Billion was withdrawn from SVB in one day. It was mostly done digitally. For perspective, that was more than twice what Washington Mutual faced over the course of days before it failed. Washington Mutual’s demise was the biggest bank failure in American history. SVB is now #2.
Bank runs are quite uncommon. But they have happened. It used to be, customers would have to go to a bank branch to get their money out. Tellers were told to count bills slowly and take breaks in order to curb the process and prevent a run. Digital banking is nearly instant. There are serious consequences for that.
On social media, fact and fiction spread like wildfires. It’s easy to yell fire in a crowded virtual room. I think back to one of my favorite Winston Churchill quotes: “A lie can get halfway around the world before the truth can get its pants on.” Fear travels fast in the Digital Age. It took down the bank.
Silicon Valley Bank prospered for 4 decades, seeding America’s innovation engine. It all ended in under 48 hours. SVB reached all-time highs in revenues and assets in 2021. Last week brought a screeching halt. The very customers that fueled Silicon Valley’s success were also the ones that led to its demise. The fact is, despite best efforts from Goldman Sachs and the Government, nobody wanted to buy Silicon Valley Bank.
It’s going to be a tougher go in the Valley in response to the bank’s failure. Risk appetites have shrunk. New ideas will likely get iced. Other regional banks are going to be more selective in how they lend. Big Banks will too. Money will be tighter. Valuations will be lower. The soil has become less fertile.
Customers from coast-to-coast have been fleeing regional banks at a fast clip. The common destination: Big Banks. Deposits at the big banks have swelled with people seeking safety. The Big Banks are more regulated than regionals in response to the Financial Crisis. Because of that, they’re in much stronger shape.
There are some serious consequences in this consolidation. The Big Banks are already twice the size they were before the Financial Crisis. Less competition generally results in higher prices and poorer service. Smaller, regional banks know their communities and understand specific industries. They bring a nimbleness and expertise. They have personal relationships. All that might get minimized.
The Market was in a tizzy this week as it tried to recalibrate, volatility increased. Surprisingly enough, the Market closed up on the week. Treasuries rallied as we’ve never before seen. Well, it was the biggest since 1987. The 2-Year Treasury yield was at 5% a week ago. That was the first time since 2007. It didn’t last long. The 2-Year fell over 1%, below 4% in the wake of the Silicon Valley scare. It happened lightning-fast. The 2-Year Treasury has seen a 50 basis point (1/2-point) daily move just 4 times in the last 25 years. It first occurred when Lehman failed in September 2008. The other 3 were this week!
The yield curve has been inverted for nearly a year. The spread between the 2-Year and 10-Year Treasury yields fell from the -107 bps last week, which was the widest in 4 decades, to just -42 bps. These are just incredibly abnormal-sized moves. An inverted yield curve has been a reliable leading indicator a pending recession. They just aren’t good timing mechanisms due to a long lag time. The Bond Market has been signaling trouble for a while. Last week we finally saw what the Bond Market had been warning.
It cannot be forgotten that the extended period of zero interest rates and emergency monetary policy from 2020 contributed to inflation and led to asset bubbles. The inflated prices in the Stock Market and Housing, and perhaps most notably in speculative cryptocurrencies, in 2021 was a generational bubble. Cheap and accessible money encouraged reckless behavior. In 2022, it reversed on a dime. The Fed’s aggressive response created a shock to the system. Something broke. It was Silicon Valley Bank. Whatever it takes comes with a cost. It’s clear, we still haven’t yet fully paid the bill.
This is definitely not the place that the Fed wanted to be. A potential banking crisis has complicated the inflation fight big time. In his Congressional testimony last week, Fed Chair Powell said no decision was made on the pace of rate hikes at next week’s meeting. That was before the bank failure. Fed officials planned to study more economic data to see if inflation was still moving back toward its 2% target. The Consumer Price Index (CPI) is the big one. It came in exactly as expected: +6%.
Inflation is still an issue, though it continues to slide from the 9% peak last year. The 6% increase is the lowest in 18 months. But of course, it’s still high. The Fed is sticking to its goal of 2% inflation. It’s a long way from there, but certainly moving in the right direction.
The cost of shelter accounted for 70% of the CPI increase, though higher-frequency metrics have shown a sharp slowdown in rents and home prices. Then there’s this: Airfares rose again after 4 months of declines, with recreation and apparel also higher. Americans still want to be out and about and Spring Break is just around the corner.
What a difference a week made. Last week the Market was pricing in an 80% probability of a half-point hike. Now, it shows zero chance of that happening and earlier this week was pricing in a coin flip of pausing hikes altogether. Heading into the weekend, the Market assigning a 63% probability of a 1/4-point hike next week. Europe raised rates this week by a 1/2 point, sticking to its discipline of taking down inflation. That likely gives Chair Powell confidence that continuing to raise rates won’t exacerbate the Market.
Perhaps the biggest bank concern still going is not even in America. It’s in Switzerland. Credit Suisse has been struggling for a while. The bank’s top shareholder, the Saudi National Bank, ruled out offering further financial assistance because it already owns a maximum 10% position. The Swiss National Bank jumped in, allowing Credit Suisse to borrow up to $54 Billion in order to shore up its balance sheet and maintain liquidity. The Market has made it clear what it thinks. The cost for 5-year insurance against a Credit Suisse default tripled this week.
So now what? It’s our sense that the Fed should raise rates by another 1/4-point next week and then reassess the situation. If they pause and keep rates where they are, it could spook the Market by sending a message that there is more to be afraid of than is currently priced in. Inflation is still elevated and the Fed doesn’t want to be caught chasing it again.
Regardless, we expect this choppy price action to persist until there’s some clarity. It might take a while, as things are pretty darn murky. We remain firmly on defense. It’s working. Gold is up big time. Treasuries are working too. Hang on tight. We’ll get through this.
Have a nice weekend. We’ll be back, dark and early on Monday.