The fallout from the failure of Silicon Valley Bank (SVB) introduces a number of challenges into our expectations around Fed/ECB policy and monetary tightening in the months ahead. Nonetheless, first it’s important to set the scene. The failure of SVB was a result of gross negligence at the highest level. The bank, which held a sizeable cache of US Treasuries and mortgage-backed securities, effectively rolled off all interest rate hedges through 2022, directly exposing depositors at a moment when the Fed was clearly signaling a policy of higher rates and quantitative tightening.
The Fed and the US Treasury forcefully stepped in over the weekend to lend support to the US banking sector and outrun possible contagion. Most importantly, all depositors of SVB (and Signature Bank) would be made whole and effectively guaranteed that all deposits would be fully protected, even above the $250k limit the FDIC already insures. Ultimately, a lack of access to capital for firms banking with SVB only lasted about a day. The longer-term risk moving forward remains the possible loss of access to credit lines for startups and other small firms banking with SVB. Secondly, the Fed created the Bank Term Funding Program (BTFP), which allows depository institutions to borrow from the Fed with a duration of up to one year using Treasuries, agency debt and mortgage-backed securities as collateral at PAR VALUE. This effectively allows banks to ignore the unrealized losses on these securities that has transpired over the past year amid interest rate increases if they need to borrow directly from the Fed. Given banks were sitting on roughly $620 bn of unrealized losses as of late last year, the BFTP is a major positive for banks who need cash to cover deposit outflows.
The Biden Administration has been quick to emphasize that the moves made by Treasury and the Fed are not bailouts, but this is largely political maneuvering. While “bailouts” is a dirty word, the BTFP essentially serves as a “potential” bailout to depository institutions that are not SVB, especially regional banks that are likely experiencing a lot of depository outflows at present, albeit this is not a systemic risk for now. Ultimately, the Fed would have to pick up the tab on the unrealized losses on Treasuries (or other debt) posted as collateral if loans made to struggling banks fail to perform (or in the least, take a long time for repayment).
Determining the economic effects of the SVB crisis is complicated to say the least. The market has quickly shifted towards a far more dovish view on monetary policy as the Fed turns its focus to financial stability. In the middle of last week, investors temporarily agreed that the likelihood of a 50-basis point rate hike was the most probable outcome for the March FOMC meeting. This looks to be completely off the table now, with majority expectation back to a 25-point increase. The two-year Treasury yield has collapsed as a result, down nearly a full percentage point after topping out intraday at 5.08% on Wednesday, March 13, following congressional testimony from Governor Powell. These are simply not moves you typically see in a market at liquid as US Treasuries. USD has also weakened with DXY, an index of Dollar strength, down roughly 2% from late last week as market expectations for a less aggressive Fed feed through.
More worrying is the fact that the market is also betting on rate cuts again for 2023. According to futures prices, a target Fed Funds rate below current levels (4.5 – 4.75%) at the September FOMC meeting is the majority probability, down from an expectation of 5.5 - 5.75% middle of last week. The shift in sentiment is problematic because such an outcome remains highly unlikely and thus, considerable volatility could be felt in markets over the next several months as disconnects between Fed policy and market expectations play out in real time. We continue to maintain that the Fed will hike to a terminal rate of 5.5 – 5.75% and we are sticking with our original expectation that the Fed will hike rates 25 basis points at the March meeting. Market watchers should expect language from Powell to remain focused on the inflation problem, albeit a healthy dose of commentary dedicated to financial stability will also be included in the FOMC press conference statement. Ultimately, the Fed will continue to pursue a stance of “inflation fighter.” CPI data, set to release tomorrow, March 14, will be critical to monitor and could change our view on terminal rates, but only with a big miss to the downside. We maintain that the US economy will enter into recession this year, finishing 2023 with GDP down 0.3% y/y.
Jumping across the Atlantic, there is also the issue of Europe. For several weeks, the ECB has messaged with near certainty the likelihood of a 50 basis point rate increase for March. Like the Fed, this appears less likely as of Monday, March 13. Leaks from the ECB indicate growing opposition to a 50-basis point rate hike. We believe the ECB will indeed only increase rates 25 basis points in March, albeit we maintain a terminal deposit rate of 4%. We also maintain our GDP forecast, which has growth decelerating 0.5% y/y in 2023.
The movement in oil prices also responded to the concerns around SVB, pushing lower by nearly 3% as of the afternoon of March 13. It is our view that the outlook for oil prices has not changed relative to the events that have transpired over the past few days (we maintain a Brent spot price band between $80/bbl and $90/bbl for the entirety of 2023, with prices likely towards the lower end of this range 2H). The Fed and ECB will both remain focused on fighting inflation, even if rates rise more slowly than the market was originally anticipating. Higher rates will eventually flow through to a contraction in economic activity later this year. With that being said, oil price volatility could ramp higher given the discontinuity seen between likely Fed policy (ongoing focus on higher rates/inflation) moving forward and current market expectations (a cut in rates by September).
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