All Things in Moderation

Vital Statistics:

Stocks are lower this morning as the markets digest the failures of Silicon Valley Bank and Signature Bank. Bonds and MBS are up big.

I talked a bit about the Silicon Valley Banking situation and the implications in a Substack article over the weekend. It goes into the theme I have been talking about where the US is re-living the 1970s. But here is the recap. Silicon Valley Bank failed on Friday, and the New York Fed took over Signature Bank on Sunday. Depositors at these banks will be made whole (even uninsured depositors). The Fed created a liquidity facility for banks over the weekend, with 1-year term loans that can be collateralized at par against Treasuries and MBS that are trading below par.

First Republic is down big pre-market and looks like the next domino to fall. Western Alliance is down big as well, despite assuring investors that its tech exposure was limited and it had ample liquidity. PacWest is another. Investors are shooting first and asking questions later

The Fed Funds futures are now handicapping a 48% chance of no move in March and a 52% chance of only a 25 basis point hike.

FWIW, I think the Fed anticipates that these bank failure will restrict credit in the banking sector, which will have a similar effect to rate hikes. In other words, they won’t need to hike the Fed Funds rate as much going forward because the bank failures are doing the work for them. We are seeing the flight-to-safety trade this morning as investors pile into sovereigns and MBS.

Silicon Valley Bank’s sin was to buy Treasuries and MBS without hedging the interest rate risk. Beset with withdrawal requests, it sold its available-for-sale securities at a loss to cover withdrawals. Every bank on the planet has been dealing with rapidly rising interest rates, and I wouldn’t be surprised to see some European banks in the same situation.

The Fed’s new credit facility is meant to prevent that from happening. Instead of selling securities at a loss into the market, banks can now pledge these securities as collateral at 100% of face for a loan to pay off deposit requests. It is a way for them to “sell” their securities for a year without taking losses. The Fed hopes that this will prevent a bank run.

The current environment is lousy for the banks because inverted yield curves make it hard to generate net interest income (i.e. the difference between what they receive on their investments minus their borrowing costs). This is why deposit rates remain stubbornly low – banks aren’t earning enough on their assets to cover the cost of market deposit rates. So people are pulling their deposits to buy Treasuries direct from the government. This is a bank run in slow motion, similar to the problems we had in the 1970s. Since this phenomenon has nothing to do with a bank panic – it is just people making rational financial decisions – the temporary bank facility isn’t going to do much to stem that problem. If deposit rates are lower than other options people are going to continue to pull money out of the banks. Other banks might have better risk management, but if deposits are falling, so will lending which will slow the economy.

While the 10 year bond has gotten the most attention, the action has been in the two year. The two year bond yield is now trading at 4.09%. It was at 5.06% on Wednesday. This is another signal the market thinks the Fed is done. Don’t forget that 2023 was the most aggressive tightening cycle in 40 years.

The upcoming week will have the Consumer Price Index on Tuesday, which creates a real conundrum if inflation is running hot again. We well also get a lot of housing data with housing starts and homebuilder sentiment.

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