United States Macro recap & Outlook

Jeromes Speech

Last week, Fed Chair Jerome Powell gave a scheduled testimony to Congress with several key takeaways. Firstly, he emphasized the Fed's commitment to returning inflation to its long-term 2% target. Secondly, he indicated that the Fed is willing to trade some pain on the economy to achieve its inflation-reduction goals.

Powell's comments suggest that the Fed is taking a deliberate approach toward resetting expectations for upcoming policy moves. The central bank is willing to accept some economic pain, such as a downturn, to achieve its inflation-reduction goals. Powell made it clear that robust economic growth and sustained declines in inflation cannot exist in perfect harmony. Therefore, the Fed's effort to bring down inflation is the right move for the economy's and financial markets' longer-term health.

Another key takeaway from Powell's testimony is that the Fed is shifting to a more data-dependent approach. Until now, the Fed has been steadfast in aggressive rate hikes to quell 40-year highs in inflation. However, Powell acknowledged that the full effects of the rate hikes have yet to work their way through the economy fully. As a result, the Fed will seek to calibrate upcoming hikes to incoming data more closely.

Markets have reacted to Powell's comments, with expectations for the peak fed funds rate shifting to an expected range closer to 5.5%-5.75%. This is higher than initial expectations for the Fed to pause when it reached the 5.0%-5.25% range. While nothing is set in stone, markets sold off in reaction to the expectation that the Fed will take rates higher and leave them there longer than initially anticipated.

The bottom line is that the Fed is hiking much deeper into a bear market than has historically been the case, and the Fed is not yet at a stage where it can take its foot off the brake. This extreme hiking has caused a bank run on Silicon Valley Bank (SVB).

How did a Bank run occur

From 2020 to 2022, the US banking industry experienced significant deposit growth due to various factors. The Paycheck Protection Program (PPP) loans and government stimulus checks injected considerable money into the economy. In addition, the low-interest-rate environment, favourable equity markets for companies, historically high valuation multiples, high levels of liquidity among investors, and good IPO/SPAC market conditions contributed to the deposit growth.

Banks invested these deposits in government-backed securities while ensuring that they maintain their regulatory capital requirement. However, banks were also reaching for a higher yield in a low-interest-rate environment, which increased earnings per share. To achieve this, they migrated their government securities portfolios toward the higher-yielding government or government-backed securities that generally correlate with longer-dated maturities. Unfortunately, the long-term maturities of these securities need to be aligned with the short-term liabilities of deposits.

The Federal Reserve commenced steep interest rate hikes in Q2 2022, causing the bond yield to move inversely to interest rates. Government and government-backed securities with long-dated maturities declined in fair market value (FMV). Accounting rules allow banks to use the book value of specific securities rather than mark-to-market, which can create discrepancies between book value and FMV. The FDIC reported that the gap between book value and FMV at financial institutions increased from $8 billion in aggregate at the end of 2019 to $620 billion as of 2022.

The Bank run

SVB is a bank that specializes in making loans to startup companies. The bank required these startups to sign documentation pledging their assets as collateral to SVB. In addition, the documentation necessary for borrowers to maintain all their accounts and excess cash with SVB. As a startup receives and deposits the proceeds of its equity raise with SVB, SVB takes these deposits and lends a fraction of the monies to the startup and other borrowers. However, in Q3 2022, equity capital raising for startups became more complicated and decreased in amount and frequency. Deposits on hand at SVB began to decline, and this decrease accelerated in Q4 2022 into January-February 2023.

To address the deposit withdrawals, SVB took steps to raise cash for deposit withdrawals and pursued a capital raise. Moody notified SVB Financial Group that it was downgrading SVB Financial Group. On Wednesday, March 8, SVB sold approximately $21 billion in long-dated government securities, resulting in an accounting loss of approximately $1.8 billion. Moody's announced its downgrade of SVB on the evening of March 8. Certain venture capitalists and other prominent/influencer/celebrity startup investors began urging their portfolio companies, other affiliates, and followers to withdraw their funds from SVB.

On Thursday, March 9, customers of SVB attempted to withdraw $42 billion. On the morning of Friday, March 10, the California bank regulator shuttered SVB and assigned it to the FDIC as the receiver. However, regulators responded quickly, and on Sunday evening, March 12, 2023, Secretary of the Treasury Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, and FDIC Chairman Martin J. Gruenberg issued a statement informing Silicon Valley Bank and Signature Bank depositors and other customers that they would "have access to all of their money starting Monday, March 13." Furthermore, they stated, "The taxpayer will bear no losses associated with the resolution of Silicon Valley Bank.

The collapse of SVB has raised concerns among analysts about the Fed's monetary policy. Some experts believe the Fed could reduce its rate hikes in the short term. Although the US economy reported solid job and wage growth for February, Fed Chair Jerome Powell had previously hinted at a more significant than expected rate hike response. However, analysts are now tempering their views in the aftermath of the SVB and Signature Bank closures.

In a note to clients, Goldman Sachs said that it no longer expected the Fed to deliver a hike in its March 22 meeting "in light of recent stress in the banking system. An interest rate hike of 50bps is farfetched at this stage, especially given the fall of SVB stems from increasing rates over the last year. The fight against inflation is essential; however, its cost to the economy and jobs must be addressed. The latest report by the US Labor Department shows that the Consumer Price Index (CPI) rose by 0.4% in February, following a 0.5% increase in January. This development has led to a decline in the year-on-year increase in the CPI to 6.0% in February, which marks the smallest annual gain since September 2021.

The Core CPI, which excludes food and energy prices, also increased by 0.5% in February compared to a 0.4% rise in January. The year-over-year core CPI recorded a gain of 5.5%, a marginal decline from the 5.6% increase in January. Economists polled by Reuters had predicted that the monthly CPI and core CPI would rise by 0.4%.

Outlook

The collapse of investment firm SVB has sent shockwaves through financial markets, leading to a reassessment of the direction of Fed policy. Swaps traders are now pricing in a 50 percent chance that the Fed will hike by another quarter percentage point later this month. The collapse has prompted President Joe Biden to promise stronger regulation of U.S. lenders while reassuring depositors that their money is safe.

The collapse of SVB has triggered trading halts across the sector, with regional banks such as First Republic Bank plunging 62 percent. The KBW Bank Index logged its most significant one-day drop since the start of the Covid-19 pandemic. The fear is that a problem in one bank can trigger fears in other banks, leading to a wave of bank runs.

The Fed’s decision will incorporate two additional factors: this week’s CPI report and the potential for financial stress to build. While the threat of inflation has been a concern for some time, the collapse of SVB has led to increased worries about financial stability. The Fed has pushed on rates until something has cracked, and now something has. The Fed has to be off the table for now, with decisive action on financial stability giving the Fed latitude to continue with rate hikes.

The collapse of SVB has also led to speculation about what the Fed will do, with some predicting a 25bp Fed hike while others predict a cut in the target rate. However, such speculation is ill-founded, with the fed funds futures pricing in cuts in the fourth quarter and a 50 percent chance that the Fed will do nothing at the March meeting. The base case for the upcoming FOMC meeting is that the Fed will raise interest rates with 25 bps, but 50bps should not be off the table.