Market Commentary March 2023
MARCH MARKET COMMENTARY
Recent market developments and some potential implications
With the recent Silicon Valley Bank failure dominating headlines over the past couple weeks we would like to share our views on what happened, the potential for contagion risk (which we view as unlikely) and some additional implications for financial markets.
As we saw on March 10th, financial regulators shut down Silicon Valley Bank (SVB), making it the largest banking collapse since the failure of Washington Mutual in 2008.
Broadly speaking, the risk of financial contagion is mitigated because the broader banking system does not share the same vulnerabilities that Silicon Valley Bank had. Some of the primary differences include but are not limited to:
- Concentrated customer base
- Recent deposit growth was extremely rapid
- Invested in higher share of long-dated bonds relative to overall banking industry
The SVB customer base consisted largely of venture capital firms and start up technology companies. This means that SVB’s clients are not like average regional banking clients. This can be seen by the breakdown of their deposit base:Another circumstance that left SVB more exposed than the average regional bank is that because of the numerous newly minted millionaires that made up their customer base, SVB’s deposit base ballooned to nearly 3 times what it was pre-pandemic.
This rapid growth in deposit base led SVB to invest all this excess cash in what they deemed to be safe securities—Treasury and agency bonds. However, there was a caveat to the safety of these securities. They were only safe if they could be held to maturity.
In a rising interest rate environment, lower yielding fixed income instruments lose value as they become less attractive in the overall market. Because SVB bought a lot of their Treasury and agency bonds in the low-rate environment of 2020 and 2021, when rates rapidly rose in 2022, the value of those securities dropped fairly significantly. A bank’s financial securities losing value often does not cause so much distress. Unless, of course, a high proportion of a bank’s depositors want to withdraw their funds at the same time.
As Harvard Professor, and former US Treasury Secretary, Larry Summers put it, SVB “committed one of the most elementary errors in banking: borrowing money in the short term and investing it in the long term. When interest rates went up, the assets lost their value and put the institution in a problematic situation.”
Further limiting the possibility of financial contagion is the fact that the banking sector is much healthier today than it was leading up to the Great Financial Crisis. As can be seen in the following chart, the Tier 1 Capital Ratio (defined as the core equity capital of a banking entity to its risk-weighted assets; in simpler terms, it is the first level of capital available to absorb losses) at US banks is near its 30-year high:In addition, the Fed’s policy response to the situation could help bolster the financial system. In early March, the market was pricing in a likely 50 basis point rate hike at the upcoming March Federal Open Market Committee (FOMC) meeting. Now, consensus stands at 25 basis points with some strategists leaning more towards no interest rate hike. At Wolf Group Capital Advisors, we believe the Fed will raise the Fed Funds rate by 25 basis points. While these decisions are always complicated and nuanced, one intention of raising rates would be to avoid scaring market participants were the Fed to keep rates the same. That is, if the Fed were to pause, they could give the impression that things are worse than what everyone thinks, thereby rattling markets even further.
Lastly, with other banks struggling and/or failing or being consolidated, the U.S. Government announced a powerful response, which included:
- Full protection of all insured and uninsured deposits at the failed banks
- A New Bank Term Funding Program (BTFP) was established at the Fed
- This allows banks to access liquidity at the Fed as opposed to having to realize losses
- Specifically, the importance of the BTFP is that it allows banks to post their Treasuries as collateral at par
The above response should help stem outflows from regional banks and provide additional liquidity where needed to banks that may remain under pressure. In theory, this forceful response should help prevent the mass banking consolidation that many were expecting as multiple regional banks were teetering.
In summary, while the events of the past two weeks have been unnerving, they should not rise to the level of systemic risk to the banking or financial system. The U.S. Government has proven they are willing to step in and create liquidity where needed to help backstop the regional banking sector. This has calmed markets.
What may further settle markets is that the Federal Reserve, while not completely pivoting, could strike a more dovish forward-looking tone. During the December FOMC meeting, the Committee was worried about loosening financial conditions. Based on the last two weeks, we are under the assumption those concerns have, at least, slightly dissipated. With the current target federal funds rate at a range of 4.50% to 4.75%, we would anticipate the Fed hiking one more time at 0.25% and perhaps leaving the door open for a further hike. With that said, the vast majority of tightening has likely already occurred. We must now consider an environment where the Fed soon pauses its interest rate hikes and transitions into more of a wait-and-see mode.
This environment creates a new set of challenges and opportunities. We look forward to navigating this evolving landscape with our clients. And as always, we will do so through a combination of thoughtful financial planning and disciplined investment management.
Chief Investment Officer
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