Policy Error, Risk Management, and 'There's An App For That'
Equities were mixed last week, while bonds moved higher as confidence in the banking sector continued to waiver.
First, a quick recap on how we got into this mess. Unlike prior banking crises, current situation began not with a "solvency" crisis, but an initial liquidity crisis that has morphed into a confidence crisis in the banking sector.
It has been driven by Fed policy error, bank risk management error, and technological advances in the banking industry.
In short, the Fed continued to raise rates too high, causing short-term Treasury bond yields to look far more attractive than traditional bank deposit account yields. Banks continued to make the higher margins on Treasury investments, while offering paltry interest rates on those same deposit accounts. As depositors realized the discrepancy, mobile apps and online banking allowed depositors the ability to quickly transfer balances to accounts where Treasuries could be purchased. In turn, banks couldn't liquidate treasury and security holdings that were pledged against deposits and a liquidity crunch began. It started with Silicon Valley Bank (who didn't even have a Risk Management Officer at the company at the time the crisis started). It has since bled over to Signature Bank. Now, First Republic Bank and Credit Suisse have been purchased by competitors.
It's important to note that this is not a 1930s style liquidity/confidence crisis.
The Fed/Treasury has stepped in with the Bank Term Funding Program and over the weekend announced a coordinated effort with other Central Banks to to enhance the provision of liquidity via the standing US dollar liquidity swap lines with daily 7-day maturity operations. So far, only two banks have officially failed. On average, 7 banks have failed per year over the last 10 years. The difference this time is the size of the banks. If the contagion stops here, it's possible markets recover.
On the economic front, inflation (as measured by both CPI & PPI) dropped in February for the 8th consecutive month on a year-over-year basis.
This further cements the Fed’s rate policy error as inflation has peaked and a pause in rate hikes would have been prudent months ago. The economy is stable at the moment as the National Financial Conditions Index is not pointing to a recession yet. In previous periods (2007 & 2020), the index quickly turned positive, meaning financial conditions were worsening.
It's solidly in negative territory. Credit Card delinquencies are no where near the levels of 2001 or 2007. The implied futures on this week's rate decision favor a 25 basis point rate hike. However, the probability of no rate hike is at its highest with a 28% probability. Now the Fed is backed into a corner: another rate hike this week could further the banking crisis with more depositor withdrawals; no rate hike could be taken by the market as a sign this crisis is worse than originally realized.
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