March 13, 2023Scroll down
Mr. Powell goes to Washington
Last Tuesday, Fed Chair Jerome Powell kicked off a two-day visit to Capitol Hill, warning Congress that the central bank might need to raise interest rates at an even faster clip if the recent streak of strong economic data continues. That data, he said, “suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.” Not surprisingly, the equity investors who “previously anticipated” something less than 5% peak policy rates didn’t like this message and proceeded to sell off their stocks, sending markets lower in the wake of Powell’s testimony. Short-term Treasuries also sold off, and FX traders bid up the dollar in anticipation of more rate hikes ahead. At the same time, 10-year bond yields fell, reflecting greater fear that the Fed might be overshooting and upping the odds of a hard landing. The market’s expectations for the next FOMC meeting in late March have also changed materially. Before Powell spoke with legislators, Fed Funds futures put the probability of a return to 50 bps rate hikes at the next meeting at just 30%. After Powell’s first day on the Hill, those odds had shot up to 75%.
Keep an eye on inflation expectations
The shifting Fed narrative, with much greater emphasis now on the speed of rate hikes, speaks to a growing concern that inflation is becoming stickier, as rising prices have moved from goods to services, where inflation has historically tended to be more persistent. Central bankers are especially sensitive to the risk that inflation becomes entrenched, leading to a vicious cycle by which the mere expectation of future inflation on the part of businesses and consumers becomes a self-fulfilling prophecy: Companies raise prices and laborers demand wage increases in tune with their beliefs about future inflation, which causes an increase in the CPI that only serves to reinforce everyone’s worst fears. The longer inflation remains high, the greater the chances that households and firms bake this bleak view into their expectations—and the longer it takes to bring inflation down. Indeed, so important are inflation expectations to the Fed’s decision-making, the bank spends a great deal of time tracking beliefs about future prices changes (see below).
From the chart, it’s clear what worries the Fed. Although consumers’ expectations for one-year-ahead inflation have come down from their 2022 Q2 peak, they’re still well above the bank’s 2% target, and the predictions of professional forecasters and businesses surveyed by the Fed have barely budged from historic highs. As long as surveys show households and firms in the grip of inflationary fear, expect the Fed to up the ante in its bid to break the cycle.
Biggest bank failure since 2008
In just around 48 hours, tech lender Silicon Valley Bank, a few days ago ranking as the 16th-largest bank in the country, faced a liquidity crisis that morphed into a classic bank run, prompting California financial regulators on Friday to step in and close the institution down after 40 years in business. What exactly happened? The drama began on Wednesday, when SVB made a surprise announcement that it would be tapping equity investors for just over $2 billion. That capital raise was necessary because the bank had just dumped its entire portfolio of so-called “available-for-sale” securities—bonds held on its balance sheet and ready to be sold on short notice to meet liquidity needs—recording a $1.8 billion loss on the sale. By the bank’s account, its equity sale was simply intended to add back some cushion to its balance sheet. The bank’s close-knit network of tech startup and VC clients didn’t see it that way and collectively decided none of them wanted to have money stuck in a failed bank. Deposits began flooding out and by the end of Thursday, some $42 billion had gone out the door, SVB’s stock was down 60% at the market’s close, and there was talk of insolvency. On Friday, attempts to find a buyer had come up short and regulators closed things down, marking the second-largest bank failure in American history.
Pandemic weirdness set the stage for SVB’s collapse
It turns out the seeds for SVB’s failure were sown many years ago, as a decade of zero interest-rate policy (ZIRP) encouraged investors of all kinds, including those managing some banks’ balance sheets, to chase yield by taking risk. Such policy distortions were exacerbated by the pandemic, which played an especially significant role in SVB’s case, as the post-COVID tech boom led its Silicon Valley clients to flood the bank with deposits. Its deposit balance more than triple through the first quarter of 2022, outpacing a still-impressive industry average growth of 37% over the same period. Seeking bigger profits and recognizing that (a) there wasn’t much demand for loans and (b) short-term government bonds didn’t offer much of a spread, the bank plowed a majority of those funds into higher-yielding long-duration bonds. Of course, longer duration means greater sensitivity to changes in interest rates, and as the Fed ratcheted up rates in 2022, SVB began taking heavy paper losses on its book of bond holdings. Fortunately for the bank, because longer-duration bonds were kept in its “held-to-maturity” account (a counterpart to the “available-for-sale” classification mentioned before), these mark-to-market changes in value didn’t bear on the bank’s solvency.
Tech sector troubles trigger bank’s downfall
For a time, it was business as usual. Unfortunately, things began to unravel for SVB in recent months, as the bank’s tech-centric clientele encountered a much tougher environment for fundraising. Consequently, startup clients were no longer adding to their balances and, to the bank’s surprise, their cash burn rate hadn’t changed much despite the gloomier outlook for the sector, so they were actually drawing down on their accounts. Moreover, rising policy rates meant increasingly attractive yields on Treasuries, which saw many tech clients pulling their deposits altogether and choosing government bonds as a better risk-free place to park their cash. The bank’s natural response should have been to increase its own rate offered on deposits to stay competitive, but that wasn’t possible given so much of its assets had been invested in held-to-maturity assets at low yields, the sale of which would have immediately plunged the bank into insolvency. SVB held on as long as it could, but the gradual drain on deposits ultimately required a shoring up of its balance sheet, which set the wheels of last week’s crisis in motion.
Fed rate hike damage appearing on a lag
While we believe the risk of a systemic crisis in the financial sector is still relatively small, SVB’s sudden implosion does point to broader macroeconomic issues—issues we have been talking about for some time. Monetary policy is known to operate on a significant lag. The effects of rate hikes, even those implemented as aggressively as we’ve seen in the current tightening cycle, don’t hit the economy immediately. The plight of Silicon Valley Bank illustrates in terrific detail how such a rapid increase in rates gradually works its way through the system, exposing faults that emerged over many years. It’s notable that the first big layoffs of this cycle occurred in the tech sector, where the pandemic boom led to apparent over-hiring: a dynamic mirrored by the rapid increase and drawdown in SVB deposits. What began in the tech sector will, of course, not be confined there, and that’s what should concern investors who might have become too complacent about the risk in risk assets. Going forward, we expect the last twelve months of restrictive Fed policy to continue playing out in the real economy in increasingly visible ways. If the equity market fallout of this episode is any indication, the fear entering stock prices will present plenty of bargains for rational investors in the months ahead.