2023-03-13 09:32:24 ET
Summary
- I believe that the SVB Financial Group collapse will prompt the Fed to aggressively rethink the interest-rate path for 2023/ early 2024.
- Notably, yields on the 2-year U.S. treasuries fell sharply in the past week.
- Moreover, eurodollar futures have already moved to now price two 25 basis point rate cuts by end of 2023.
Following the collapse of SVB Financial Group, the past week was quite a roller coaster for equity investors. And although over the weekend the FED introduced a $25 billion Bank Term Funding Program to stabilize the financial system, more support is likely in the making.
In this article, I will argue why I believe that the SVB collapse will prompt the Fed to aggressively rethink the interest-rate path for 2023/ early 2024.
That said, although knowing what happened to SVB is not a supremely important requirement for this article, I would quickly cite an abbreviated explanation of one of my previous articles where I tried to structure a "simple explanation." Depending on your level of interest, feel free to skip this passage, or refer to more detail - here :
The COVID-crisis prompted an unprecedented liquidity flood. This liquidity flood, which has been seen as a Fed put, provoked a boom in venture capital activity. This boom flushed start-ups and founders with cash, and Silicon Valley Bank, which has positioned itself as the bank for the venture capital market, enjoyed an inflow of deposits ... growing from $61.7 billion in 2019 to $173 billion as of December 2022.
Now, what should SVIB do with these deposits? With a compressed NIM spread (which was another consequence of QE), writing loans was not very attractive. So, SVIB decided to park the excess liquidity in U.S treasury securities and similar low-yield risk-free notes. Although these securities have been considered 'risk free', with the end of QE and start of QT these securities depreciated sharply in lock-step with rising interest rates. (Remember that the value/ price of a bond is inversely related to the interest rate level).
SIVB suddenly needed to struggle with falling prices of its holdings of fixed income securities. Meanwhile, concerns about a depreciating asset base were compounded by an outflow of deposits, as savers were seeking higher yield opportunities than parking cash at a bank. A balance sheet crunch was looming. And after the market woke up to SIVB's struggles, the meltdown materialized quickly.
So the situation is a bit perverse: While the 2008 financial collapse was caused by bank's exposure to non-investment-worthy mortgages, the SVB collapse was caused by excess exposure to risk-free government securities, where the bank bought the valuation top and failed to hedge the interest rate risk.
It is important to understand that the SVB's balance sheet composition was quite unique, and large U.S. banks don't share the SVB risk (read my article about JPMorgan Chase (JPM) - here) . But still, U.S. banks' portfolio of fixed income securities is not something to be ignored. As of early 2023, unrealized losses attributable to U.S. banks' HMS and AFS securities portfolio have exploded to $650 billion.
FDIC
Now, 'unrealized losses' don't matter much if they are held to maturity -- a thesis that is supported by JPM's capital management activity in 2022, when the bank moved $78.3 billion of securities from AFS to HTM. But it is also important to understand that, if the AFS and HMS portfolio would need to be liquidated in a fire sale-- for whatever reason--, financial stability would melt quickly.
The Fed is of course not ignorant to this fact. And this is exactly why a Fed 'pivot' now looks so extremely likely. Remember the saying: the Fed will/ must/ should tighten until something breaks. Now, something--even though minor--has broken. And given that the unknown risk is now known, the Fed will likely not push on with financial tightening until something big breaks.
Markets are acting on the thesis already. Notably, yields on the 2-year U.S. treasuries fell sharply in the past week. In fact, within only 3 days, traders pushed for a close to 75 basis point drop, something that has not occurred since 1987!
Moreover, eurodollar futures have already moved to now price two 25 basis point rate cuts by end of 2023.
All that said, a Fed pivot looks likely. And rightly so. Personally, I would rather have a few years of excess inflation over interest rates than a collapse of the U.S. financial system. The former feels like being slapped as compared to getting hit by a bus for the latter. I am sure the majority of Seeking Alpha readers will agree.
For further details see:
Prepare For The Fed 'Pivot'