It was another exciting ride this month in the bond market. The 10T dropped about 50bps to 3.5% and the 2T lost roughly 80bps to 4.1%, with multiple daily swings of 30bps+.
While recent economic data has supported the Fed’s case to continue raising rates, turmoil in the banking sector and fears the crisis may spill over into the larger market have raised questions on the Fed’s ability to further tighten conditions without exasperating the issue.
Data Source: Bloomberg
Volatility spiked as uncertainty gripped markets. We can see this in the dramatic shifts in rate expectations (the forward curve) from one day to the next.
The market was debating whether the Fed would continue to hike rates given the emerging cracks in the economy .
The FOMC stated months ago that they expected economic pain on the path towards lower inflation, the FOMC’s credibility would be brought into question if they balked at the first signs of pain.
Data Source: Bloomberg
Economic Data Remains Strong
The February jobs report showed the US labor market remained resilient despite stubborn inflation and an aggressive tightening cycle by the Fed, with the economy adding 311k jobs vs expectations for a 203k increase. Monthly job gains over the past six months have averaged 343k, so while 311k marks a slowdown from the recent trend, the pace of job growth is still too rapid to sway the Fed from continuing to push rates higher.
With the unemployment rate close to all-time lows at 3.6%, the labor market appears to be getting tighter.
Inflation continues to run stubbornly high, with core CPI increasing 0.5% in February, the highest reading in five months. Shelter cost, which represent over 34% of the CPI index, increased 8.1% over the last 12 months, the highest since June 1982.
PCE data is in line with other inflation metrics, such as CPI, which suggest that inflation peaked in the summer, but remains elevated.
Bottom line – Inflation remains sticky and the labor market continues to be strong, both of which support the Fed’s case to continue raising rates if taken in isolation.
The main event in March was not the FOMC meeting, but the collapse of Silicon Valley Bank and concern the crisis would spread as a larger bank run. So far that has not been the case, as the issues facing SVB were as much to do with management decisions as with the tighter financial conditions.
- SVB had a large proportion of deposits from startups, many of whom received large cash injections during the COVID stimulus days. For context, from 2020-2021 deposits at US banks rose by $5.40 trillion.
- The vast majority of the bank’s depositors had well over the FDIC’s $250,000 limit, with $152 billion out of its total $173 billion deposits being uninsured.
- In 2021 SVB invested heavily in longer-term securities in search for yields, increasing the duration of the bank’s Treasury and MBS portfolio to 6.2 years.
- Interest rates increased, collapsing the market value of SVB’s securities portfolio at the same time venture capital funding evaporated.
- SVB had more assets than liabilities, but a good deal of its assets could not be liquidated without major loses, making the bank technically insolvent.
- While SVB was trying to finalize a plan to liquidate securities and improve the balance sheet, Moody’s downgraded the bank’s debt and word quickly spread, sparking many of the bank’s customers to withdraw their money. According to California’s bank regulator, customers initiated $42 billion of withdrawals from SVB on March 9th, representing a quarter of its total deposit base.
The larger concern was contagion; would other banks face a run by depositors as liquidity evaporated? During the Great Depression over 9,000 banks collapsed, with almost 2,000 banks failing in the first two years of the recession. In response, the government established the Federal Deposit Insurance Corporation (FDIC) in 1933. The insurance was less about actually paying out depositors in the event of a crisis, but instead giving bank customers confidence they wouldn’t lose their money if their bank failed. By giving depositors a guarantee the government would step-in if their bank couldn’t meet withdraw request, it effectively stopped bank runs before they started.
It is then no surprise that the government took a similar approach to the SVB crisis by making additional funding available to eligible banks through the Bank Term Funding Program. From the joint statement released by the FDIC, Treasury Department, and Federal Reserve (emphasis ours):
“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer…
Shareholders and certain unsecured debtholders will not be protected. Senior management has also been removed. Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law. Finally, the Federal Reserve Board on Sunday announced it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.”
We will see if SVB (and Signature Bank) were an anomaly or a symptom of a larger issue, but for now the crisis appears to be somewhat contained.
There was tremendous uncertainty on whether the Fed would hike in March or pause. Prior to the SVB Crisis, we received a strong jobs report and inflation data was higher than expected, so Chairman Powell and the rest of the FOMC were expecting to continue tightening financial conditions in an effort to bring down inflation. Earlier in the month Powell told Congress,
“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”
At the beginning of March, the fed funds rate was 4.60% and the market was pricing in a 70%+ chance of a 50bp hike following strong economic data and hawkish Fed speak, with rates peaking at 5.70% and ending the year at 5.55%. The previous summary of economic projections by the FOMC were released in December and the committee was forecasting a 5.15% fed funds level at the end of the year, so expectations were for the Fed to increase rate expectations this year.
And then SVB failed, and pets’ heads were falling off… Rate expectations collapsed, with the market taking a 50bp increase off the table and pricing in an 82% chance of a 25bp hike. Following the meeting the market was forecasting a peak rate of 4.96% and fed funds to end the year at 4.37%…over 100bps lower than forecasted at the beginning of the month.
Data Source: Bloomberg
The Fed was walking a tightrope…risk exasperating the bank crisis by continuing to hike rates or lose credibility on its battle against inflation and hit pause. Given the Fed’s recent rhetoric, it was no great surprise the Fed elected to raise fed funds by 25bps to sustain their crusade against inflation.
The FOMC did acknowledge the elephant in the room in its post- decision statement, stating “The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effect is uncertain. The Committee remains highly attentive to inflation risks.”
Chart Source: Bloomberg
Cap costs moved lower by the end of March, but for about a week following SVB’s collapse cap, pricing increased 30%+ despite rates being down over 50bps. The driver was volatility, which spiked to it’s highest level since the financial crisis.
Fortunately volatility has been settling over the past couple of weeks, significantly improving cap cost. Pricing ended the month down about 30%.
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