Banks and the Markets: What Investors Need to Know
In this article we review:
- The sudden and unexpected collapses of Silicon Valley Bank and Signature Bank
- The swift government actions taken, in our view helping to avert a further crisis
- The establishment of the Fed’s Bank Term Funding Program and why that could play a crucial role moving forward
- The rescue acquisition of Credit Suisse Group AG by UBS Group AG and its potential impact on the global markets
- How these events should be viewed in combination with recent inflation data and why they could change the pace of Federal Reserve rate hikes
- Potential impacts of these events on the stock and bond markets
The sudden and unexpected closures of Silicon Valley Bank (SIVB) and Signature Bank (SBNY) spurred government action and quickly resulted in declining stock prices and falling interest rates as markets looked to sort through previously unrecognized risks in the banking sector and the prospects of wider contagion and broader economic spillover. These concerns were further accelerated on a global basis following announcements made by Credit Suisse Group AG (Credit Suisse) and its lead investor, Saudi National Bank, representative of deteriorating financial conditions at Credit Suisse, ultimately requiring its acquisition by UBS Group AG (UBS).
With this backdrop, we believe pertinent points for investors to consider include the following:
We view the swift actions of the Federal Reserve, U.S. Treasury Department, and Federal Deposit Insurance Corporation (FDIC) as being crucial in averting a potentially wider crisis in the financial system. Following the collapse of SIVB and SBNY, these three entities jointly announced actions to enable the FDIC to complete its resolutions of SIVB and SBNY in a manner fully protecting all depositors, both insured and uninsured. Under this scenario, no depositors at either bank will lose money, though stock and bond investors will be subject to losses. This outcome has provided safety for depositors while not bailing out investors or the banks themselves.
The Fed also announced additional funding for eligible depository institutions through the creation of the new Bank Term Funding Program (BTFP). This new program will offer loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions allowing for U.S. Treasury bonds, agency debt, and mortgage-backed securities to be pledged as collateral.
Of vital significance in this new program is that banks will now be able to garner liquidity by receiving up to one-year loans from the government based on the par value (maturity value) of their bond portfolios. This component of the BTFP could prove critical to avoiding future collapses. Allowing banks to raise capital using the maturity value of their bonds as collateral rather than current market prices (which for most banks have declined materially amid the rising interest rate environment of the past year) should serve to mitigate major balance sheet shortfalls (which played a major role in the SIVB and SBNY collapses).
It is also important to emphasize that unlike the global financial crisis of 2008, the SIVB and SBNY failures appear to be mostly the results of asset liability mismanagement as opposed to widespread credit deterioration throughout the banking system. While the risk of duration mismatch between deposits and longer-term Treasury bond portfolios certainly took its toll in these cases, systemically speaking, we would view the current banking environment as being in more of a liquidity crisis than a credit crisis and thereby effectively addressed through actions such as establishing the BTFP. Therefore, while the overall situation in the banking industry, and for regional banks in particular, remains a fluid one and there is clearly much to play out in the days and weeks ahead, we view recent government actions as helping to avert a greater liquidity crisis and potentially deterring contagion fears and depositor angst.
Global banking concerns have been further exacerbated by the deteriorating financial condition of Credit Suisse, ultimately requiring a rescue acquisition by UBS and substantial capital commitments from the Swiss National Bank. Following news from Credit Suisse on March 16 of “material weakness in financial reporting” and a statement from its lead investor, Saudi National Bank, that no further investment would be forthcoming, markets reacted in a strongly negative manner to both this stock and the European banking sector. On March 19, it was then announced that UBS would be acquiring Credit Suisse for approximately 3 billion Swiss francs ($3.2 billion), reflecting about a 60% discount to the previous trading day's Credit Suisse closing stock price and about 90% below its stock price of a year ago. The UBS acquisition also came accompanied with a pledged loan from the Swiss National Bank of 108 billion Swiss francs ($100 billion) and a guarantee from the Swiss government to assume losses of up to $9 billion Swiss francs ($9.6 billion). Despite these actions by UBS and the Swiss government preventing Credit Suisse from failure, stock and bondholders of the bank now face major losses and this overall development could likely add to global economic uncertainty and market volatility.
Immediately following the UBS-Credit Suisse acquisition announcement, a coordinated statement was made by six global central banks regarding access to U.S. dollar funding. This group included the Swiss National Bank and U.S. Federal Reserve stating that weekly auctions of U.S. dollars, also known as dollar swap lines, would be moving from a weekly to daily basis lasting at least through the end of April, thereby increasing access to dollar-denominated funding and further ensuring liquidity throughout the global banking system. While markets appear to be viewing this as a positive coordinated move by central banks, there is some question as to whether it has been implemented for precautionary or reactionary purposes. Daily auctions of U.S. dollars by central banks last took place in 2020 at the height of the COVID-19 crisis.
The SIVB and SBNY collapses combined with the growing global banking concerns fueled by Credit Suisse will likely now impact Fed policy in the months ahead. These recent events, in our judgment, could now be shifting the Fed’s primary emphasis from fighting inflation to avoiding systemic damage in the financial system. While the Fed will certainly maintain its inflation fighting profile, there now appears to be a meaningful probability the Fed could take a pause on raising rates at the upcoming March meeting. This could be for no other reason than to survey the ongoing effects of the past year’s rate increases and let financial conditions absorb the recent bank closures, and the government’s response to them. Regardless of whether the Fed passes on a rate hike or raises the federal funds rate by 0.25% at its March 22 meeting, we would still be reticent at this point to accept newer market expectations of the Fed cutting rates in the second half of the year. We believe the Fed is likely to remain resolved in its battle against inflation, even after perhaps concluding the current tightening cycle in the months ahead.
Recent inflation data, in our view, also increases the probability of the Fed concluding the current tightening cycle by midyear. Under this scenario, we could see the tightening cycle finishing in the summer months perhaps after one or two more quarter-point rate hikes and with a lower bound on the federal funds rate in the range of 4.75%–5.00%. Such an outcome could be further supported by the recent February Consumer Price Index report displaying headline year-over-year inflation of 6%, its lowest level since September 2021, and a core (ex food and energy) reading of 5.5%, its lowest since December 2021. While this pace of declining inflation is far from rapid and will be subject to monthly aberrations, we feel there is enough in the general trend to warrant the Fed concluding rate hikes by about midyear to assess conditions and let higher rates fully filter through the economy.
Nonetheless, the two bank closures and the tighter credit and financial conditions that are still likely to ensue, combined with growing banking uncertainties in Europe, in our view, support the recession risk we view as increasing into the second half of the year. We continue to believe there is a high probability of recession beginning by year-end and, at this point, we still lean toward a moderate downturn similar in nature to those beginning in 1990 and 2001 rather than a prolonged and severe recession akin to those beginning in 1981 or 2007. While recent employment and consumer spending data, released prior to the SIVB and SBNY closures, has been strong, leading economic indicators, such as the Conference Board Leading Economic Index and the currently inverted slope of the Treasury bond yield curve, in our judgment, continue to point toward a high probability of recession beginning in the year ahead.
Even though longer-term interest rates have recently come down following the SIVB and SBNY collapses, we still caution bond investors to heed the risk of the currently inverted yield curve and the potential future upward path of longer-term rates. As of market close on March 17, the 3-month to 10-year Treasury yield curve stood at an inversion of 1.13% (4.52% vs. 3.39%), representing close to its widest margin in more than 40 years and, on a percentage of yield, close to its widest ever. History has shown yield curves typically invert prior to recessions and return to upward slopes as those downturns play out, which has proved to be the case in all eight recessions since 1969. Therefore, should the Fed continue to raise rates, or even simply hold tight at current levels, into an approaching recession, it is most likely the yield curve eventually reconciles to an upward slope via rising long-term rates, and for this reason we believe fixed income investors will be better positioned in short- and intermediate-term maturities.
We believe strong opportunities still exist in short- and intermediate-term corporate bonds. High-yield bonds are now offering close to their highest levels of income since 2020 (ICE BofA US High Yield Index Effective Yield 8.8% March 17) and investment-grade bonds close to their highest yields since 2009 (ICE BofA Single-A US Corporate Index Effective Yield 5.1% March 17). Even given the recent bank closures initiating government actions, we still view overall credit risk in the corporate markets as more benign than prior to previous recessions. This is due, in large part, not only to the BTFP put into place by the Fed but also opportunistic refinancings during the pandemic and aggregate maturity schedules in the corporate markets more heavily weighted toward the latter parts of the decade.
Finally, while we see the equity markets remaining volatile in the months ahead, we are maintaining our year-end S&P 500® price target of 4,400. This is based, in large part, on the markets looking past a moderate recession, recovering in the aftermath of peak inflation, and the conclusion of the Fed’s tightening cycle as well as an improving corporate earnings outlook in CY 2024.
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