James: Why Banks Are Blowing Up
Posted March 10, 2023
This entire trading week was meant to come down to a single economic report, the employment situation report released by the U.S. Bureau of Labor Statistics (BLS).
The only thing Wall Street wanted out of the employment report was confirmation that the Fed would stick with the previously suggested 25 basis point interest rate hike when they meet on March 22, or that labor and inflation were still out of control and a 50 basis point hike was back on the table.
Concern over a 50 basis point rate hike returned earlier this week when Chair Jerome Powell said the Federal Reserve would consider hiking rates by a half percentage point later this month and would likely keep rates higher, longer, to cool an economy that continues to run at full steam.
Here’s what the Chairman of the Fed told the Senate Banking Committee earlier this week:
“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. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
That’s Fed Speak for “Watch out, rates are headed higher!”
Almost immediately after Powell made those comments to the banking committee, the CME FedWatch Tool that prices in interest rate hikes and reductions showed that Wall Street had pivoted and was pricing in solid odds of a 50 basis point hike at the next meeting.
The current Federal Funds interest rate range is 4.50% to 4.75%.
The screengrab above shows that one month ago, on February 7, traders were pricing in about a 9% chance of a 50 basis point rate hike this month. But after Powell spoke to Senators, those odds spiked to nearly 70%.
Based on this data, we would immediately assume we’re staring at another big interest rate hike later this month.
But then Silicon Valley Bankcorp happened!
While this morning’s employment report continues to show a strong and resilient jobs market that, in the Fed’s view, needs to cool off, the Fed must now deal with the implosion of a large regional bank and the possibility that its desire to hike interest rates could further sink the financial sector.
Let me explain what I mean.
We learned on Thursday that SVB Financial, the parent of Silicon Valley Bank, was being surrounded by Wall Street vultures after news broke that SVB revealed that it would book a $1.8 billion after-tax loss on sales of investments and that it would need to raise around $2.25 billion through the sale of common and preferred stock.
The Fed’s to blame.
At the heart of SVB’s implosion is the fact that the Fed’s aggressive interest rate hiking campaign has caused the value of existing bonds with lower payouts to decline in value.
In some cases, the declines have been significant. Since banks like SVB own a ton of those bonds, we know that some banks are likely sitting on massive unrealized losses.
We always knew we’d need to pay the financial piper for those years of near-zero percentage interest rates, but clearly, institutions like SVB hoped the day of reckoning wouldn't come quite so soon!
Here’s where the inflationary economic data, rising interest rates, and the potential for contagion in the banking sector crash together...
While the economic data continues to come in above expectations and paint a picture of a stronger-than-desired labor market with strong inflation, the rising risk of banking contagion has put the Fed in a bind.
Suppose Powell hikes rates aggressively to further cool the labor market in hopes of bringing inflation down. In that case, he runs the genuine risk of also triggering a collapse in the banking sector -- especially among regional players like SVB.
Before Wednesday night, when SVB warned Wall Street that they had a problem with their loan portfolio, my investment team expected the Fed to hike by 50 basis points on March 22.
But with the collapse of SVB likely leading to its complete demise and the very high likelihood that SVB is not the only regional bank to have made countless questionable loans with cheap or free money, my team and I are on the fence regarding this month’s rate hike.
Will the Fed hike rates later this month? Absolutely.
But rather than a half percentage point being a near certainty, we now believe the odds favor a smaller, quarter-point hike.
Interest rate hikes aside, this week’s loan portfolio blow-up at Silicon Valley Bank has reminded Wall Street and the Fed that pushing rates from near-zero to almost 5% in 12 months isn’t an economically risk-free endeavor. SVB may be the shot heard ‘round Wall Street, but the odds of it being a one-off occurrence are between slim and none, and slim just left town.
We’ll continue to keep an ear to the ground as the situation continues to unfold and, of course, report back to you.