“When the facts change, I change my mind. What do you do, Sir?” While this quote is typically attributed to the famous economist John Maynard Keynes, historians are not sure he actually said it. Nevertheless, it is good advice, as many facts have changed in the wake of the failure of Silicon Valley Bank (SVB) and the subsequent decision by the Federal Deposit Insurance Commission (FDIC) and the Federal Reserve (Fed) to make all depositors whole. Taking the time to re-evaluate one’s views on the U.S. economic outlook makes considerable sense. And, in so doing we want to frame the dilemma facing the Fed as it makes difficult decisions about the path of short-term rates.
Question of Systematic Risk?
Bank deposits up to $250,000 are insured by the FDIC. In the wake of the SVB failure, the FDIC and the Fed jointly agreed, however, to make all depositors fully whole regardless of the amount by invoking the systematic risk exception clause. While the degree of systematic risk from the SVB failure did not appear to come close to the systematic breakdown that occurred with the bankruptcy of Lehman Brothers and the bailout of AIG back in September 2008 that led to the Great Recession, there were signs of a modest degree of systematic risk that might well have rapidly tilted the economy into recession.
That is, making all depositors fully whole was critically important to depositors at SVB, as well as many other small-to-moderate size regional banks that were exposed to a similar run on their deposits. Since SVB catered to businesses that typically held considerably more than $250,000 in their accounts, if the FDIC and the Fed had not decided to make depositors fully whole, many companies relying on SVB would not have been able to make payroll or pay vendors. Moreover, risks at other regional banks with large exposures to small company deposit accounts would have faced serious contagion. The domino effects that would have rippled through the economy from the payroll misses, employees being laid-off, vendors not being paid and other banks facing similar pressure, etc., in our assessment, would have immediately triggered rising unemployment, cutbacks in consumption, and declines in real GDP – that is, a recession. Such a recession would probably have been more like the 2001-2002 downturn, which was a relatively mild recession, and nothing like the Great Recession of 2008-09 when unemployment soared to 10%.
Our conclusion, shared by most analysts, is that the U.S. financial system as a whole does not appear to be at risk given that large banks are exceptionally well capitalized. Nevertheless, we will continue to monitor how market participants and financial institutions, along with regulators and central banks, manage banking system risks. That said, even after the resolution of the SVB failure, probabilities of the U.S. slipping into recession have risen. Many startup companies (i.e., without revenues) and some emerging companies (i.e., with revenues, but still negative free cash flow) may need to raise more capital in the next six to 18 months, and that will be much more difficult in the wake of the SVB failure. Lending standards are likely to tighten across the board. That is, slower economic growth as 2023 evolves may emerge from meaningful negative effects rippling through the U.S. economy, including further layoffs in the technology sector, from fin-tech to bio-tech to social-tech and beyond.
Inverted Yield Curve and Risk of Recession
Inverted yield curves have a well-deserved reputation as a reliable indicator of a potential U.S. recession down the road, and the U.S. yield curve remains inverted with short-term rates considerably above long-term Treasury yields. In the past, when an inverted yield curve occurred, something in the economy went awry or broke, and a recession ensued. In 1990-1991, it was the savings and loan crisis. In 2000-2002, it was the “tech wreck” on Wall Street. In 2008-2009, the sub-prime mortgage crisis triggered the Great Recession.
Figure 1: Inverted U.S. Treasury yield curve
Figure 2: Causes of U.S. Recessions
As the Fed has raised rates, we have been cautious and not made a U.S. recession our base case this time around because we were having trouble figuring out what might break or go awry in the economy. We now know that what broke was the interest-rate risk which was buried in the “hold to maturity” portfolio of SVB. “Hold to maturity” portfolios are not marked-to-market for the purposes of calculating required capital in the U.S. financial system. That is, a financial institution can purchase Treasury and mortgage-backed securities and designate them to be held until maturity and never traded. Since these securities are never supposed to be traded, the financial institution will receive their par value when they do mature.
As it turns out, many financial institutions, not just SVB, used these “hold to maturity” portfolios to take considerable interest rate risk by purchasing medium to long-dated fixed-income securities which would gain in value if bond yields declined and lose value if bond yields rose. Once the Fed started raising rates in 2022, the yield on U.S. 10-year Treasuries, for example, rose sharply, and prices fell. In the case of SVB, the mark-to-market on their “hold to maturity” portfolio would have shown an estimated $15 billion loss if they had to sell the securities, which would effectively have wiped out their equity capital. Even though the portfolio did not have to be marked-to-market for capital adequacy purposes, as investors became aware of the substantial losses in SVB’s portfolio, they factored this into their valuations of SVB as a going concern. And when SVB announced during the week of March 6, 2023, that they were seeking to raise more capital, it triggered a run on the bank, leading to its failure. SVB was not remotely alone in having losses in its “hold to maturity” portfolio, but the magnitude relative to the bank’s capital was exceptional, and the concentration of small technology companies in its depositor base exacerbated the problem once the bank run commenced. And in the online age, bank runs happen at the speed of a click, as we all witnessed.
Complications for the Fed’s dual mandate
Prior to the Fed being created in 1913, the U.S. had not had a central bank since the 1830s, when then President Andrew Jackson did not allow its charter to be renewed. The Fed was born in the aftermath of the 1907 financial crisis (or panic as it was termed back then) specifically to prevent systematic risk in the financial system leading to recessions. The Fed’s first test was the stock market crash of 1929, when many commercial banks held substantial equity portfolios. The Fed did not serve as a lender of last resort to the banking system as designed, and the Great Depression ensued. The historical memory of the Fed failing its first systematic risk test is deeply engrained in the modern Fed. Former Fed Chair Bernanke wrote his Ph.D. dissertation on the subject. The bottom line is that the Fed may have a dual mandate from the U.S. Congress to encourage full employment and price stability, yet the Fed’s duty to maintain the safety and security of the financial system takes primacy. Thus, while markets have been stabilized by the Fed-FDIC actions related to SVB, Fed decisions about future rate increases are going to be carefully evaluated in the light of a likely increase in the probability of a recession and any potential that additional systematic risk challenges might emerge from pushing the yield curve to an even more inverted state.
Market participants and the Fed will also be watching the European Central Bank (ECB) and the Swiss National Bank (SNB) as they manage stresses in the European banking system triggered by the troubles at Credit Suisse. The SNB has provided a massive loan facility for Credit Suisse, which gave the ECB the confidence to go ahead with a 0.50% rate rise in its efforts to constrain inflation in the eurozone.
Figure 3: Implied federal funds rates from the futures market
What the Fed will decide to do on rates is up for debate, however, federal fund futures show the degree by which market participants have re-assessed the probable rate decisions by the Fed. The situation remains fluid, so these market expectations could change between now and the next FOMC meeting and rate decision coming on March 22. As of March 16, though, the peak or terminal federal funds rate target range is now expected to be between 4.5% and 5.0%, essentially a toss-up as to whether the Fed raises rates again or pauses. This new market consensus represents a considerable downgrade from expectations held on March 7, just days before the SVB failure, which saw a sequence of rate rises extending through June 2023, with a peak rate between 5.5% and 6.0%.
Fed’s Inflation Dilemma
Consumer price inflation has come down on a year-over-year percentage basis from the 9% peak in June 2022 to 6% as of February 2023. Shelter inflation has been a challenge. The CPI inflation rate excluding shelter actually peaked above 10% and is now down to 5%. While that is encouraging progress, it still leaves the headline and core inflation rates well above the Fed’s 2% target. And, worries about inflation still influence consumer confidence in a negative way.
Figure 4: U.S. inflation
A critical point of debate within the Fed and among market participants is how patient the Fed should be in attempting to encourage inflation to decline to the 2% target. Pushing short-term rates well above the prevailing inflation rate, as former Fed Chair Volcker did in the early 1980s, virtually guarantees a severe recession. In the 1980-1982 case, unemployment rose to 10%, as the price of getting inflation under control. Fed Chair Powell has been more moderate, guiding that the Fed would like to see rates get to a sufficiently restrictive level and then the Fed would keep them there as it monitored the progress of reducing inflation. So, what is sufficiently restrictive?
One line of thought is that the federal funds rate needs to be above the prevailing rate of inflation to be restrictive. That is, rates adjusted for inflation (real interest rates) need to be positive. This would imply a 6%-plus federal funds rate if using the headline CPI, and a 5%-plus rate if using the core (excluding food and energy) PCE inflation rate as your guide. And we know the Fed is also watching the inflation excluding shelter rate, which would also imply a 5%-plus federal funds rate.
Another line of thought is that interest rate policy is restrictive once the yield curve is inverted, which it already is and has been for some time. From this line of thought, no further rate rises are needed at this time. We have seen that house prices, equity prices, and bond prices in the asset world have been hit hard by rising rates. And, we have witnessed that an inverted yield curve can cause pain in the banking sector and increases systematic risk. So, according to this view, if the Fed can be patient regarding how fast inflation declines, maybe no further work on rates needs to be done.
Yet another line of thought is that inflation cannot be tamed without tamping down aggregate demand by forcing the unemployment rate higher. A number of voices in the Fed, including Chair Powell, have made this argument. We note, however, that this surge in inflation was not created or led by rising labor costs. Pandemic fiscal and monetary stimulus while economic output was constrained by the shutdown of parts of the hospitality and travel sector of the economy, coupled with supply chain challenges, were the inflation culprits. Since in this episode, the primary causes of this inflation surge have all been removed, perhaps, one need not worry as much about creating unemployment to more rapidly reduce inflation, so long as one is patient.
Adding yet another complexity to the inflation debate is the likelihood that demographic headwinds may make it hard to return all the way to the 2% inflation rate target. Populations in China, Japan, Europe and the U.S. are aging, and baby-boomers are retiring in growing numbers. At the same time, the younger age cohort of 15-to-25 year-olds is no longer growing. That is, labor force growth is likely to be stagnant, unless the labor force participation rate rises materially. This suggests that rising labor costs are likely to continue, partly resulting in stickier service inflation where labor costs are key and potentially be a drag on earnings growth and serving as a headwind for any equity market rally.
For now in the aftermath of the tensions in the banking system, the market consensus is bouncing between the view that the Fed will pause or possibly will raise rates 0.25% at its March 22, 2023, FOMC meeting, and then, in light of rising recession risk, call that the terminal rate, pause and monitor the inflation progress. Raising rates by 0.25% is one way the Fed can imply that the current bout of systematic risk has been managed, while shifting the rhetoric to the rising probability of a recession as an argument to pause. Doing nothing would recognize that credit conditions are tightening and recession risks rising. In any case, markets will be on edge awaiting the Fed’s decision on rates as there is considerable uncertainty surrounding the consensus view, and even that view could change between now and the FOMC meeting.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.