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Did We Just Drive Onto the Shoulder?

Did We Just Drive Onto the Shoulder?

March 13, 2023

Bank Failures - Did We Just Drive Onto the Shoulder

In February of 2022 I wrote on this blog:

"We did have something new last year that looks like it will be with us a bit longer than first expected - inflation. To put it simply, there is too much money chasing too few goods. Sprinkle in a little pent-up demand from the pandemic, and voila, prices go up. The only question is - will the Fed run the economy into the ditch trying to tamp down inflation?

Federal Reserve Rate Hikes

Jerome Powell and the Federal Open Market Committee has been on a tear, raising rates in an attempt to get inflation under control. So far, they've managed to lower the rate inflation somewhat, but they still aren't satisfied with the results. I attended a meeting in December where the keynote was the number two person at the Atlanta Fed. He was very clear that they were way more concerned about inflation becoming imbedded in our economy short-term than they were about damaging the economy long-term. The question now is, did they just drive onto the shoulder and did it wake them up?

We're not in a ditch...yet.

Keep in mind, the Federal Reserve has two economic mandates. One is full employment, the other is inflation below 2%. But with just about any large scale Federal Program, there are going to be "unintended consequences".  As I've said probably a thousand times, "when interest rates go up, bond prices go down", and aggressive rates hikes are beginning to cause consequences - intended or otherwise.

One, 2022 was the worst year for bonds in history. Yep, you read that right, and you likely saw it play out if you own bond mutual funds. The Barclays Bond Aggregate Index - which is arguably the most used index to measure bond returns - was down a whopping 15% in 2022. 

In some ways, normalizing interest rates is a good thing. Fixed income investors are now able to obtain returns on low risk assets that are more consistent with historical norms. But it's difficult for a bank, or any institution - to take a 15% reduction in the value of their fixed income portfolios (that aren't supposed to go down that much) and not have a ripple affect.  As I heard it said today by Mohamed El-Erian, on CNBC "This is what happens when you slam on the brakes".

Which brings me to number two -  the failure of Silicon Valley Bank or SVB.  Apparently a while back, SVB decided to purchase bonds that didn't mature for many years because, at the time, they were able to earn enough on those bonds to support higher interest rates for their customers, which attracted new business. Their customers aren't your average everyday Americans, but venture capital firms that raise money for brand new companies also known as start-ups. This worked for a while, but in September when rates really started to climb, SVB was apparently caught flat footed and ended up selling the bonds at a huge discount/loss to raise money. Then the online rumor mill in Silicon Valley started and there was a run on the bank. 

Now what? Since Friday, there have been 3 banks to fail in some way. One of them, Signature Bank - which happens to have Barnie Frank on their Board - failed at least in part because of losses in Crypto Currency. They great irony is that Barnie Frank wrote the bill known as "Dodd-Frank" which heightened financial requirements for banks after the Great Financial Crisis, but in my opinion, this is likely an isolated case.

I'm not certain, but it seems to me now that the Federal Government has back-stopped depositors, we should be ok. However, much depends on whether or not the Federal Reserve continues to aggressively raise interest rates. We're likely to find out next week when the Federal Open Market Committee (FOMC) announces their next increase.

One thing that I find interesting is that this was the first "digital" run on a bank in history. Remember the movie It's a Wonderful Life when George and Mary were leaving on their honeymoon and there were lines of people waiting in the rain to get their money out, including The Building and Loan. This time, there were no lines or waiting in the rain. Customers of SVB simply wired their money out to another institution.