A brief – What has happened so far
At the core of the crisis of Silicon Valley Bank, as well as the closures of Signature Bank and Silvergate Bank, are massive losses that piled up on the bank’s internal holdings of U.S. treasuries. While we won’t get too far into the details of what has happened at these banks, as it has been widely covered by the broader financial media, the U.S. regulatory response to this crisis has significantly increased the likelihood that interest rates could be at, or near, a top for the foreseeable future, regardless of the lingering impacts of inflation.
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The rapid and steady increase of interest rates over the last 18 months has created huge losses in the bond portfolios of these institutions. In the case of financial institutions like Silicon Valley Bank, it was these bond losses that led to the bank not having enough money to cover large withdrawals from its primarily tech-based clientele.
On Sunday, March 12, 2023, when U.S. regulators announced that they would step in to back-stop all deposits in these now-failed banks, they highlighted that this would primarily be done through a new lending facility aimed at providing extra funding to eligible institutions to ensure the banks would have the ability to meet the needs of its depositors.
The primary asset base of the failed banks was U.S. Treasuries – the primary form of collateral used to access the lending facility. For the most part, these U.S. Treasuries will be taken at their par value by the U.S. Federal Reserve (the “Fed”), in exchange for funds for depositors.
While not explicit, this move signals the Fed’s intent to backstop the U.S. Treasury holdings of U.S. banks and effectively reprices the U.S. Treasury market extensively, given there is an implicit Fed backstop on major holders of treasuries.
The chart below shows the extent of uninsured deposits of the major U.S. banks. The majority of assets under management (AUM) in these buckets is comprised of “Held-to-Maturity” assets, like U.S. Treasuries, that are likely in substantial loss positions. If there is a major repricing of risk on U.S. Treasuries, significant changes in these values are reflected in the treasury market.
Source: S&P Global Inc., March 13, 2023
Could This Impact Interest Rates?
If rising interest rates have exposed the significant risk to the banking of “Held-to-Maturity” assets, then the Fed’s commitment to raising rates to battle inflation starts to become problematic as higher rates increasingly threaten the stability of the global banking system. Any major collapse of institutions is an incredible deflationary risk.
As a result, the market has taken a 180-degree turn on its outlook for Fed interest rate hikes as observed in the following two Bloomberg charts. The first chart is the Fed overnight outlook consensus from the U.S. analyst community as at March 7, 2023, with the implied overnight rate targeted at over 5.5% going into June.
Source: Bloomberg, as at March 7, 2023
Take a look at the chart in the aftermath of the collapse of the three banks below, as at March 15, 2023. The updated consensus now highlights an expectation of implied cuts occurring in the back half of 2023. The market is now betting, in a big way, that regardless of what the Fed does at its March meeting, the era of rate rises is over after that session.
Source: Bloomberg, as at March 15, 2023
This can create confusion for ETF investors who are also likely seeing that U.S. Consumer Price Index inflation came in over expectations on Tuesday, March 13, 2023, which will likely force the Fed to still consider a rate hike in March. Inflation and interest rates are clearly correlated but not mutually exclusive, the likelihood that the Fed can keep hiking when massive systematic cracks in the financial system have been exposed (not to mention the cost of protecting investors from it) may supersede the need to target 2% inflation.
Bond investors have placed their bets, and it’s on a pivot. In the chart below, the U.S. two-year treasury rate fell 65 basis points on March 12, 2023 –– the most since the 1987 Black Monday stock market crash. This rate is extremely important as it generally forecasts the direction of the overnight rate. The forecast of the two-year treasury rate signals where the market thinks the Fed will move in the future and effectively offers a prediction on the future economic outlook. In turn, its signal can impact the rest of the bond market.
U.S. 2-Year and 12-Month LIBOR Treasury Rate
Source: Bloomberg, as at March 13, 2023
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