Published March 17, 2023
The tumult over the past week+ in the banking sector has taken over financial markets. We are publishing two good overview articles of the action. Our view is simple: markets are prone to emotional outbursts swinging between fear and greed. Rather than get caught up in the emotions of the moment, we have long found it more profitable to distill market action down to a few simple inputs related to price and volume. Are market participants, in aggregate, buying or selling, and to what degree. Our models then take a position based on decades-long analyses of the price-volume data, a period incorporating very many emotion-driven markets, both up and down.Here are those summaries of recent events, first from Delta Research, followed by the New York Times economic analysis team.
“Fast rising interest rates and deposit outflows caused Silvergate Bank, Silicon Valley Bank (SIVB) and Signature Bank (SBNY) to fail in the past week. At some level, all banks are vulnerable to negative mark-to-market changes to their bond portfolios in a rapidly rising rate environment. Credit Suisse (CS, large Swiss bank) reported it has “material weaknesses” in its financial reporting process and is pre-emptively borrowing 50 billion CHF from the Swiss National Bank to stabilize its liquidity position. First Republic Bank (FRC) is down over 80% since the middle of last week and is looking to be acquired.
Time to dust-off the Great Financial Crisis (GFC, 2008/09) terms “counterparty risk” and “systemic risk.” It turns out that shutting the economy down for a pandemic, increasing the money supply by 42% and holding interest rates near zero for a long-time can stimulate record inflation and record Fed rate hikes. This sequence of events is causing parts of the financial system to break. Oh snap!
The banking sector failures in the past week will likely cause the Federal Reserve to increase the Fed Funds rate no more than by 0.25% this month because: 1) systemic risk to the financial system is more important than the pace of inflation reduction and 2) the dislocations in the banking sector are likely to cause loan issuance to slow which is disinflationary. Loan growth was already expected to slow this year to ~2-3% from 7% last year. With the recent bank failures, there will be further pullback on risk commitments until there is clarity around what will happen to funding bases, cost of funding, changes to bank regulations, as well as the broader impact on the US economy.
Small and medium-sized banks play an important role in the US economy. Banks with less than $250B in assets account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending.
The amount of change in financial market expectations in the past week is extraordinary.
Although expectations about the investment landscape have shifted significantly, many important risk measures are not signaling that all of the shift is negative. The S&P 500 index is just below the 4000 level which is a small negative change week-over-week. The NASDAQ 100 appreciated in the past week, most likely on the reduction in interest rates and the cash stability and durable growth characteristics of large capitalization technology companies.
The CBOE Volatility Index (VIX) is trading in the low 20s which is well below the high-anxiety levels of 35 and up. The high-yield credit spread (a bond market measure of risk) has moved up to just over 5%, a risk warning threshold level, but just barely. We will be watching this indicator in the next week to see which way it turns – risk on or off.
The pace of change in the financial markets is accelerating. The most recent point of acceleration is in how fast the government stepped in to backstop all depositors and prevent bank failure contagion. For the moment, the ramifications of the investment landscape shifts of the past several days are not clear. We may have increased the probability of recession and accelerated the timing or we may have removed the Federal Reserve as a block to economic growth and higher stock prices. Hopefully the cause-and-effect relationships will become evident soon. It remains important to have a nimble investment approach.”
And now, the NYT economic team’s summary of events:
“It was a week of market turmoil that began with the collapse of a small bank in the United States, spiraled into a panic about the global financial system and ended with a bold effort to stanch the cascading crisis.
And it was the clearest illustration yet of the dangerous side effects of campaigns by central banks to raise interest rates.
In the year since the Federal Reserve began pushing rates higher, in an effort to stamp out runaway inflation, investors have watched shares of speculative tech companies crash, emerging markets fall into default and the nascent cryptocurrency market unravel.
This week, it was the collapse of Silicon Valley Bank, a midsize bank that predominantly served start-ups and venture capital firms, that incited chaos in the markets and prompted fears of a financial crisis.
Stocks swung wildly day to day, oil prices slid to lows not seen in over a year and yields on government bonds suddenly reversed their march higher as investors began to wonder about the impact of the escalating crisis on the economy.
As the dust begins to settle, here’s a summary of what happened in markets this week, and what it tells us about investors’ views of the world.
1) A crisis in small banks was provoked by the collapse of a bank critical to Silicon Valley
The trouble began on March 8, when Silicon Valley Bank revealed steep losses on its portfolio of government bonds and mortgages, ostensibly safe investments that backed the bank’s deposits and that had taken a hit from rising interest rates. The bank’s shares plunged, depositors rushed to pull out their money and, within days, authorities seized control of the bank (as well as Signature Bank, based in New York), pledging to keep it open for business.
But in the markets, investors couldn’t shake the worry that other banks were facing similar problems, and that induced a panic regarding a number of small lenders, including First Republic Bank, PacWest and Western Alliance. The wave of selling in their shares appeared to end only on Thursday, after a group of rival lenders said they would bolster First Republic with $30 billion in deposits.
But even after a rebound, most of those banks’ share prices remain sharply lower than they were before the collapse of Silicon Valley Bank. First Republic has lost over 70 percent of its value since the start of the month, while PacWest and Western Alliance are both down more than 50 percent.
2) The broader market seemed to look past beyond the week’s banking turmoil
The good news for most investors is that the S&P 500 was resilient to worries that centered on the banking industry, and after a big rally on Thursday the index was actually on track to end the week with a gain of around 2.5 percent. If that holds, it would be the index’s second-best week of the year.
It shows that, to stock investors at least, the crisis in the banking sector appears mostly contained. It helped that policymakers in the United States and Europe stepped in to back their banks. Authorities guaranteed deposits at SVB and Signature, and in Europe, Credit Suisse said it would tap a $54 billion lifeline from the Swiss National Bank after investors there began to panic over its financial state — though for very different reasons than with SVB.
3) But investors in other markets are worried about the economy
Perhaps the starkest evidence of a shifting view on the economy came in the market for government bonds. On Wednesday, the yield on two-year U.S. government notes, known as Treasuries, plummeted by a magnitude not seen since Black Monday in October 1987, one of the worst market crashes on record.
The two-year yield is a barometer of the changing expectations for interest rates, and it had been climbing fast as investors bet on further rate hikes from the Fed.
In early March, the yield had crossed above 5 percent for the first time since 2007. By late Thursday, the yield had tumbled to just 4.14 percent — a huge swing by the bond market’s standards.
The signal from the markets was clear: The Fed is going to need to start cutting interest rates, instead of raising them, sooner than was thought — something it typically does only when the economy runs into trouble.
It isn’t just the American economy that investors are worried about. A slide in commodity prices this week shows that they’re concerned about the global economy, too.
Crude oil prices are illustrative of this. After suffering its second sharpest fall of the year, on Wednesday, a barrel of West Texas Intermediate crude is now close to its lowest price since late 2021.
Demand for oil is global, making it a barometer for the health of the world’s economy. It often fluctuates with economic news from other parts of the world. When things are booming, oil demand is high, and oil prices typically rise. Such a sharp fall is a warning that investors fear demand will wane if the economy falters.
4) In other words, it may not be over yet.
For the time being, a semblance of stability has returned, but investors remain on tenterhooks about the potential for more damage to emerge.
Asked about the possible risks, some analysts point to other corners of the market susceptible to high interest rates, like the corporate debt market that ballooned after the 2008 financial crisis. The pain in the banking sector could also prompt lenders to pull back from new business, tightening access to a crucial source of cash should companies start to run into trouble — restrictions that could weigh on growth.
And, of course, a big fear for investors is usually that something has yet to be uncovered, like the trouble at a regional bank in Silicon Valley just over a week ago.”
As our article above spells out, investors are reeling with big macro assumptions having been completely upended by the banking crisis. This week’s trading volatility put the competing narratives on full display. Coming off the shocking demise of Silicon Valley Bank at the end of the prior week, stocks held relatively firm Monday as another leg down in regional bank shares was offset by a notable drop in interest rates, with investors seeking the safety of U.S. Treasury bonds to push rates downward. The rationale behind Monday’s trade was completely reversed Tuesday. Stocks ripped higher along with interest rates as investors embraced the idea that the bank issues might be contained to a very small group of troubled institutions and the Fed would continue its rate hiking path. On a negative note, however, oil prices fell -4% when OPEC cut its demand forecast, a recognition of possible global recessionary pressure. Oil prices dropped another -5% Wednesday while one of Europe’s biggest, but most troubled, banks sold off hard. Credit Suisse shares plunged over -20% when one of the bank’s largest shareholders told reporters they would not be adding to their stake in the bank. Why he felt the need to say that is anyone’s guess. Coming on the heels of the U.S. bank issues, investors absolutely panicked, assuming the worst for the second-largest Swiss bank. Investors again rushed to the safety of U.S. Treasury bonds leaving stocks stumbling to a -0.7% dip. The drawdown would have been much worse were it not for a late-day announcement by the Swiss National Bank that they would help Credit Suisse. Ah, but only a very temporary reprieve for bank stocks. Thursday morning brought news that First Republic Bank of San Francisco was under immense stress. Shares of the bank opened the day down more than -30%. By midday that drop was completely erased when a broad swath of the nation’s biggest banks agreed to put cash into the bank in a bid to ease investor and depositor concerns. Stocks went on to post a solid +1.8% gain for the day. But again, in Friday’s trade, market backtracked, giving up -1.1% with First Republic Bank back down by -30% as investors reassessed the outlook for regional banks and determined that there remained massive uncertainty around their prospects.
One perhaps surprising consequence, for this week at least, was a shift by investors, returning to the mega-cap tech stocks for safety. Whereas rising interest rates hit the tech/consumer giants hard, the sudden plunge in interest rates and distress in other market sectors has brought money back into the group sending shares of Microsoft, Apple, Google, Amazon, along with the semiconductor sector, all notably higher. As these stocks remain by far the largest in the broad market, any upward move in their shares tempers other downward impulses to lessen the impact of selling on the broad market indexes.
In a week that felt completely out of control, the S&P 500 (SPY) somehow managed a +1.44% gain as the above-noted rise in tech/consumer heavyweights more than offset the bloodbath in the banking sector and a sharp drawdown in recession-sensitive energy and materials stocks. Smallcaps (IWM), without the Apple/Microsoft/Google/Amazon quartet to help, and more exposed to the weakness in bank/energy/materials stocks, suffered a -2.81% fall this week. The Nasdaq 100 (QQQ), by contrast, rose +5.83% to reflect the strong upward advance in those tech/consumer stocks. Microsoft, bid up on its potentially transformative AI business, rose +12% to its highest point since last summer.
Warm wishes and until next week.