March Madness

March 16, 2023
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Summary

  • Some agony was experienced in March due to the anticipation of further rate hikes, leading to the second-largest bank failure in U.S. history and a combined liquidity backstop from the U.S. Treasury Department, Federal Reserve, and FDIC to prevent bank runs across small and medium-sized banks.
  • The failure of Silicon Valley Bank and Signature Bank had a significant impact on the U.S. regional banking sector, as reflected by the SPDR S&P Regional Banking ETF (Ticker: KRE), which experienced one of its worst months on record with a decline of 27.49%, and its worst week since the COVID outbreak in early 2020.
  • A flight to safety in treasury bonds occurred across all maturities as a result of the destruction of bank stocks and the financial sector. Consequently, there was an enormous drop in the two-year Treasury yield from its high on March 8th of this year at 5.07% to 3.89%.
  • With the two-year Treasury yielding 86 basis points less than the federal funds rate, the market expects the Fed to pause or increase only slightly at its upcoming meeting, despite the European Central Bank's decision to raise its main refinancing operating rate to 3.5%, up from 3.0% previously.
  • Although short-term volatility is expected to continue, as shown by the rise in various indicators, the current performance of the broad stock market and subdued credit spreads suggests that there is minimal concern for serious systemic risk experienced during the Global Financial Crisis.

This year, March Madness seems to have begun a bit earlier in the month, and it's not the thrilling kind that comes from seeing your beloved basketball team advance in the tournament. In our commentary from last month, we discussed how further rate hikes would likely lead to more market pain. It appears that the financial industry was the first spot to crack.

As many of you are aware, recent challenges in the U.S. banking system have led to the second largest bank failure in the U.S. history (not adjusted for inflation) this past Friday, followed by a combined liquidity backstop on Sunday, March 10 by the U.S. Treasury Department, Federal Reserve, and FDIC to prevent bank runs across small and medium-sized banks. The largest bank to collapse was Washington Mutual, which occurred during the Global Financial Crisis in 2008.1

Prior to this past weekend, Silicon Valley Bank (Ticker: SIVB), was far from a well-known bank to the average American, despite its founding in the late 1980s and a chest-pounding stock price return of 37,571% as of the end of 2022.2 This particular bank was a top-20 bank in the United States by asset size, and a high percentage of west coast early stage technology and venture capital firms banked with the company, creating most of the niche depositor base. Bottom line, Silicon Valley Bank carved out a distinct and riskier position than other banks, setting itself up for future problems down the road.

In this month’s commentary, we aim to provide our clients with answers to questions that are most top of mind:

  • What went wrong and what are the potential effects for the broader banking and financial system?
  • How have markets reacted?
  • What do we expect to see moving forward?

What Happened?

To fully grasp the recent events, one must go back in time. The failure of Silicon Valley Bank—and the crisis facing the banking industry today—started with the U.S. government’s response to COVID. After doling out fiscal stimulus in response to COVID in 2020, everyone’s bank accounts swelled and deposits at banks increased at an unprecedented rate. Typically, banks will originate loans with increased deposits, but it takes time to find creditworthy borrowers. So while banks originated new loans, they also had to put the excess deposits to work by buying Treasury securities, mortgage-backed securities, and other interest rate sensitive assets seeking to earn a respectable yield—or at least a decent yield at the time.

Source: FDIC. Verdad Weekly Research, “Bank Run”. Data as of December 31, 2022.

This is where banks ran into trouble. The Fed increased interest rates at one of the fastest paces in history, raising its benchmark rate from basically zero to the current target range of 4.50%-4.75%. When interest rates rise, bond prices fall in response, and banks that held fixed income securities were underwater.

On the surface, higher interest rates aren’t too big of an issue for banks as long as they hold the fixed income securities to maturity to get their principal back. However, if the deposit base decides they want to pull their money from the bank at a rapid pace, the bank will have to sell their securities at a loss and it can create a doom loop that can cause a bank run.

Given the linked behavior of its clients, Silicon Valley Bank was more vulnerable to a bank run than other banks due to its highly concentrated depositor base and elevated levels of uninsured deposits. Per Matt Levine, a writer for Bloomberg Opinion, “The lesson might be that there are some industries that are bad to bank.”

The subsequent impact on trust and potential for a contagion that would affect other financial institutions are two major risks following the news that two banks had failed. Authorities in the United States were aware of the problem and met this past Sunday to allay fears of systemic danger. The outcome of the meeting resulted in bank customers of the two failed banks (Silicon Valley Bank and Signature Bank) having full access to all of their deposits, both insured and uninsured.3

Actions taken by the U.S. Treasury, the Fed and the FDIC were applauded by the public and investors, with the S&P 500 Index only down -0.21% on Monday, March 13.

Market Reaction

As one might have guessed, the collapse of SVB sent other bank stocks tumbling, specifically regional banks. The SPDR S&P Regional Banking ETF (Ticker: KRE) dropped -8.11% on Thursday, March 9 and the decrease continued on Friday, March 10, with the index falling an additional -4.39%. The ETF is now down nearly 27.49% for the month and is on pace for the worst week since the COVID shock in early 2020.

Source: Bloomberg. Nova R Wealth. Total return through 1/1/2023-3/15/2023. SIVB & SBNY are not included due to a trading halt and the FDIC taking over both of the respective banks.

As a consequence of the destruction of bank stocks and the financial sector, there was a flight to safety in treasury bonds across most maturities. As we type this, the two-year Treasury yield is 3.89%, down from its high on March 8th of this year at 5.07%. This is an enormous move in what is typically one of the most stable assets across the financial spectrum. In fact, to put this recent move into perspective, the only other time that the two-year yield has had as many 20 basis point moves in succession over the last 45 years was in December 1980.

Source: Bespoke Investment Group

The two-year Treasury yield typically leads the federal funds rate, and it now lands 86 bps below the federal funds rate. Historically, each instance where the two-year Treasury yield fell below the target  rate, a rate pause or cut ensued.

Source: Bloomberg. Nova R Wealth. Data from 03/31/1999 – 3/15/2023. USGG2YR – 2 Year Treasury Yield, FDTR Index – Federal Funds Target Rate (Upper Bound).

Will this time be any different? Well, the implied federal funds rate is now calling for only a 50% chance the Federal Reserve even raises interest rates 0.25% in its upcoming meeting. This is a drastic shift from investors pricing in a high probability of a 0.50% increase just one week ago. So, in short, the market is SCREAMING at the Fed and telling it to pause further rate hikes.

Will the Federal Reserve listen? It remains to be seen, and we will find out on March 22nd; however, the European Central Bank—despite trouble brewing within their own financial sector at Credit Suisse—hiked their main refinancing operating rate to 3.5%, up from 3.0% previously. Therefore, if Europe is any guide, it's possible that interest rates will continue to rise despite the recent events to subdue inflationary pressures, which could place more pressure on risky assets.

Moving Forward

Although short-term volatility is expected to continue, as shown by the rise in both the VIX Index (which reflects the market's anticipation of volatility in the next 30 days) and the MOVE Index (which measures Treasury rate volatility), the current performance of the broad stock market and credit spreads suggests that there is little concern for systemic risk. Nevertheless, we believe that it would be prudent to review your FDIC insurance coverage for your checking and savings accounts at your preferred bank and potentially consider other strategies for managing your liquidity in the current environment should your account size exceed FDIC insurance limits.

  1. Michael Cembalest (March 10, 2023). Eye of the Market, J.P. Morgan. https://www.jpmorgan.com/wealth-management/wealth-partners/insights/eye-on-the-market-silicon-valley-bank-failure
  2. Bloomberg.
  3. U.S. Department of Treasury (March 12, 2023). Joint Statement by the Department of the Treasury, Federal Reserve, and FDIC. https://home.treasury.gov/news/press-releases/jy1337

Important Disclaimers and Disclosures