Unintended Consequences 3/23
Over 12 months ago, the Federal Reserve embarked on one of the most aggressive tightening programs that the US economy has experienced in over 40 years. In order to combat rampant inflation that was seeping thru the system, they began raising rate at an unprecedented pace. Their apparent goal was to lower the rate of inflation from around 10% to near 2% annually. They hoped that the higher rates would lead to slower economic growth, an increase in the unemployment rate from record lows and a tightening of financial conditions.
For a number of years prior to this action, the Federal Reserve had kept interest rates at extremely low levels near 0%. Investors needed to invest in securities with maturities of 7 years or longer to achieve a yield of 1.0% or greater for US Treasury securities. This meant that pension funds, municipalities, insurance companies and others were required to buy long dated securities with very little return. These securities had large price exposure to interest rates. When interest rates began to rise, the price of these securities dropped precipitously.
This is how the Federal Reserve actions has affected the recent bank problems that have been in the news. After the Great Financial Crisis (GFC) of 2008-09, banking rules were adapted to increase the credit worthiness of financial institutions. Banks were increasing their reserve holdings of US Treasuries, deemed to be of the highest credit rating. However, since interest rates were so low, the Treasuries that they held were of longer maturities in order to increase the coupon return of the securities. These holdings were deemed to be held to maturity meaning they would be redeemed at their par purchase price. Hence, no actual gain or loss on the security would have to be realized.
The dramatic rise in rates caused the price of fixed income instruments to drop. A good proxy for bond returns last year is the iShare Bond Index (AGG), lost around 13.5%. That reflects one of the worst annual return that bonds have experienced in generations. This loss resulted in the drop in bond prices mentioned earlier. It has been reported that at the end 2022, the FDIC believed that unrealized losses on the banks reserves amounted to over $650 Billion. There wasn’t an enormous concern about this since the banks didn’t have to realize the loss if they didn’t sell the securities.
Banks are only required to hold a percentage of their deposits in reserve. The balance they lend back out as loans. When a run on a bank occurs, depositors demand their money back. Allegedly, the problems at Silicon Valley Bank (SVB) began on Twitter when a large and prominent investor suggest people should remove their deposits over the FDIC limit of $250,00. Depositors jumped on their phones (didn’t have to go to the bank and stand in line) and began transferring funds. To meet those demands, SVB sold off some of the securities that had dropped in price. Once they realized the loss on those securities, fear ran thru the marketplace that the remaining securities, also lower in price, would not be suffice to cover the depositors demands for cash. .
Those fears were probably correct. The FDIC stepped in and took over the bank. The Federal Reserve and The US Treasury have back stopped the FDIC and stated all deposits are guaranteed, not just to a limit of $250,000. The Federal Reserve has implemented a system where Financial Institutions can bring in their securities that have dropped in price and get loaned the par amount of those securities. This has offered some relief from the threat and banks have stabilized.
These are the unintended consequences incurred because of the Federal Reserve action. Their quest to quelch inflation by raising rates has put undue stress on the banking system. The precipitous drop in the price of their holdings has caused concern about their financial stability. The Federal Reserve is responding to this by acknowledging the effect the crisis will have on the economy. It is expected that the banks, especially small and mid size community banks, will become more conservative with their lending standards. They will pull back on the amount of capital that will be available. This will be a defacto tightening. I would expect the Federal Reserve is near the end of their rate raising cycle. In fact, the treasury market is currently pricing in one more slight rate rise and then lowering the rate going into year end. The bank crisis has raised the chance of a recession, something the Federal Reserve was trying to avoid.
While I don’t think that the current crisis s as systematic as the GFC of 2008, I would be wary of what is ahead. A loss of confidence in the banking system could spiral thru the economy. Commercial Real Estate could become vulnerable to the tightening lending standards. Companies that are fiscally sound, show strong balance sheets and are not dependent upon borrowing to survive should outperform over time. Rates have probably peaked in their rise and should settle into a range. All in all, I would expect the equity markets to further price in the chance of a recession. The markets may then perform better going into the 2nd half of the year as the crisis subsides.
The opinions expressed herein are those of Riverbend Planning Group. The data and opinions are furnished for informational purposes only and should not be considered a solicitation for an investment decision. Although it is derived from sources believed to be accurate, Riverbend Planning Group makes no guarantee to the accuracy of the information
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