March 13, 2023
Good morning,
The U.S. is in a liquidity crisis. So much has happened since the closing bell rang on Friday and the failure of Silicon Valley Bank (SVP). The most obvious thing to note is the quick policy response of U.S. authorities over the weekend, which protects even uninsured depositors and offers up liquidity to the rest of the banking system, including with a new Long Term Refinancing Option (LTRO)-style financing facility (a European Bank system import).
That the Bank Term Funding Program will accept collateral at par value is a key component of the response, as it drives a wedge between access to liquidity and the impact of higher interest rates. Ostensibly, that could (and should?) allow the FOMC to keep addressing the inflation issue with its primary policy tools while assuaging concerns about the financial system with the other.
From an equity perspective, the Fed’s reaction to this crisis may well keep them from piling on more rate hikes, which is why there has been another huge rally at the front end of the Treasury yield curve. In three days, we have now completely wiped out all of the tightening built into the yield curve since the February Fed meeting, with a concomitant sharp steepening of the curve.
All of this has occurred during the FOMC blackout period makes things extra spicy, though the Fed is still at liberty to guide the market with leaks via favored journalists. It seems pretty unlikely at this point that the Fed would hike next week if the market is not priced for it– for now, the market has the odds at a bit better than 50%. Throughout the entire tightening cycle, the Fed has largely ignored the equity market as it has focused on inflation. Now that something in the financial system has broken, the FOMC may well look to equities as a sign of whether it is safe to keep going (Bloomberg).
The scope of the Fed’s actions over the weekend suggests that it was concerned about the possibility of further runs on banks. It has set a precedent for guaranteeing all bank deposits, not just those under the FDIC’s $250,000 limit. The implications for moral hazard are obvious. So why was the Fed so concerned? SVB’s situation was not usual. It was a bank that saw huge deposit growth but lent little and instead invested heavily in long-dated fixed income at a point in time when yields were close to all-time lows. It was heavily exposed to rising rates both on its asset side and because of its depositor base.
But deposit outflows are not limited to SVB. Banking deposits expanded massively during the pandemic as low rates, government handouts and lockdowns left both companies and consumers flush with cash. One of the side-effects of Fed tightening has been to make money-market funds and short-term Treasuries more attractive. As a result, depositors have been pulling money from the banking system at the fastest pace since at least the 1970s.
Futures opened last night up +1.5%, suggesting a favorable interpretation of the U.S. response to the crisis. However, as we approach the opening of the U.S. cash market, Futures have been declining, and are off -1% at 9am ET. I suspect traders will have to see stability in the regional bank sector (down a lot pre-market) before they consider the disinflationary effects of the Fed’s reaction to this crisis and the bullish influences of dramatically lower rates in the yield curve.
See you in the morning, if not sooner – it is warranted.
Be well,
Mike