SVB, Inflation & the Fed

Major stock market indexes opened higher this morning despite stubborn inflation data. Currently, the Dow is up 155 points and the S&P 500 is up 1.1%. The VIX fear gauge, which briefly spiked to 26.5 as Silicon Valley Bank (SVB) failed, is back down to 24.5. We’ve seen huge volatility this week, and we’re only two days in. For example, SVB’s demise smacked the KBW Bank Index down by 7.6% since Friday. Commodities are all over the place as well. WTI crude oil is down 3.7% in two days, and gold spiked 5% over the past week. The bond market has been a rollercoaster. Fears of a possible banking crisis & recession caused traders to pile into safe-haven Treasury bonds, driving yields lower. But today that trade is unwinding.

Although inflation has been decelerating for eight straight months, the pace of improvement has sort of stalled in early 2023. The Consumer Price Index (CPI) slowed to a 6% annual rate in February vs. 6.4% in January. On a month-to-month basis CPI rose .4%. Stubbornly high prices for services like airfare, car insurance and rent are preventing the index from falling faster. Of course, we know that CPI’s rent estimate is contrived, posting record 8% price growth vs. Zillow’s more accurate 6.3%. But that’s still rather high. We’ll have to wait a few more months to see services cool down.

Yesterday, the US Treasury, Federal Reserve and FDIC announced that the government will fully protect all deposits in Silicon Valley Bank (SVB). This is a highly unusual move since FDIC insurance only covers $250,000 per bank account. What’s more the group pledged quick accessibility of funds. At the risk of setting a terrible precedent, the move seems to have allayed fears of contagion.

What went wrong at SVB? The bank’s big error was to invest a huge chunk of depositors’ money in long-term mortgage-backed & Treasury bonds. (This was a change of strategy; the bank used to invest in short-term bonds.) When interest rates soared last year, the value of these bonds took a big hit. When I say big, I mean that the bank’s liabilities exceeded its assets—a condition we call insolvency. This situation in itself didn’t signal ruin because given enough time the bonds would mature at full value.

But as it turned out, SVB didn’t have time. The bank’s major customers—venture capital & start-up companies—were draining deposits faster than expected as the entire tech sector suffered through last year’s bear market. Perhaps management also knew that credit rating agency Moody’s was preparing to downgrade SVB’s debt. Anyway, facing higher withdrawals and desiring to reinvest in short-term bonds with higher interest rates, management decided to sell its long-term bonds at a $1.8bil loss. To replace lost capital, SVB then tried to arrange a stock sale, which failed because investors sniffed desperation. A crisis of confidence soon spread and depositors lined up to pull out their money. It became a game of musical chairs since there wasn’t enough money to go around.

So how do SVB and the latest inflation report play into the Federal Reserve’s next interest rate decision? The Fed has tightened financial conditions quite a bit over the last year and knows that raising interest rates and making credit less available impact the economy with a lag. Investors like to say that the Fed raises interest rates until it breaks something. Well, SVB is that broken something. We all shrugged off crypto’s collapse because the risk seems rather contained among a group of wild speculators. But I think SVB is a more reliable sign that Fed tightening is having a real impact on real businesses. So it may be time to pause the tightening cycle. On the other hand, judging from current rates of inflation the Fed has more work to do. And there is some evidence that the economy can withstand somewhat higher rates. After all, the unemployment rate remains low and corporate/consumer balance sheets are strong.

But I think the Fed will judge that financial stability is more important than fighting inflation. And that’s why most economists (and bond market traders) are drastically reducing their expectations for further interest rate increases. In fact, trading in Fed Funds futures suggests we’ve already seen our last rate hike.