2023 Q1 Commentary: Walk and Chew
- The excitement and relief of “no landing” and “soft landing” in the U.S. during the past 6-months have given way to a hard landing scenario on March 10th when Silicon Valley Bank was shut down by federal regulators. An investigation is still ongoing to identify all the contributing factors (regulations, regulators, management, rising interest rates, etc.), but one thing is clear: the bank poorly anticipated the speedy rise in interest rates and responded accordingly to the impact of such rate increases to its reserve and balance sheet. There was a clear and serious mismatch of investments (bond duration) and labilities (liquidity) – basic competence of bank management. The subsequent failure of Signature Bank happened two days later as we witnessed a run on banks. These are examples of liquidity problems rather than solvency issues. The increasing loss in investor confidence ultimately forced the demise of the 167-year-old Credit Suisse which fell into the arms of UBS.
- These events caused significant fear and discomfort among savers and bank depositors and witnessed a rush of depositers pulling their money out of banks and into money market funds (primarily investing in U.S government securities) as a safe haven. This massive exodus from banks brought into question the stability of all banks (except the top tier). The Federal Reserve and the FDIC had to step in to reassure the market that they are there to provide liquidity and protection1. These events also suggest bank regulatory failures.
- These bank failures, which resulted in tighter regulatory scrutiny, and the desire to restore confidence in the system will both lead to tighter financial conditions. This means banks (especially the small and medium size banks) are more cautious in providing credit and lending. This reaction is equivalent to the Fed raising interest rates to slow down economic activities. Market participants now expect the Fed to have reached the end of its hiking cycle. The market indicates that the Fed will likely be lowering rates in the second half of 2023.
- The Fed has and continues to focus on bringing inflation back down to the 2% range. To do so, it has a well-known tool kit of hiking rates and shrinking its balance sheet, among others. These are specific to restoring and maintaining price stability. At the same time, the Fed has macroprudential tools to deal with financial instability such as the current banking debacle, although some of the actions would cross over and impact financial and price stability. With that said, however, the Fed is focused on diminishing economic activities (higher unemployment and tempering consumer spending and corporate investment), and reactions to bank debacle-led tightening financial conditions (tougher lending standards and less willing to provide credit) would help the Fed in its quest for price stability. Nonetheless, the Fed is able to Walk and Chew at the same time. Case in point, the Fed raised rates in its March meeting and is likely to raise rates again in May while taking steps to support banks.
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