ECONOMY & POLICY
March 20, 2023
CIO Larry Adam outlines the positive events that are outweighing negative developments and looks at dynamics to focus on in the week ahead.
While the financial markets and headlines remain volatile, there has been some incremental positive momentum. Review below some of the positive events that outweigh the negative developments over the last few days, as well as some dynamics to focus on in the week ahead.
• Global financial contagion averted | Over the weekend, UBS agreed to buy the troubled bank, Credit Suisse, for more than $3 billion. The last-minute deal prevented the bankruptcy of a global systematically important bank and should lay the foundation for greater stability in the banking sector globally amid the current crisis.
• China cutting interest rates | China’s 0.25% reduction in the reserve requirement ratio is another indication that the country’s economic cycle is very different from that of the rest of the world. As the rest of the world has continued to increase interest rates, the Chinese central bank has reduced rates to support Chinese economic activity after the abandonment of the country’s “zero COVID” policy. China stimulating global growth is encouraging to offset any potential weakness in growth in the developed world.
• Central banks enhance liquidity provisions | Over the weekend, the Federal Reserve (Fed) plus the central banks of Canada, England, Japan, the ECB and the Swiss National Bank agreed on a “coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements.” The new measure increases the frequency of “seven-day maturity operations from weekly to daily.” With this new daily frequency, the central banks will be better equipped to deal with global funding issues across the global economy. Increased liquidity for the markets is constructive.
• Lifting of FDIC insurance limit rhetoric | There is growing momentum for allowing the FDIC to either backstop all deposits in the U.S. banking system and/or allow the FDIC to increase deposit insurance from the current $250,000 to a higher level. The first sign appeared over the weekend with an association of mid-sized banks requesting the FDIC to insure all deposits at mid-sized banks for two years to reduce the flow of deposits from smaller banks to larger banks. In addition, on the Sunday talk show circuit, no less than four Congressional leaders – Senator Elizabeth Warren (D), Senator Mike Rounds (R), Senator Chris Van Hollen (D), and Representative Patrick McHenry (R) – suggested the need to revisit the ‘adequacy’ of the current levels. The significance is that this appears to be bipartisan to fully protect depositors and reduce the probability of bank runs.
• Banks helping banks | Last Thursday, eleven of the biggest US banks designed a $30 billion deposit package to help solidify ailing First Republic bank. These uninsured deposits are required to stay for 120 days and are intended to show solidarity and confidence in the U.S. banking system. The participation is notable as the consortium included all five diversified banks, the top two investment banks, and the top two regional banks in the S&P 500 based on GICS sub-industries.
• Falling bank share prices drawing interest | Over the weekend it was leaked that Warren Buffett was in discussions with the Biden administration to help shore up the regional banking sector. As of this writing there has been no news on Buffett making a move, but value-oriented investors appear to be looking for opportunities. Remember that Buffett became a high-profile investor during the 2008 financial crisis and helped build further confidence in the banking sector. In addition, it was announced that the failed Signature Bank was to be purchased by New York Community Bank for $2.7 billion. The point is that the stress-induced declines in several of these institutions are starting to attract high-profile investors, which could lead to further investment and the building of confidence.
• Market holding up (some sectors rallying) | The overall market has been resilient since the start of this banking crisis on March 8. During this period three sectors have been positive with Communication Services and Information Technology leading on the expectation of lower interest rates. Three additional sectors are down less than a percent, including both consumer sectors. The losses have been focused on Financials, particularly regional banks and Energy, as the price of oil dropped. The positive interventions over the last week helped the S&P 500 finish in the green for the week with 7 of 11 sectors and 15 of 25 industry groups positive.
• Long-term interest rates declining | The root of the problem, high interest rates, is already being addressed as high interest rates are already coming down. Lower interest rates will actually increase the value of bank long-term Treasury holdings and improve their financial wellbeing. In addition, with the 10-year Treasury yield having already fallen 60 bps from its recent high, mortgage rates should fall and that will help stabilize the housing market.
• Oil prices falling | As oil prices have fallen 17.7% year-to-date (to ~$66/barrel), lower gasoline prices for consumers are likely on the horizon. Falling gasoline prices should not only provide relief to consumers but should also provide a catalyst for further deceleration in inflationary pressures – a helpful dynamic to support the Fed in ending its tightening cycle sooner.
• Downgrading of banking sector and individual banks | Moody’s lowered its outlook on the U.S. banking system to negative from stable mid-last week and placed six banks under review for possible downgrades. By week’s end, Moody’s, and other credit rating agencies (S&P and Fitch), downgraded First Republic Bank’s credit rating to junk status. Even though First Republic received a $30 billion cash infusion of deposits last Friday, its credit rating downgrade will make it even more challenging for the bank to raise capital to shore up its finances.
• Elevated uncertainty and volatility | The velocity of news during this banking crisis has led to an increased level of uncertainty and rapidly changing market conditions. The VIX, a measure of S&P 500 volatility, is up nearly 40% since the start of this crisis, finishing at 25.50 on Friday. This week the 2-year Treasury yield hit both 3.71% and 4.53%, the widest weekly dispersion since 2008. This upcoming Wednesday, we will have one of the most uncertain Fed meetings in the post-Alan Greenspan history. This close to the meeting the outcome is typically priced in and very well-choreographed, but currently, the probability of a 0.25% hike is ~60% while no cut is ~40%. Potentially even more impactful will be the comments, which can go in many different directions at this stage. The markets prefer clarity, not uncertainty.
• Growing Fed balance sheet | The ~$300 billion increase in the Fed’s balance sheet will have limited impact on economic activity other than helping stabilize the financial market during a time of stress. This increase in bank borrowing from the Fed is improving banks’ liquidity to regulatory levels rather than creating the potential for banks to increase lending.
• Investors not unscathed | Equity and bond investors have lost money with the recent crisis. In the U.S., several regional banks have suffered significant declines. Overseas, Credit Suisse equity investors have seen their stock price decline over 80% month-to-date and 99% from its peak in 2007. In addition, as part of the UBS’ takeover, the value of Credit Suisse’s $17b ‘CoCo’ bonds were written down to zero by the Swiss regulators, leaving bond holders with a complete loss on their investment. Moves by regulators have targeted stabilizing the financial stability of banks, not the investments of equity and bond holders. Selectivity within the financial market remains imperative.
We remain optimistic that the equity market (S&P 500) will move higher by year end and that interest rates (10-year Treasury yield) will move gradually lower. Overall, there have been some positive developments in dealing with the potential banking crisis. While the positives outweigh the negatives over the last week, that does not mean we are ‘out of the woods’ yet. Watching the funding rates and deposit flows of banks will remain critical drivers of the market and pressure points worth monitoring.
With the rapid rise in interest rates a major contributing factor to deteriorating fundamentals of some banks, focus will be on the Fed’s FOMC meeting this Tuesday and Wednesday. While the Fed is still likely to raise interest rates by 0.25% (to 4.75% - 5.00%), it is a close call as there is the potential it could decide to pause. Although the Fed’s main roles are price stability, i.e., low inflation, and low unemployment, it is also responsible for financial stability in the U.S.. Thus, it will have to weigh the importance of each one of these roles and come up with a decision regarding interest rates.
The Fed has plenty of instruments to deal with financial stability but only one to deal with inflation, the federal funds rate. Thus, it could decide to continue to increase interest rates and at the same time guarantee the stability of the U.S. financial system. However, the recent banking issues are tightening monetary conditions in the U.S. so the Fed may be inclined to err on the side of pausing. In the end, the message from Fed officials will determine the path it is going to choose.
While the rise in interest rates is important, it may take a backseat to the Fed’s new updated forecasts and the guidance it provides for monetary policy going forward. Some key questions include: How many more hikes are projected in the Fed’s forecast? If the Fed does raise interest rates, are there any dissents? Does the Fed believe the ‘disinflationary process’ is still underway? How strong or fragile is the overall banking system? The confidence, or lack thereof, that the Fed exudes in the economy, inflation and banking system will likely affect the direction of the markets.
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