Special Market Update– A Banking Crisis and the Fed’s Rate Decision

Over the past several weeks, U.S. equity markets have been dominated by headlines involving uncertainties over banks, liquidity problems, and potential insolvencies.  The collapse of three U.S. banks and the scramble to rescue others, including Europe’s Credit Suisse Group AG and First Republic Bank, sent stocks and bond yields plunging.  Volatility in the bond markets has surged to the highest level since 2009. 

Today, the Federal Reserve voted to increase the Fed Funds rate by 0.25%, as was widely expected.  Some economists have suggested that the banking crisis might be equivalent to a 1.00% hike in the Fed Funds rate and that further tightening is no longer necessary to get it into restrictive territory as Fed officials have been aiming to do since they started the latest monetary policy tightening cycle a year ago (Yardeni Quicktakes).

Future policy moves remain very uncertain as the Fed must continue to battle inflation while simultaneously dealing with a banking crisis that was, in part, triggered by its own actions to choke off inflation.  During his semi-annual testimony before Congress in early March, Fed Chair Jerome Powell said strong economic data would likely push interest "higher than previously anticipated."  Within a matter of just days, the second-largest bank failure in U.S. history unfolded and the Fed, Treasury, and FDIC had stepped in to backstop deposits at the bank and, in effect, deposits across the banking system.

The world appears to be waking up to the reality that there are consequences to ill-conceived government policies.  Government spending and pandemic stimulus payments fueled the highest rate of inflation since the 1980s.  Then, after artificially holding interest rates at near zero for many years, the federal reserve raised interest rates at the fastest pace in U.S. history.  The aftershocks stemming from this significant reversal of financial conditions are likely to be varied and lagged as I have pointed out regarding monetary policy in general.

History shows that every tightening cycle produces credit or liquidity problems, and here we are again.  Regulators acted swiftly to contain the Silicon Valley Bank crisis by effectively guaranteeing all FDIC-insured deposit accounts no matter the size.  It is likely that this action will avert a “run” on the banking system, however I do not believe we yet know the full extent of related stress points or the unintended consequences of the latest round of emergency policies. 

So far, the risk of contagion in the banking sector appears to be contained.  The yield spread between high yield and Treasury bonds is consistent with this scenario, however the situation remains quite fluid.  Agency mortgage bonds represent roughly $8 trillion of the bond market and are widely held by banks, insurers and bond funds.  While these securities may be backed by the mortgage loans from government-owned lenders Fannie Mae and Freddie Mac, they are not immune to rising interest rates.  It was the rapidly rising interest rates that pushed their prices down last year and burdened institutions with unrealized losses.

The good news in this ongoing story is the fact that the Global Financial Crisis of 2008 lead to massive changes in our banking system.   From a capitalization perspective, we believe the U.S. banking system is in relatively good shape.  Moreover, the nature of the current bank problems is liquidity based and not yet related to economic problems or escalating credit defaults. 

This said, there is real risk that unexpected side-effects or reverberations stemming from the recent troubles are simmering beneath the surface.  These hazards must be taken seriously.  At the very least, it is likely that very low confidence and sentiment levels will persist until the dust settles from the bank related headlines. 

Even if we assume that the bank run will be contained, which is not the case at this point, we still need to deal with the repercussions from its impact on the real economy.  Lending standards are tightening, and credit availability is decreasing for a large part of the economy.  The economy will slow further because of these developments.  It is increasingly likely that employment growth will soon stall, and the odds of a recession are climbing. 

The Conference Board Leading Economic Index® (LEI) for the U.S. fell again in February 2023, marking its eleventh consecutive monthly decline.  The LEI is now down 3.6 percent over the six-month period between August 2022 and February 2023—a steeper rate of decline than its 3.0 percent contraction over the previous six months (February–August 2022).  We have never seen the leading indicators decline so much without the economy entering a recession. 

It is important to note the most recent financial turmoil in the U.S. banking sector is not yet reflected in the LEI data, nor is it reflected in earnings expectations.  Financials make up the second largest contributor to S&P earnings representing more than 16% of total profit estimates.  If problems for the banking sector and credit markets linger, the outlook for economic activity and future earnings will deteriorate further.  

Periods of recession have historically placed downward pressure on valuations (as measured by the price/earnings ratio).  Taken together, lower earnings and lower multiples, these measures point to the possibility the U.S. equity markets could experience lower lows before this bear market ends.

Of course, no one knows exactly how this will all play out.  Some analysts have argued that inflation is falling more rapidly than is widely understood and the Fed will begin cutting interest rates as soon as this summer.  Were this to happen, the equity markets conceivably could bottom sooner than expected and potentially rally sharply into the end of the year.

Herein lies the consequences of ill-conceived government policies.  For many months I have been writing about how policy mistakes would prove to be the greatest risk to the U.S. economy.  As long as government policy makers believe they can control the economy by shifting back-and-forth between loose and tight financial conditions, the more the economy is likely to struggle. 

For now, we hold fast to the belief this complicated phase of the cycle will eventually give way to a period of expansion and a new bull market.  There is a lot at stake in this environment and we believe being prepared for “what comes next” should be the foremost objective for long-term investors.

Please reach out to us directly should you have and questions or concerns.  As always, thank you for your continued confidence in Clearwater Capital Partners – especially during challenging times.

John E. Chapman

Chief Executive Officer / Chief Investment Strategist

March 22, 2023