The collapse of Silicon Valley Bank (SVB) has sent shockwaves through the financial industry, with rating agencies cutting the outlook for the US banking system to negative and many regional banks put on negative watch. The KBW Regional Bank index is down 20% in the past month, and 44 members are down less than 15% in that timeframe. This has led to the Fed taking a cautious approach into the March FOMC meeting next week.
The collapse of SVB is an indication that the Fed's monetary policy is finally "biting." Fed hikes are directly driving losses for banks, which were $620 billion at the end of 2022. The Powell testimony last week likely pushed this to nearly $900 billion, as two-year and 10-year yields surged. In other words, the Fed's monetary policy is finally having an impact on the banking industry's securities portfolio while deposits are drained from dwindling savings, move to US Treasuries, and distrust of banks.
The FDIC/Fed took action to protect depositors, but equity and bondholders of systematically important banks like Citigroup (C) and Credit Suisse (CS) were wiped out. Capital markets are understandably wary of banks, which is a concern for the Fed as it was established to provide the nation with a safer, more flexible, and more stable monetary and financial system.
The Fed hiking aggressively further is delivering even greater pain to the banks. If the Fed pauses, and yields fall, this will drive a recovery of some bond prices, helping to repair bank balance sheets. This is another argument for a pause, and we expect the Fed to either pause or do a mere 25 basis points, with 50/50 odds.
A pause in the Fed's monetary policy would be good for the rest of the stock market, but unfortunately, financials are still in a world of pain, with the bulk of that pain already delivered. Inflation is becoming somewhat of a sideshow as the "credit contraction" generated by above, coupled with the shock to start-ups, means hit to the jobs market, and means inflationary pressures are abating. This will not show up in the official data for some time as CPI is lagged.
We will likely see this show up in jobless claims (labor softens = no wage pressure) and in credit contraction (H8 weekly report by Fed). Both are major disinflationary impulses with known connections to credit events. Feb CPI came in "tame" today, with Feb core CPI MoM up 0.45%, somewhat higher than last month's 0.41%. The YoY slowed to 5.5% from 5.6% (Jan), but this rise is really housing (+0.30% of 0.45%) and travel (0.08%).
Does the Fed want to hike in response to "hot" housing (slowing) and travel versus hikes creating more problems for banks? Besides, ex-housing, Core CPI came in at around 2.0% annualized.
The VIX is resuming its "contango," meaning the one-month VIX futures contract is no longer above the four-month VIX. That is a sign that the "stress" is passing. This is also supported by the VIX settling down to 23 after surging to a capitulatory 31 yesterday.
Tom Lee at Fundstrat predicts an eight-week rally (end of April) towards the S&P 500 at 4,250. This also aligns with Mark Newton's view that markets would begin to strengthen on March 15.
As for valuation, the S&P 500 P/E (’24E) ex-FAANG has dropped to 14.3X. This is a 7% earnings yield. The stock market is offering a staggering high level of earnings yield for the investor today.
"The 'Do-Over': The Ironic Approach of SVBs and VCs to Mend Fences Despite the Lingering Effects of a Major Financial Crisis"
It is ironic that Silicon Valley Bank (SVB) and venture capitalists (VCs) are trying to move past the events of a major financial crisis with a "do-over" mentality, as though nothing has happened. Despite the fact that the repercussions of the crisis are still being felt, there seems to be a desire to brush past it and start anew.
Some people may be under the impression that the Federal Reserve's only responsibility is managing interest rates or employment, but they are overlooking the fact that the Federal Reserve Act specifically mandates financial stability as a primary goal. While some may argue that avoiding bank runs is important for financial stability, it is only one aspect of this objective.
Despite the broader market recovery, regional banks are struggling to regain their pre-pandemic levels. Even as the economy recovers, many regional banks are still down by 20% from their previous highs. For instance, Pacific Premier Bancorp (PACW) is still down 52%, reflecting the damage to investor confidence in these institutions.
The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve have stepped in to protect depositors from bank failures, but equity holders have suffered significant losses. As a result, many investors are wary of investing in regional banks, given the uncertainty and risk associated with these institutions.
The recent action taken by the ratings agency appears to be a retrospective evaluation to me. It seems that this downgrade should have been factored in last year due to the rapid interest rate hikes by the Federal Reserve.
The banking sector is currently facing a dual challenge of declining deposits, as previously mentioned, and the declining value of their bond holdings. This situation is exacerbated by the direct impact of Federal Reserve interest rate hikes on bank losses. As of the end of 2022, bank losses stood at $620 billion, and the Powell testimony last week likely pushed this figure to nearly $900 billion.
Source: Fundstrat Research (Fsinsight.com)