Two months ago we speculated that the Federal Reserve would continue its inflation fight “until inflation clearly was under control or something broke in the financial system”. We have witnessed two “breaks” with the failure of Silicon Valley Bank and Signature Bank. The question today is: Do these failures represent THE break, or are they just a couple of bumps in the road?
Background Into The Recent Silicon Valley Bank And Signature Bank Failures
Bank deposits are essentially loans from depositors to banks and are liabilities on the bank balance sheet. In general terms, banks may use up to 90% of the deposits to make loans and investments which comprise the asset side of the balance sheet. They are required to hold at least 10% of their assets in reserve to support depositors’ withdrawals.
Banks are allowed to consider government backed bonds and mortgages as “risk free” and include them at amortized cost towards their regulatory capital – as long as they intend to hold them to maturity. All banks have hidden, unrealized losses on their balance sheets within their “hold to maturity” category. In order to raise cash to fund significant deposit outflows (to maintain that 10% reserve), a bank may be forced to remove securities from their “hold to maturity” category and realize losses. Realized losses reduce the bank’s capital, reduce its solvency, and in extreme cases, may lead to insolvency.
There are many factors that led to the Silicon Valley Bank and Signature Bank failures, including significant deposit growth over the last several years, a concentrated deposit base, and loans to more speculative grade borrowers. However, the tipping point was reached when losses on “risk free” securities erased all their regulatory capital.
In aggregate, the banking sector is sitting on approximately $340 billion of unrealized losses on “hold to maturity” securities. While this is a large number, it is dispersed across the industry.
Among the large money center banks and super-regional banks, some analysts estimate that average tier 1 capital might drop from 11% to 7%. Some banks might need to raise more capital to meet regulatory requirements, but none would become insolvent. And none of this would happen unless there was a significant outflow of deposits. And, the Federal Reserve has created a new liquidity facility that allows banks to pledge government guaranteed assets, at face value, in exchange for cash.
Banks have been flush with deposits over the last few years, and the Federal Reserve inflation fighting posture has made disintermediation more attractive. Money fund rates above 4% compared to less than 1% at the bank is a compelling spread. In fact, money center bank deposits are down 3.5% over the last year and regional bank deposits are down 6.0%. If banks wanted or needed to retain deposits, they could offer more competitive rates.340
Back To The Question At Hand - Where Do We Stand On A Fed Pivot?
Over the last three days, the bond market has essentially repriced the yield curve as if the Fed will reduce rates by August of this year – a Fed pivot! Over the last year, the bond market had priced in a Fed pivot several times and was proven wrong every time. Inflation remained stickier than anticipated and the Fed’s resolve has not wavered.
Referring to some of our “key points to remember for 2023”:
- Fighting inflation is normally a multi-year project
- The Federal Reserve sees retreating too soon as their biggest potential error
- Optimism for a “Fed Pivot” should be considered judiciously
Given the recent PCE report and today’s CPI reports, there is still insufficient evidence to declare an end to the inflation fight. We expect the Federal Reserve considers the failures of Silicon Valley Bank and Signature Bank as isolated breaks and not evidence of systemic weakness in the financial system. We expect the market is wrong again and while the Fed may pause its rate increases for a couple of months, a pivot is still not on the Fed’s calendar. If we are correct, this sets up the market for another potential disappointment when the Fed meets next week.
What Does This Mean For AAMA's Portfolios?
As we’ve said in the past, the investment team at Advanced Asset Management Advisors (AAMA) will continue to diligently monitor and evaluate the markets, positioning our portfolios accordingly. In our equity portfolio, we remain focused on large cap companies, tilted toward more defensive sectors with an emphasis on earnings (Healthcare remains a standout). In our fixed income portfolios, we remain positioned in short-term and high-quality debt instruments to reduce the risk to principal in a rising rate environment.
Do you have questions about the market, the economy, or our fundamentally-rooted investment portfolios? Click here to contact us. We’d love to continue the conversation with you.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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