There was never a dull moment for financial markets in the first quarter of 2023. Markets seesawed monthly between optimism and pessimism. The Fed hiked interest rates twice, with another expected. Two banks collapsed amid old fashioned bank runs. The US debt ceiling was reached, with no solution in sight. Here we’ll provide perspective on the factors behind these headlines and the implications for your portfolio.
In a real sense, it all begins with the pandemic—its aftereffects run throughout the recent economic and market turmoil.
Recall that when the pandemic began three years ago, Washington passed huge spending bills to try to prevent the economy from sinking into too deep a hole. The Federal Reserve financed this stimulus through massive money printing to the tune of $5 trillion. Initially, the money surged into financial and other markets, causing a nearly two-year boom in stocks, real estate, and other assets.
As life began returning to normal later in 2021, consumers accelerated their spending on goods and services, making up for lost time. Inflation promptly ensued, with prices rising at their quickest pace in four decades. In response, the Fed has sharply raised interest rates over the past year, pushing up short-term rates from near zero to almost 5%.
After putting the pedal to the floor in 2020 and 2021, the Fed slammed on the brakes in 2022. An economy accustomed to near-zero interest rates for years on end is understandably experiencing shock at the dramatic reversal of policy.
This Year’s Aftershocks
The Fed’s tough medicine has caused cracks in the financial structure, some of which came into plain view in the first quarter of 2023. Most notable was the failure of two banks in early March. The first, Silvergate Bank of La Jolla, California, was briefly viewed as an isolated incident—a bank highly dependent on business from cryptocurrency companies that were reeling from the collapse of crypto broker FTX last November. But as Silvergate’s depositors fled en masse, attention quickly turned to other banks that might suffer a similar run.
Next in the crosshairs was Silicon Valley Bank (SVB). After a mostly illustrious 40-year history, SVB fell stunningly in just 24 hours. The collapse seems obvious in hindsight. Companies funded with venture capital were major beneficiaries of the government’s money fountain of 2020 and 2021. Many of these companies poured deposits into SVB, nearly quadrupling the bank’s total deposits in just three years, from about $50 billion at the end of 2018 to nearly $200 billion in 2021. Deposits exceeding the FDIC’s $250,000 per depositor insurance limit made up well over 95% of SVB’s total deposits.
Unable to generate loans nearly as fast as deposits were piling up, SVB plunged into long-term bonds at the Fed-induced very low interest rates of 2020-21. Rising interest rates in 2022 savaged the value of those bonds, as well as mortgages and other loans carrying fixed interest rates well below today’s rates. Remember, rising rates push down the price of existing bonds (as well as loans) to keep their yields competitive with new, higher rate bonds. The risk: a sudden withdrawal of deposits would force the liquidation of bonds and loans at sharp mark-downs. Taken to its extreme, SVB would not have enough to pay off all depositors. Combine this with a large and concentrated base of mostly uninsured deposits, and fears of a bank run quickly became a self-fulfilling prophecy.
Banking disruption quickly spread abroad, as 163-year-old banking giant Credit Suisse was forced into a fire sale acquisition by rival Union Bank of Switzerland on March 19.
US bank regulators did not have a good month of March, and not only because of the clearly inadequate supervision of SVB in the period leading up to its failure.
Rewind to 2011 when, in the wake of the 2008-09 Great Financial Crisis, regulators deemed eight large US banks “systemically important” (SI), meaning that these SI banks were “too big to fail” and thus all their deposits would be federally insured. In that moment, the regulators implicitly said that the other 4,000+ US banks were not too big to fail, meaning depositors holding uninsured balances there would surely flee at the first sign of trouble. Twelve years later, this unintended consequence came home to roost.
The FDIC compounded the risk of contagion—bank runs spreading across the industry—in its clumsy shutdown of Silicon Valley Bank. After the FDIC seized SVB on Friday, March 10, it announced it would pay off insured deposits Monday morning, but uninsured deposits (those exceeding $250,000 per depositor, i.e., nearly all SVB’s deposits) would be paid with an IOU, one that almost certainly would not be worth its face value, given SVB’s huge portfolio losses. If uninsured depositors at other banks weren’t already worried, the FDIC had just posted a
flashing red exit sign.
Realizing its predicament, and prodded by Treasury Secretary Janet Yellen, two days later federal regulators took the extreme (and inevitable) step of declaring SVB systemically important (ironic, as SVB had already failed), thereby insuring all SVB deposits and hopefully heading off other bank runs.
Non-SI banks and their larger depositors remain in a sort of limbo, hoping that the Treasury will wave its magic SI wand for these banks, should push come to shove. The Treasury has been maddeningly vague on this point, and the result has been a $500+ billion exodus of deposits from non-SI banks into SI banks, Treasury bills, and money market funds (which these days mostly invest in Treasury bills). Non-SI banks will experience a significant profit squeeze as a result, which in turn will exact a toll on small and midsize companies. These businesses rely heavily on community and regional banks for loans, and they also account for an outsized share of US job creation.
Debt Ceiling Impasse Looms
On January 19, the US national debt reached the $31.4 trillion limit imposed by current law. The debt grows over time because the US government almost always spends more than it collects in taxes each year, so it must borrow additional funds each year to cover the shortfall. Since January, unable to add to the debt, the US Treasury has used various accounting tricks to continue to
pay bills without breaching the limit, but this buys only so much time. Sometime this summer, either Congress and the President will agree to raise the ceiling, or the government will start missing some payments.
Getting agreement on anything is a challenge in Washington today. However, compromise was reached even in past fractious times, albeit often at the last minute. For example, in 2011 the US came perilously close to some form of default before ultimately raising the ceiling. In response, leading ratings agency Standard & Poor’s downgraded US debt from AAA to AA+, where it remains today.
The question is whether today’s highly polarized political climate will prevent a timely agreement.
The economic and political costs of a US default would be large, growing rapidly until resolved. Consequently, we expect the ceiling will be reached, but probably not before the last minute or even a bit after. Be prepared for a crescendo of fearful statements, accompanied by market volatility. If it happens, remember that your investment time horizon is much longer than the relatively brief period of upheaval. We will watch the situation closely and communicate with you as needed. Of course, we’re always here for any questions.
For a fuller discussion, be sure to see our Q1 Economic & Market Review.