Consider the geopolitical chaos in the world right now. The Middle East is in bloody upheaval – thousands of people dead, hundreds held hostage and no end to the conflict in sight. Antisemitism is breaking out on college campuses and elsewhere. Oil could be priced at $150/barrel next year, according to Bloomberg. There’s a new Russian offensive in the Ukraine. Putin is having “a very good October,” according to a Washington Post column. And then there’s a paralytic Congress, lurching through fiscal showdowns and government shutdowns.
Consider the financial chaos as well. Treasury markets are “in turmoil,” according to the Financial Times. Or is it a “meltdown,” as Charles Schwab contends? Bond markets are even more volatile than stock market – the gap is “the most on record,” Bloomberg reports. The housing market is “painful, ugly, anxious” (per CNBC), “completely broken” (per Bloomberg) and “a crash that can sink the American economy” (per CNN). The banking industry – to include even some of the great pillars of the financial system – has been shaky all year, with balance sheets awash in unrealized losses that will take years to work out.
And Yet, On Wall Street, Euphoria Reigns
Yet on Wall Street, there’s euphoria. Last week, the Nasdaq had its best stretch in a year. Since October 27, the index has been up 8.4%.
It’s not just tech. The broad market is up. The S&P 500 had its best week since June 2022 – gaining 6% in the last 10 days.
It’s a relief rally, and a strong one. But given the threats and the chaos all around, it bears asking: Relief from what?
The Financial Ceasefire
Let the news ring out: The Federal Reserve seems to have declared a ceasefire in its campaign to rein in a too-robust economy.
But not everyone is as happy. While the market now celebrates the apparent pause in the Fed’s activist program, it is worth surveying some of the collateral damage the policy has caused along the way.
The Fed’s Quixotic Campaign
To review: the Fed launched its rate tightening offensive, more or less without warning, in March 2022. Perhaps they didn’t even realize what they were getting into. The Fed had been serving up dovish guidance to the financial markets for months. Nine months earlier, in June 2021, a majority of the members of the Federal Reserve’s Open Market Committee (FOMC) had claimed not to see the need for any rate hikes at all in 2022. In his press conference following the FOMC meeting, Chairman Jerome Powell could even suggest that “rate increases are really not at all the focus of the Committee.”
By September 2021, there was a slight shift and a split vote. Of the 18 FOMC members, nine predicted one increase in 2022. The other nine still saw no rate rises ahead for 2022. Looking further out, 13 members projected two rate hikes for 2023. Four members saw just a single rate hike by then. (One optimistic member saw no need for any rate raises in 2022 or 2023.)
By December 2021, nerves were fraying a little. Two thirds of the FOMC now expected three rate hikes in 2022.
In the event, there were seven rate increases in 2022, and four more in the first half of 2023. In the roughly 500 days between the first increase in March 2022 and the last one in July 2023, the Fed jacked up the Fed Funds rate by 525 basis points (5.25%).
It was the steepest tightening program since 1980.
The Fed’s aggressiveness took many by surprise, including the Fed itself. Here below is the Fed’s famous “dot plot” from September 2021. This chart expresses the views of the FOMC members regarding the future levels of the Fed Funds Rate. Each dot represents the forecast of one of the FOMC members. The average forecast Fed Funds Rate for 2023 (year’s end) was a little more than 1%. In reality, it came in at more than 5%.
Obviously, the crystal ball wasn’t working.
The Impact Of Rate Increases On The Banking Industry
Another group taken by surprise was the banking industry.
Bankers, generally speaking, are not traders. They aren’t typically screen-watchers, set on a hair-trigger, ready to react quickly to breaking news and rapid market shifts. Traditionally, bankers are expected to be thoughtful (i.e., slow) and steady by nature. Out of habit, they tend to build their plans around an expectation of continuity and stability, not disruption.
The speed and intensity of the Fed’s rate tightening program was unprecedented. Banks arguably were not prepared to pivot as quickly as the Fed had done. In particular, it is likely that they were taken by surprise with the sudden deterioration of their bond holdings. The Fed’s campaign drove the entire interest rate environment higher across the markets and the broader economy. This amplified the interest rate risk inherent in long-term bonds, which derives from the inverse relationship between interest rates (and market yields) and bond prices. As the interest rates rise, the market prices of bonds fall. The longer the term of the bond, the more severe the impact on prices. And as the market value of the bonds declines, so-called mark-to-market accounting rules can kick in and under some circumstances force the holder of the bonds (e.g., a bank) to write down the bonds’ value carried on the balance sheet, even if those bonds are not sold and no actual loss is realized. These “paper losses” still generate a hit to earnings, and reduce the bank’s net assets.
The Fed’s hyper-accelerated rate increases thus drove drove down bond prices across the market. Many banks had failed to anticipate such a drastic campaign, and were not sufficiently hedged against this scenario. The drastic drop in the value of their bond holdings tore huge holes in banks’ balance sheets before they could react.
The damage was massive. Long-dated Treasury Bonds – Full-Faith-and-Credit obligations of the United States of America, mind you – lost more than one-third of their value in the 18 months since the Fed began tightening. Medium term Treasurys were down 14%. (These figures are drawn from the values of iShares ETFs – symbols TLT and IEF – which are proxies for long-term and medium-term Treasury bond values.)
Bond investors do not expect to lose value on this scale. A 35% loss on “super-safe” Treasurys is far more shocking than a similar decline in the stock market.
Silicon Valley Bank
Silicon Valley Bank was the first and most spectacular victim of this process. As the Fed raised rates aggressively, SVB’s unrealized losses — that is, the paper losses the bank was forced to recognize as a result of mark-to-market accounting on their holdings of long-dated Treasurys – quickly mounted.
- “The Federal Reserve’s increase in rates over the last year greatly reduced the market value of SVB’s investment portfolio — about $15.9 billion in unrealized losses in the third quarter compared to the company’s $11.9 billion of tangible common equity.”
The post-mortems on the SVB collapse have identified many contributing factors, from a too-high level of uninsured deposits and insufficient hedging to the lack of a chief risk officer for much of the critical period. But these factors are secondary. The main cause of the bank’s collapse was its failure to anticipate the unprecedented ferocity of the Fed’s campaign. Which, as shown above in the dot plot, even the Fed itself did not anticipate.
It was common in the post-SVB narratives to describe its collapse as a failure to follow the rules of “Banking 101.” And indeed, interest rate risk is a standard topic for Banking 101. But what isn’t a 101-level topic is a scenario where an activist central bank, to show its moxie, decides to accelerate the interest rate flywheel faster than the economy and the banking industry can handle. The slow-and-steady leaders of the industry – at both the banks and at the Fed itself – did not recognize quickly enough the complex way in which rising rate risk would interact with changing and sometimes obtuse accounting rules. They did not foresee how the process could speed up in a technologically amped up eco-system and suddenly rip apart the banks’ balance sheets. They did not see how bankers’ traditional conservative mindset – normally seen as an asset – could become a liability in this new context.
The Fed’s Blind Spot
Did the Fed recognize these risks it was creating? Does it even today acknowledge the problem? I’ve read through the Fed’s after-action report on SVB, published in September. It is not clear that the authors understand the causal chain described here. All of the report’s recommendations focus on strengthening bank supervision. The report briefly addresses the matter of interest rate risk as though it were some sort of natural disaster that SVB did not take sufficient precaution against.
- “During a period of low interest rates, SVB invested a large amount of the influx of deposits in securities with long-term maturities, specifically U.S. Treasury bonds and agency-issued mortgage-backed securities.” (Page 2 of the report)
This would likely have been viewed at the time as a safe and prudent way to earn interest on SVB’s cash balances without taking on credit risk.
Then,
- “When interest rates started to rise in 2022, SVB did not heed the early signs of market risk and the rising rates adversely affected the value of SVB’s investments in securities with long-term maturities.” (From page 14.)
Finally,
- “After SVB management removed the hedges, interest rates continued to rise and the bank experienced a significant increase in unrealized losses on its investment securities.” (From page 15).
The hole in SVB’s balance sheet grew from a little less than $1.4 billion at the end of 2021 to $17.7 billion at the end of 2022 – big enough to consume the bank’s entire equity, its capital cushion. SVB was now technically insolvent.
A the Fed report sees it, the fault lies with SVB and its failure to adjust “when interest rates started to rise.” But interest rates did not just “start to rise.” The phrase reveals the blind spot at the central bank. Interest rates were rising because the Fed’s actions were forcing them to rise. Perhaps there was good reason for this tightening policy (or perhaps not — see below), but in this report there is no real recognition that the Fed itself failed to foresee the impact on the banking system of going into Fast and Furious mode.
The Contagion
Silicon Valley Bank was not the only casualty. The contagion penetrated the entire financial sector.
Several other regional banks went down. Even the biggest banks were hit hard. Bank of America seems to have suffered the worst. On October 17, Reuters reported that the Bank of America had unrealized losses of $131.6 billion on securities in the third quarter, up from $106 Billion in 2nd quarter.
- “All of these are unrealized losses on government-guaranteed securities,” Bank of America’s CFO told reporters on conference call discussing third-quarter earnings,” per Reuters. “We’re holding them to maturity, we will anticipate that we’ll have zero losses over time.”
Yes, they were “government-guaranteed securities.” SVB and these other banks were parking their cash in what they may have thought were the safest of asset classes, US Treasurys. Their mistake was not in buying Treasurys, nor in failing to understand interest rate risk per se, but in not anticipating the speed and intensity of the Fed’s onslaught.
Today the banking industry as a whole is estimated to be carrying more than $650 Billion in unrelated losses on their books – which “could squeeze their finances for years to come,” highlights a Bloomberg report. It may not be an existential threat, but it is weighing heavy on valuations. Banking shares are down 40% against the S&P 500 since the SVB crash, and have not recovered even as the crisis has passed. In short, the financial sector was revalued, downwards. Shares of even the largest banks trade at a significant discount to their 10-year averages (measured by P/E ratios). The size of the discount reflects the scale of the paper losses these banks have suffered.
The collapse of SVB and a few small banks was financially insignificant compared to the huge impact on the sector as a whole. In short, the banking sector today is depressed – and it will stay depressed until it can work out of the deficit created by the Fed’s tightening campaign (and absurd mark-to-market accounting complexities). Or until rates fall, and prices rise, allowing for a revised mark-up to market. But with the Fed’s bluster about rates staying “higher for longer” — well, it may be a long wait.
‘The Fed is Done’
In any case, this kneecapping of the banking sector by the unelected economists at the Fed is a demonstration of the Fed’s awesome power over the market and the economy. The effects of the Fed’s tightening campaign have gone beyond just snuffing a few high-flying regional banks. They have also paralyzed the housing market, and may have seeded a recession.
And for what? The rationale for the tightening campaign was to control inflation, but the Fed’s policy has had little if any impact on this inflation. It has not reined in consumer spending. It has not dampened the labor market. Even the Wall Street Journal is now admitting that “there is no obvious link between the Fed action and the slowdown in inflation.”
Meanwhile the Fed’s campaign has created huge problems for foreign countries and businesses that financed themselves with dollar-denominated debt.
- “Many smaller emerging markets are confronting a “silent debt crisis” as they struggle with the impact of high US interest rates on their already-fragile finances, the World Bank has warned.” – The Financial Times (Nov 7, 2023)
It has stimulated capital flight from China (and many other countries). According to the World Bank, since March 2022 when the Fed started its campaign,
- “There has been a large capital flight from emerging markets and developing countries, leading to declines in their foreign exchange (FOREX) reserves, local currency depreciation and difficulties to repay dollar denominated loans.”
A side effect of Fed policy aimed (ineffectually) at mollifying American consumers annoyed at the temporarily high price of eggs and gasoline has been a huge disruption of government budgets all through the developing world. The tightening campaign could not resolve shortages in semiconductors or eggs or used cars or lumber or any of the transitory price increases which have now slowed and in many cases gone into reverse — all on their own, through the natural working of the market mechanism.
In any event, the financial markets have welcomed the monetary ceasefire – which everyone hopes will become now a permanent peace. That is what the Nasdaq’s surge over the last week was all about.
But the other side of the coin is fear: the market has learned to fear the Fed more than anything else – more than recession, more than conflict in the Middle East or $150 oil, more than Putin’s missiles. When that fear is (perhaps temporarily but blessedly) lifted, the response is a grand relief rally that seems oblivious to all the other perils of this perilous moment in world history.
Is The Market Broken?
Euphoria is pleasant enough (while it lasts). But the larger questions about the Fed’s aggressive monetary actions, the market’s reaction to them, and the seeming obliviousness of investors to the “real world” crises exploding all around them, are: Is this strange relief rally a sign that financial markets have become dysfunctional? Do they no longer perform the service of allocating capital efficiently based on economic fundamentals? Have they instead become a rather simplistic barometer narrowly focused on policy maneuvers and ruminations at the Federal Reserve?
Since the mid-1990s, the Fed has become the single most important factor in moving the financial markets. A 2013 study by two Fed economists found that “since 1994, the S&P500 index has on average increased 49 basis points in the 24 hours before scheduled FOMC announcements.” The authors observed that “these returns do not revert in subsequent trading days and are orders of magnitude larger than those outside the 24-hour pre-FOMC window. As a result, about 80% of annual realized excess stock returns since 1994 are accounted for by the pre-FOMC announcement drift.”
This does not seem healthy. The market appears to have become a dependent variable hanging on the pronouncements of the Federal Reserve, the tone of the FOMC meeting minutes, and the speeches, gestures, improvised remarks, and facial expressions of its leaders. Why worry about subsidiary factors like corporate earnings, or the implications of global conflict, when the main game is now all about what the Fed will say or do next?
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