Since the news of Silicon Valley Bank’s (SVB) collapse broke in early March, the bond market has reacted with one of the largest declines in short-term interest rates1 in history. The market is now pricing in2 a potential interest rate cut by the Federal Reserve (the Fed) in the middle of the year, and a repricing of the September Fed funds rate3 down by over 1.5%. In this market piece, we will explore how central banks will respond and the potential investment implications.
An expected event as part of the tightening cycle?
The recent SVB event should not come as a surprise. Earlier this year, we published our 2023 outlook piece where we discussed the sharp tightening4 of monetary policy by central banks to combat multi-decade high inflation following a period of unprecedented policy easing5. The rapid increase in SVB deposits from ~$50bn to ~$200bn occurred in a short period of time, as Venture Capital (VC) companies raised more money than they could invest in. During periods of tightening cycles, easy money is taken away, causing events like the SVB failure.
While each cycle may be different, the broader contracting dynamic beyond VC is potentially the same. The bank failure is a “canary in the coal mine” that could have knock-on effects in the VC world and beyond, potentially forcing central banks to bring back easy money by cutting rates to stop the self-reinforcing debt contraction, which is what the bond market is now pricing in.
How will central banks react?
However, inflation in the US and other developed markets is still too high, and the Fed will still need to continue hiking the official cash rates. The latest US CPI release indicates that price pressures remained elevated in February 2023, including core services inflation excluding shelter, which continues an uptrend that started in December 2022.
There are three potential outcomes: 1) aggressive tightening leads to a recession, 2) the Fed keeps rates at restrictive levels for a prolonged period, or 3) the Fed threads the needle, and the economy comes to a soft landing6 with inflation easing – a Goldilocks scenario. The latter was a key driver of the October 2022 rally.
To date, only regional banks have been severely impacted (down ~30%) while broader markets are only down a few percent. This suggests very little repricing of economic conditions. SVB’s sensitivity to security values was uniquely high, more than double the share of any of its regional bank peers. Unless the improbable event of SVB contagion is uncontained, we should focus on the broader implications of the Fed creating demand-destruction (a recession) or a prolonged period of restrictive financial conditions, both of which are challenging for the equity markets.
By: Frank Li, CFA, is a Portfolio Manager within Insignia Financials’ Diversified Portfolios (Default) team which manages in excess of $60 billion on behalf of our superannuation members. He has over 10 years’ experience in institutional multi-asset portfolio management.
Date: 28 March 2023
1 Short-term interest rates: Interest rates on short-term borrowings (maturities up to a year)
2 Pricing in: Market has incorporated or reflected current information in prices.
3 Federal Funds Rate: Target interest rate set by the FOMC. It is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.
4 Tightening: A general rise in interest rates to curb inflation and reduce credit creation.
5 Easing: A general decrease in interest rates to stimulate demand through credit creation.
6 Soft landing: a balanced outcome where central banks achieve both price stability and full employment.
If you are keen to read more around this event, we recommend the following blog from CFA Institute:
The SVB Collapse: FASB Should Eliminate “Hide-‘Til-Maturity” Accounting >