by Paul Hoffmeister, Chief Economist
The Federal Reserve and US government moved to aggressively support banks in March. At the same time, the market expects a major reversal in Fed policy.
But macroeconomic indicators continue to send worrisome signals; banking risks remain; and Fed officials are not yet calling for interest rate cuts.
The yield curve suggests another major drawdown is likely in equities.
Despite the fact that a banking panic erupted last month, the S&P 500 is up nearly 8% year-to-date, and the Nasdaq is up almost 16%. This resilience in risk-taking can be largely attributed to the major banking-related support from the Federal Reserve and US government during the last month, as well as the dramatically dovish change in the Fed outlook.
Specifically, in response to the failures of Silicon Valley Bank and Signature Bank in March, the Fed created a new bank lending program called the Bank Term Funding Program (BTFP), for banks to receive loans on collateral valued at par, as opposed to lower mark-to-market valuations that would force those banks to realize massive losses. Many believe that sizable unrealized losses were primarily behind the deposit runs at SVB and Signature and ignited the concerns about the viability of many other banks.
What led to those sizeable unrealized losses? Due to rising interest rates of the last year, longer term maturity assets, such as Treasuries and mortgage-backed securities, acquired by banks when interest rates were lower, became worth less than their face values. According to the FDIC, at the end of 2022, the total unrealized losses on available for sale and held to maturity securities was $620 billion.[i]The scale of these unrealized losses suggests that the BTFP is one of the biggest bank support programs in history.The famous TARP program of 2008 was initially authorized to spend $700 billion; and total disbursements were less than $500 billion according to the Congressional Budget Office.
Concurrent with the new BTFP program, the FDIC and US Treasury announced that all deposits at SVB and Signature Bank would be guaranteed, arguably giving confidence to financial markets and investors that potential bank contagion would be defused for the near-term.
In addition to these major actions, the interest rate outlook has turned dramatically dovish during the last month. On March 6 -- days before the SVB/Signature turmoil – federal funds futures were expecting the Fed’s target overnight rate to be 5.50% by year-end; as of last Friday, the market expected a year-end funds rate of 4.48%.[ii] The recent bank troubles as well as softening inflation and growth data have worked together to keep Fed rate expectations dovish.
Arguably, financial markets seem to have a great degree of confidence that banking problems are contained, and that the Federal Reserve will soon terminate the interest rate hiking cycle that has pained markets during the last year and that it’ll even start to ease later this year.
This is certainly possible. But, in our view, this doesn’t mean that we see an all-clear signal to add significant risk today. There are still a handful of significant risks.
First, a variety of macroeconomic data that we’ve been highlighting in recent months appear to suggest a substantial economic slowdown will soon occur. For example, the yield curves for the major western economies – United States, Canada, UK, France and Germany – were each inverted as of last week; something we haven’t seen in the last 20 years. Leading economic indicators remain negative. And, even before last month’s bank turmoil, banks were already signaling tighter lending conditions. Now, with the recent bank problems, the prospect of reduced loan volumes for the US economy looks even dimmer. All together, these are worrisome signs of a pending slowdown.
Second, we don’t believe that banking risks are completely behind us, and this seems to be confirmed by recent market behavior. The S&P Regional Bank Index has not rallied with broad market indices during the last month. In fact, the bank index is trading lower today than it did during the week following the demise of SVB and Signature Bank. It’s worth noting, too, that famed investor Warren Buffett revealed last week that he had recently sold stakes in several banks.
So, what would the market for bank stocks still be concerned about? The market could still be worried about deposit outflows similar to what occurred at SVB and Signature, rising costs for deposits held at banks that will likely reduce future bank earnings, and possibly significant credit risk if the economy markedly deteriorates.
In early March, FDIC Chairman Martin Gruenberg highlighted a number of areas of potential credit risk for banks. He noted modest increases in auto loan and credit card charge-offs in 2022, and the potential for this to increase should cash-strapped consumers face even greater repayment difficulties.[iii]
Gruenberg also highlighted the surge last year in commercial real estate loans (CRE) and construction and development loans (C&D loans), which increased 10.7% and 16.5% respectively. While commercial property generally performed well in 2022, these could be of concern if the economy entered recession. He added that structural trends toward remote work raise the question of whether this has permanently and materially reduced the need for office space. According to Gruenberg: “Since the start of the pandemic, the national average office vacancy rate has trended upwards, from about 9.6 percent at March 31, 2020, to about 12.5 percent as of yearend 2022. As of the fourth quarter of 2022, five major metropolitan areas had office vacancy rates between 15 percent and 20 percent.” Those cities are Chicago, Dallas, Houston, San Francisco, and Washington, D.C.
While lower occupancies could lead to lower rents and operating income by office properties, higher interest rates could make future refinancings more expensive. According to Gruenberg, approximately $56 billion in loans financing office properties that are collateral for commercial mortgage-backed securities are coming due in the next 3 years. If the valuations of these properties suffer, it could be present a challenge for their owners, including banks that hold some of these loans as assets on their balance sheets.
Therefore, while the recent banking worries appear to have been contained for now, there are still risks to banks, especially if the economy slows significantly. Commercial real estate, as well as auto and credit card loans, could be market segments to watch.
Lastly, most Fed officials do not yet seem to agree with the market’s dovish rate outlook. Most officials expect the funds rate to end the year between 5% and 5.25%. Even more, in recent weeks, St. Louis Fed President Jim Bullard raised his year-end target for the funds rate to 5.5%-5.75% “in reaction to the stronger economic news and also on the assumption that the financial stress abates in the weeks and months ahead.” Additionally, Fed Governor Chris Waller, while not affirming an exact year-end target, said last week, “Monetary policy will need to remain tight for a substantial period of time, and longer than markets anticipate.” Both men cited the strong labor market and inflation that’s running higher than the Fed’s 2% target.
With no Fed official yet calling for rate cuts, Fed policy remains well out of line with market expectations. Even worse, it suggests that the Fed might not begin cutting interest rates until it’s forced to, by either significantly weak financial markets and/or much weaker economic data.
Conclusion: Despite the recent market optimism and risk-taking, we do not believe there’s an all-clear “risk on” signal for investors because of many macroeconomic data points that portend recession, persistent risks at banks especially if the economy slows, and an official Fed policy position that is not yet signaling a reversal in policy.
The yield curve, as measured by the spread between the 10-year Treasury and 3-month T-bill, is the most inverted it has been since the early 1980s. The correlation between this part of the yield curve and the S&P 500 suggests that equity returns will be challenged during the next year, and another major drawdown in equities could be likely. We expect it would be due to economic and/or financial panic that will then force the Fed to begin reversing its hawkish policy of the last year.
[i] “Remarks by FDIC Chairman Martin Gruenberg at the Institute of International Bankers,” by Martin Gruenberg, March 6, 2023.
[ii] Source: Bloomberg.
[iii] “Remarks by FDIC Chairman Martin Gruenberg at the Institute of International Bankers,” by Martin Gruenberg, March 6, 2023.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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