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Calm Returns to Markets

After a few wild days, equity markets found a footing and have rallied decently. Most, if not all, of the regional U.S. bank stocks previously in freefall bounced back meaningfully today, led by a gain of more than 25% in First Republic Bank. Shares of First Republic had fallen more than 80% since last Wednesday, which was the day before Silicon Valley Bank announced that it was raising money to shore up its balance sheet.

Frankly, we were surprised that banking stocks continued their downward slide on Monday, despite the U.S. Government’s commitment to backstop uninsured deposits and provide emergency lending facilities to banks with liquidity challenges.

In a joint statement released on Sunday, Treasury Secretary Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, and FDIC Chairman Martin J. Gruenberg confirmed that they would step in to protect depositors. Protecting deposits was important to stem further runs on other banks. Importantly, taxpayers won’t foot the bill for any shortfall in honouring deposits at the banks. Instead, the costs will be borne by the banking industry, which is reassuring because a government bailout would be extremely unpopular.

The regulators also announced an emergency funding vehicle called the Bank Term Funding Program, which banks can use for liquidity if and when they have withdrawal requests that would otherwise force them to sell securities with meaningful, unrealized losses. The facility will help banks with large unrealized losses on low-coupon securities rebuild their balance sheets. That said, we are unsure that any will want to actually use the facility outside an emergency situation, as doing so would signify weakness. 

While risks in the banking system are clearly greater than investors appreciated, we believe the industry is stronger than some fear. Bank failures are scary, yet they are more common than one might think. In fact, according to Bloomberg, there have been 565 bank failures in the U.S. since 2000. While many of them occurred in the aftermath of the 2008/09 Financial Crisis, it’s probably surprising to learn that there were roughly two bank failures per month between 2011 and 2020. Still, the demise of SVB and Signature Bank (SBNY) was alarming because they were the second- and third-largest bank failures in U.S. history.

In our view, bank stocks are rallying for two reasons:

1. Investors appreciate that SVB and SBNY are unique situations. Both had highly concentrated, uninsured deposit bases (SVB with start-up companies and SBNY with crypto clients), both took undue interest rate risk (borrowing short term and lending long term), and both did an incredibly poor job of managing risk.

    

2. The deposit guarantee commitments and emergency liquidity facilities now in place go a long way to arresting panic and reducing the risk of additional bank runs.

Aside from significant downward pressure on bank stocks, the other bizarre action over the last few days was in the bond market. Between March 8 and March 13, the yield on the two-year U.S. Treasury bond declined 109 basis points, from 5.07% to 3.98%, and then increased to 4.24% today. The last time volatility in the U.S. government bond market was this extreme was during the 2008/09 Financial Crisis.

Attitudes about Federal Reserve monetary policy have also flip-flopped. A week ago, with inflationary pressures in the economy persisting, investors were betting that the Fed would raise administered interest rates another 50 basis points at their meeting next week and remain on course to keep interest rates higher for longer. But further rate increases were off the table by Monday and the Fed Fund Futures were discounting a 75-basis-point reduction by the end of the year. Today, the market is back to expecting a 25-basis-point increase next week and only 25 basis points of easing by the end of the year.

Banking is a trust-based business, and the events of the past few days have exposed an ugly underbelly of the U.S. banking system. Bankers took on too much risk and regulators did a poor job of policing them. While we still believe the banks and the overall banking system are much stronger than they were prior to the financial crisis, they are not as solid as we thought, and there is rebuilding to be done. 

Regulators and bankers alike will be looking to reduce risks and fortify their balance sheets. Such actions will reduce credit in an environment where consumers and businesses are already under pressure from higher inflation and interest rates. Tighter credit conditions will have a negative influence on the economy, and we continue to believe a recession is likely. Importantly, however, we think it will be relatively mild and short.