Something Broke

A few weeks ago we shared our thoughts on the SVB collapse and the regional bank crisis. As we enter the fourth week of this crisis, we can begin to draw more conclusions. First, banks do not seem to have the same balance sheet problems as in 2008. Back then no one was sure what the value of mortgages held on their balance sheets really was and so banks stopped trusting each other. Interbank loan rates went through the roof.

Today, the situation is very different. The concern is not so much that banks are holding on to a lot of mispriced assets, but that they can no longer fund themselves with higher rates and an inverted yield curve, and thus do not have much of a business model.

Therefore, this crisis seems to be weeding out where the most excess was built during an era of low cost of capital. For example, SVB delivered remarkable returns by embracing an aggressive growth strategy, at a time, and a place, when such a strategy was rewarded—until it was not.

In the meantime, most US banks will face more regulation, additional government scrutiny, reduced animal spirits and a diminished appetite to lend. This likely means weaker economic growth. A powerful solution to this problem would be for the Fed to cut rates. However, will they pivot from their ongoing battle with Inflation?

Monetary Policy is Tight

If you did not think so before, it is clear now how tight monetary policy is as it filters its way through financial conditions and the entire economic system. It is often said that when the Federal Reserve starts to raise interest rates, it generally keeps doing so until something breaks. Well, something just broke. So, has the Fed now caused enough damage to take a step back?

Let us first look at what the Fed is doing. As the pain grew, the Fed rapidly returned to being a provider of excess liquidity, wiping out 60% of the quantitative tightening program over the last year.

Now let us look at what the Fed is saying. Powell created a clear ground for changing the trajectory of policy conditional on broader pain in the banking sector hitting the real economy. Therefore, if that does not emerge and the strong inflation and labor market data holds up then rate hikes could re-accelerate.

The juxtaposition of interest rate policy and financial stress poses risks of monetary overkill. However, the Fed will want to tread lightly to maintain credibility. We believe that they overreacted to the inflation slump during the Covid crisis by easing financial conditions too far for too long. The eventual result was an overheating economy and overly hot inflation. The risk now is that the Fed is tightening conditions so much that it has initiated a disinflationary process that will overshoot to the downside, may in turn, cause a recession.

Asset Market Implications

Asset Markets remain at a critical juncture. Stocks have been rangebound for a year now, but still well off their previous highs. Bond yields have started to come down for the first time in years and the yield curve is deeply inverted. Economic data, specifically inflation, will be extremely important in dictating future Fed policy. As we laid out in February we do believe we are at the beginning of a cyclical disinflationary cycle and that the Fed will eventually have to pivot. While that indicates that we are closer to a firm equity market bottom and new bull market, ultimately, we believe their will need to be more pain in the economy and markets before that happens. We continue to hold convicted positions in cash equivalents, credit, real assets, and quality equities.

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