March 10 2023
This week we heard from Jerome Powell who provided his update to Congress. Here he confirmed that he was prepared to increase the pace of interest rate hikes if the data warranted this. He also commented on the fact that the most recent economic data had been stronger than they had expected, therefore the rate at which interest rate peaks, or terminal rate, was likely to be higher than had been expected.
After some stubborn inflation data recently the market was quick to react to his testimony. Firstly, they were very quick to price in a much higher probability of a 0.5% rate hike later this month. On the 6th March the probability of a rate hike of this magnitude stood at a little over 31%. By the 8th however this had increased to over 80%. A hike of this magnitude would take rates to the 5%-5.25% range. We also saw a pick up in the expected terminal rate. The market was already pricing in a much higher rate than that expected at the beginning of February, but this took another leg up to 5.69%.
These moves caused rates at the shorter end of the yield curve to rise the US Treasury 10 year-2 year yield curve to invert further into negative territory, reaching the -1% level. Many commentators believe this yield curve action to be a precursor to a recession. Historically, however, recession tends to come to the fore after the yield curve has started to invert itself. No one seems quite sure when this will be, but that could tie in with a Fed pivot which, for now, doesn’t seem to be on the short term horizon at least. For now, higher short term yields continue to raise asset allocation questions. It would appear that ‘There Is No Alternative’ no longer applies.
The story dominating the end of the week however is Silicon Valley Bank (SVB). The bank saw its share price plummet over 60% on Thursday and was expected to open lower again in Friday’s trading session. But why was this seen? In the US, banks enjoy favourable regulation whereby they are able to hold ‘available for sale’ securities and ‘held to maturity’ securities. In order to try and generate more return the bank had previously transferred bonds, in the form of Treasuries and mortgage backed securities (MBS), into their ‘held to maturity’ reserves.
The benefit here is that bonds held within this reserve do not need to be marked to market, therefore any unreleased losses on these positions do not impact the bank profit and loss account. If these assets are subsequently required to meet cash calls from depositors however, there lies the problem, as these assets need to be sold and losses on the positions realised. This is what has been seen, with SVB reporting a $1.8bn loss.
This has sent ripples through the banking sector share prices. This includes the much larger banks such as Wells Fargo. At the time of writing two regional US banks have seen trading in their shares suspended due to the scale of their share price falls on Friday and the US Treasury has reported it is monitoring ‘a few’ banks due to this issue. For now, however, expectations are that SVB will not a harbinger for an industry wide shock. The unique position of bank, in terms of who it was lending to in terms of fledging companies, has been the key contributor to its issues.
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