Cross Asset Strategy
At this week’s FOMC meeting the Fed hiked its policy rate by 25bps, to a range of 4.75-5%. This was in line with expectations, as the rates market priced a roughly 80% probability to the hike prior to the meeting. Regarding forward guidance, the Fed changed the phrase "anticipating ongoing increases" in rates to “some additional policy firming may be appropriate”, suggesting that we are close to the end of this hiking cycle. Chair Powell also called out financial stability risks, stressing the handoff from monetary policy to tightening by bank lending channels as the reason why the median dots only project one more hike. He explicitly stated that tightening in lending conditions is equivalent to rate hikes, but expressed uncertainty on the magnitude.
On the recent bank issues, Chair Powell almost appeared to make an implicit guarantee for all deposits, despite being somewhat vague – saying “Depositors should assume that their deposits are safe”. In a Congressional Testimony Treasury Secretary Yellen seemed to contradict that by saying that the Treasury is not considering a broad increase in deposit insurance, which appears to have hit risk assets into Wednesday’s close. On the other hand, Powell suggested that the Fed did not even discuss modifying the pace of quantitative tightening (QT). It seems like the central bank is trying to completely distance QT from the financial stability concerns. Their main tools for the current situation are the discount window as well as the Bank Term Funding Program (BTFP).
Markets took the meeting as dovish and moved to price the first rate cut as early as this June. The meeting further strengthened our conviction towards long duration in portfolios, due to a larger chance of lower rates in the US as well as its ability to serve as recession protection.
Strategy Question: Is the recent banking turmoil the start of another GFC?
This latest episode of banking turmoil has reminded many of the Global Financial Crisis. Investors are concerned that the problems in US regional banks and certain European lenders like Credit Suisse are analogous to the first tremors of the crisis in late 2007 and early 2008. A similar upheaval in the financial system, deep recession, painful deleveraging, and staggered recovery, would obviously be detrimental to the economy and investment portfolios.
The banking system is, and has always been, built on confidence. When confidence comes into question, it can lead to a sense of panic that feeds on itself and becomes hard to contain. It also makes this situation very difficult to predict with any precision.
While there is tremendous uncertainty, given that the banking sector drives credit creation and subsequent economic growth, this episode is probably a negative for the market and economic outlook.
But this probably isn’t 2008, for three key reasons:
- Policymakers have tools to solve banking crises, and the bigger banks are much stronger
- The economy is in a much different place
- The magnitude of the problem is, so far, much smaller
Policymakers have the tools to solve a banking crisis, and the bigger banks are much stronger
The primary function of central banks isn’t managing inflation and employment, it is acting as a lender of last resort. In this way, central banks provide the bedrock for the banking system. The Fed’s ability to perform this role expanded during the Global Financial Crisis. They created many different types of lending facilities to provide liquidity to banks, and many former “broker-dealers” (like Morgan Stanley and Goldman Sachs) became bank holding companies.
Policymakers also understand how impactful decisive action can be. The new Bank Term Funding Program that they instituted is designed to alleviate the pressure that banks face from unrealized losses on their portfolios of high-quality treasury, agency, and mortgage-backed debt securities. U.S. dollar swap lines are also an underappreciated tool to alleviate the strain that can come from a global scramble for dollars. During the Global Financial Crisis, the U.S. dollar surged 25% in twelve months following the Bear Stearns collapse. Throughout this current episode, the dollar has been falling, which signals a more sanguine liquidity environment.
While the nominal amount drawn from the Fed’s discount window (the primary facility through which banks can borrow) is concerning, and also seems to have been concentrated in the banks that are under the most stress (three of which have already failed). It usually isn’t “good” when banks are using the discount window, but it does signal that the Federal Reserve is able to serve its primary function for the financial system.
It is also clear that policymakers are trying to ring-fence the weaker links in order to arrest a downward spiral in confidence. It may take time, a more powerful form of intervention, capital raises at much lower valuations, or a combination of all three, but policymakers understand what it takes to soften the blow of a banking crisis.
Post-financial crisis regulations have required the largest financial institutions to be much less levered, better capitalized, more transparent, and more liquid. The Volcker Rule prohibits banks from having their own proprietary trading and investment desks that could put depositor funds at risk. They also have lower reliance on wholesale (i.e. market based) funding from institutional investors, which is usually less sticky than standard deposits. The biggest banks are much stronger now than they were in 2008.
The big risk in the current instance is deposit flight, but that could prove to be an easier problem to solve than the core issues of leverage, mistrust between financial institutions, deteriorating credit and asset quality in the U.S. housing market, and difficult price discovery that occurred in 2008 – even if the profitability of the banking sector will likely be impaired.
The economy is in a much different place
When J.P. Morgan purchased Bear Stearns from the brink of failure in March 2008, the economy had shed jobs for three straight months and the critical construction sector had peaked a full two years earlier. Home prices peaked in the spring of 2007, and there was a tremendous glut of supply: vacant homes accounted for almost 15% of the total housing stock.
Household and corporate balance sheets were also much weaker. Mortgage debt was a staggering 65% of GDP vs. a more manageable ~45% today. Consumer and corporate debt service ratios are at secular lows.
Over the last three months, the economy has averaged 350,000 jobs gained per month, the construction sector is still growing, home prices are only down marginally from the peak, and housing inventory is very tight.
Today, the residential real estate market that was the epicenter of the 2008 collapse is much more resilient. Credit standards are higher (the cutoff for a bottom quartile credit score today is above 700 vs. 650 in 2007) and most borrowers are locked into a low rate.1
The banks that are in trouble today had concentrated deposit bases and poor interest rate risk management, but not necessarily bad loans. Further, the FDIC has guaranteed the deposits of failed banks, so there has been no asset impairment (at least so far). That could change as growth slows, but it is a very different problem than what we dealt with in 2008.
For now, the magnitude of this problem is smaller
At time of failure, Silicon Valley Bank ($209bn) and Signature Bank (~$110bn) combined have around half the assets that Lehman Brothers (~$640bn) had. Bear Stearns (~$400bn in assets) was also larger than each. That’s not to mention the many other firms that were acquired, placed into receivership, or otherwise assisted by the government (Merrill Lynch, Wachovia, Washington Mutual, and AIG come to mind).*
More importantly, the interconnectedness of the system in 2008 is hard to quantify. Trillions of dollars of opaque securities with tranches and derivatives formed a knot of Gordian proportions. The 2010 Dodd-Frank Act and subsequent regulations required these positions to be registered with transparent clearing houses. From a market perspective, the financial sector was the largest weight in the S&P 500 in 2008. Today, its ~13% weight is still meaningful, but is dwarfed by technology (~25%).2
That isn’t to say that this situation couldn’t spiral into a much larger problem. It is to say that as of now, the magnitude and potential for contagion due to complex counterparty risk seems much smaller than it was in March of 2008.
The nature of the problem is also different. The Global Financial Crisis was about asset quality problems with poor disclosure leading to a solvency crisis. This turmoil is caused by rapidly rising interest rates impacting assets with pristine disclosures that in turn leads to a liquidity issue.
Conclusion – Steady hands prevail
This spate of banking stress is likely to drag on growth and raises the (already elevated) probabilities of a recession later this year. Even if market volatility subsides in the coming weeks and months, banks will probably lend less. Less credit flowing into the economy means lower growth and elevated probability of a contraction. We are particularly worried about the linkages between regional banks and the commercial real estate sector (especially Office). On the other hand, it probably means less restrictive Fed policy and lower interest rates.
But this seems like a very different situation than the Global Financial Crisis. Then, oversupply in the housing sector, poor underwriting standards, overleverage, and interconnectedness combined to create a downward spiral for asset prices and the economy. Today, we are dealing with banks whose high quality bond portfolios have lost value, depositors who can move their cash quickly, and impaired profitability for smaller banks as they raise deposit rates to compete with larger ones.
Markets, for their part, are already pricing in a materially weaker outlook for banks. In fact, the relative performance of banks versus the rest of the market is already commensurate with the experience of both the Savings and Loan crisis of the early 1990s and the Global Financial Crisis.
What does it mean for investors?
For investors, core fixed income can help to provide crucial protection. The swift move lower in yields reminds us of the protection that bonds can provide as the growth outlook worsens. We continue to focus on high quality, investment-grade credit. Long-duration core fixed income also remains our high conviction idea. USD weakness could return on the back of lower expectations on US rates, despite that weaker risk sentiment limits where one can express that view with the right risk/reward. We favor short USD against alternative reserve currencies, i.e. JPY, CHF, EUR. In addition, a weaker dollar and lower real rates can both benefit gold. We believe the yellow metal presents a good opportunity considering the elevated volatility at the moment.
*(those numbers are also in nominal terms, if adjusted for inflation it would only emphasize how much smaller SVB and Signature are than Lehman and Bear).
1Bloomberg and factset, standard.
2Bloomberg and factset, standard.
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