Banking system fears causes sharp bond market reaction

Thoughts

• Equity markets look to stabilize following a difficult week that saw several bank closures, resulting in the largest weekly decline since September 2022. Last week was a reminder of the underlying pessimism of institutional investors, along with the fragility of the market. The sell-off was broad-based, led by small caps, value, and emerging markets. The S&P 500® Index begins the week less than 1% above the level from the beginning of the year, dropping 7% from early February. Volatility has returned in force, with the VIX at the highest level (29) since October, while the MOVE Index (measuring bond market volatility) up 43% since early February. As has been the case since the beginning of last year, bond investors are exhibiting greater signs of emotion than the equity market, which is unusual during periods of uncertainty.
• The bond market continues to post extreme volatility, including a roughly 0.50% drop in the 2-year yield on Monday, registering the largest two-day drop since the financial crisis, and suggesting investors are rapidly shifting their expectations for Fed policy. The federal government stepped up to support the banking system with a pledge to support depositors above the FDIC’s $250,000 insurance cap, potentially introducing a “moral hazard,” essentially uncapping the FDIC threshold in the minds of depositors. This volatility could continue over the next two weeks, with contagion in the banking system a concern, a reading on CPI and PPI coming this week, and an FOMC meeting next week.
• The Fed’s new Bank Term Funding Program, combined with the temporary expansion of FDIC insurance announced yesterday, effectively solved for any fundamental concerns regarding bank solvency or liquidity related to held-to-maturity securities portfolios, which has been an area of focus over the past week.
• Today’s movement in bank equities, rather, is emotion driven. But that fear isn’t pervasive. Two data points are instructive here: First, CNN’s Fear & Greed Index has seen a wholesale shift towards fear (from 78-Extreme Greed to 18-Extreme Fear) in only 40 days. At the same time, overnight interbank lending rates have remained relatively stable and low, by historical standards, at 0.29%. If all things stay the same, this will likely be a buying opportunity once the dust settles.

News

• The health of the banking system has been under scrutiny over the past week with the collapse of several banks. Regulators shut down Silicon Valley Bank, with $211 billion in assets and $173 billion in deposits, following a run on the bank late last week. On Sunday, the Treasury Department, Federal Reserve, and the FDIC announced actions to restore confidence in the banking system, pledging to “fully protect all depositors” at SVB despite roughly 97% of deposits above the $250,000 FDIC insurance threshold. Additionally, the Fed announced a new “Bank Term Funding Program” offering better terms on one-year loans to banks, along with relaxing terms at the discount window, the primary direct lending facility. The KBW Bank Index lost 16% last week, the worst since the beginning of the pandemic.
• Investors are struggling to gauge the direction of Fed policy with the banking industry struggles contrasted with the stubbornly high level of inflation. The terminal rate has fallen to 4.79% on Monday, down nearly 1.00% since a week ago, and down 0.20% from the beginning of the year. The Fed Futures curve now embeds a near 50-50 split between no action at next week’s FOMC meeting and a 0.25% hike. It was near 50-50 between a 0.25% and a 0.50% hike last week following hawkish commentary by Fed Chair Powell to Congress, where he stated that we will see “higher than previously anticipated” rates for an extended period. “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell told the Senate Banking Committee. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.” It is unclear how the disruption in the banking system may impact that path.
• Payrolls in February were a stronger-than-expected 311,000, better than the 225,000 estimate, but down from 504,000 in January. According to Bloomberg, payrolls have topped estimates for 11-straight months, extending the longest streak since 1998. The unemployment rate ticked higher to 3.6% from 3.4% last month despite strong job growth, as the labor force participation rate rose. Average hourly earnings grew by 4.6% from a year ago, slightly lower than estimated, but faster than in January. CPI came in at 6.0% headline (5.5% core) for February, suggesting a 23rd straight month of negative real wages. The JOLTS report showed 10.8 million job openings, down from 11.2 million in January, but still much higher than the 5.8 million unemployed people.

What to Watch

• Inflation is in focus this week, as CPI came in at 6.0% headline (5.5% core) for February, suggesting a 23rd straight month of negative real wages, and the report on PPI will come Wednesday. Other notable releases include the NFIB Small Business Index today, retail sales on Wednesday, housing starts on Thursday, and industrial production, leading indicators, and consumer sentiment on Friday.