SVB Failure Won’t Change Fed Calculus
What You Missed
Given how quickly things are changing, the usefulness of almost any analysis at the moment is short. But, certain fairly basic truths about the market, the financial system, policy, and the economy may still be distilled. One of the most significant is that, especially in the present social-media era, it’s critical to keep an open mind about how things can change when faced with crisis-like circumstances.
Yields across the maturity spectrum have plummeted, breaking a four-week streak of increases, amid a spike in concerns over the banking sector after the failure of Silicon Valley Bank (SVB) and Signature Bank, its east coast equivalent. Behind the news headlines however, the interest rate dynamic largely remains the same: A benign combination of receding inflation readings and moderating US economic growth in January have given way to troubling inflation reports and signs that the economy isn’t slowing quickly enough to send the Fed to the rate-hiking sidelines any time soon.
That being said, at the time of this writing, investors have scaled back their bets on how high interest rates will go in a huge way, spurred into action by fears that the bank failures could spread through the banking industry. Interest rate futures now project that the Fed Funds rate – that’s the rate the Fed raises of lowers as it affects interest rate policy – is already as high as its going to get at 4.75%, and that their will be no more rate hikes. If the banking industry is truly in real danger (and keep in mind that social media may make an imagined threat real), it wouldn’t make sense for the Fed to keep raising rates until they have a better understanding of the situation. We suspect these moves are overdone, and once calm is established, that markets will settle with an expectation that we’ll get at least another 50 basis points in rate hikes, spread out over the next several months.
For the week, the 2, 5, 10 and 30-year Treasury yields fell a whopping 76, 57, 43 and 27 basis points respectively. Of note was the 2-year Treasury yields rise to 5.07% mid-week, a level that hasn’t been seen since June 2007. It’s now fallen it’s fastest since 1987, to 4.09%. The fall in short-term yields released some pressure in the 2s-10s yield curve, a widely watched barometer of looming recession, easing to -60 basis points, well off its most inverted levels since the 1980’s at -89, seen just last Friday.
Elsewhere, global equities on the week were spurred lower on the back of the SVB failure and continued lack of confidence in the resilience in corporate earnings. The price of a barrel of West Texas Intermediate crude oil slipped to $76.65 from $77.50 a week ago, as the US Dollar and Gold both strengthened.
Hedging Costs Ease but Remain High
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, backed off all-time highs near 5.12%, to 5.03%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate of where markets expect 3-month Term SOFR will be a year from now, fell a whopping 113 basis points from this time last week, to 4.15%, reflecting the sudden, SVB-inspired belief that the Fed may not hike rates as high as previously thought. Take these levels with a grain of salt. Given the surprise and swift failure of SVB (48 hours from the first signs of trouble to failure), we doubt these levels will hold as markets are still figuring out what the failure means and will continue adjusting throughout this week.
The SOFR futures market, a widely observed signal for how SOFR will behave in the coming months, implies that 3-month SOFR will now peak in June near 5.22% (it’s 5.03% now), followed by a gradual decline over the next three years as the Fed eventually eases.
Finally, interest rate volatility, a key driver of the cost of interest rate caps, spiked higher to levels last seen in December 2022, and when combined with the huge moves lower in yields, lowered rate cap prices in the process. Despite the rise in volatility, it remains lower than the peaks we saw back in the last half of 2022. We still expect rate volatility to continue to moderate over the long term, and rate cap costs continue to fall, with some bumps higher in between, as the end of the Fed’s rate hiking campaign inches closer.
Curious about where interest rates are headed for the rest of the year? Check out our Interest Rate Outlook
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible.
What SVB’s Failure Means for Interest Rates
New to bank failures? We aren’t. Some of the Derivative Logic staff had a front row seat – as employees – to the bank failures seen during the 2008 financial crises (e.g. Wachovia). To sum up the experience, just take us at our word when we say that we learned the hard way that employees, no matter how important they think they are, are one of the last considerations of regulators as they work through the process of making depositors whole. While that’s understandable, to some it came as a shock after years of bloated salaries and bonuses. SVB and Signature Bank employees are likely to be equally shocked in the days and weeks to come.
While you’ll likely read the blow-by-blow of what happened at SVB elsewhere, just know that the event reminds us why banks hate having fixed rate assets (e.g. fixed rate loans) on their balance sheet, especially in a rapidly rising interest rate environment. It’s why you rarely see loans of size, say north of $5 million, being offered by medium to large banks at a fixed interest rate. Why? Fixed rate assets hobble a bank’s ability to manage its asset (loans and bonds) and liability (deposits) mix. SVB is now a poster child of what can happen when a bank’s asset-liability risk management function is lacking. As you may know, banks attempt to help borrowers manage this floating rate risk by requiring that the borrower enter into a interest rate swap, which synthetically fixes the rate.
Did the Fed’s aggressive rate hikes over the past year cause SVB’s failure as some believe? No. Overall, SVB’s collapse is not a result of the Fed’s overly restrictive monetary policy and likely will not have significant repercussions for the economy and financial system as a whole over the long run.
Will SVB’s failure prompt other systemic problems in the banking sector? No. While some journalists are attributing SVB’s losses on the fixed income securities it holds to higher interest rates, the bank’s notoriously unpredictable deposit base – where there is a high level of cash burn and a limited ability to raise outside capital in an environment of rising interest rates – is the single factor that led to the realization of those losses and the bank’s ultimate failure.
Financial contagion is sometimes connected to fire sales by one institution that drive down the value of similar assets held by other institutions. Although SVB holds nearly $50 billion in Fannie and Freddie backed mortgage-backed securities (MBS) in a market that is over $8 trillion, the size of its holdings is a drop in the bucket compared to the size of the market, so even if SVB sold all of its MBS, it is unlikely to have a significant impact on prices more generally, weakening the potential of contagion via that channel. Contagion is further limited by the likelihood of a swift and orderly receivership under the FDIC. This lightens any pressure on the Fed to act in response to rebalance any potential change in its perceived balance of risks.
Will SVB’s failure force the Fed to alter its rate hiking plans? No. Although the Fed closely monitors the health of the financial system, top officials have previously acknowledged that monetary policy is not the most effective means of addressing problems with financial stability.
Bottom line? Yes, given the now increasing inflation pressures and still-strong jobs market, it seems the Fed will keep hiking until something breaks. The SVB failure isn’t it. There will be more Fed rate hikes soon, and something structural is bound to go sideways somewhere, at some point. But SVB is not a Lehman Brothers moment. The most important variable for the Fed in the near term is looming, refreshed gauges of inflation, via the producer price index (PPI – due March 15) and the consumer price index (CPI – due March 14). As long as the February CPI data comes in above expectations, we don’t believe SVB’s collapse will deter the Fed from hiking rates by at least 25 basis points at its March 22nd policy meeting.
Hot jobs market keeps the Fed on track for more rate hikes
As evidenced by recent data, the jobs market remained strong in February, with companies creating 311k new positions in February after a 504k increase in January. The available data indicates that the jobs market will continue to be too tight for the Fed’s taste and that inflation pressures will remain strong. Preliminary signs of a cooling in jobs market – via lower hours worked and falling wages – are now seen as being as ineffective.
Elsewhere, according to the January JOLTS report, a measure of job openings and labor turnover, there were still roughly 1.9 job vacancies for every unemployed worker, which is probably just too many for a Fed trying to cool the jobs market and get inflation under control.
The fly in the merlot? Initial unemployment claims are still below the pre-pandemic average, indicating that firms are holding onto employees. However, there are signs that the dynamic may be changing. Initial jobless claims increased to 211k in the week ending March 4 after being below 200k for seven consecutive weeks. Should ballooning jobless claims persist in response to a spike in layoff announcements in January, it will help erode the job market strength over time. Only time will tell.
What to Watch This Week: Inflation Data Has Now Settled the Fed’s 0, 25 or 50bps rate hike dilemma
Amid the SVB and Signature Bank fallout, it’s all about refreshed inflation data this week, with both the CPI and PPI on tap. Last week’s red-hot jobs report led markets and us to expect the Fed to hike 50-basis points at its March 22nd meeting, but events late last week concerning SVB have spurred some – including us – to scale back their rate hike expectations to just 25 basis points.
The strong core CPI for February demonstrates that inflation is not declining quickly enough to support current market expectations for significant rate cuts by year’s end. The argument that the tight labor market is supporting upward inflationary pressures in that sector is given credence by the resilience of core services inflation, which is driven by housing rents. The likelihood that core PCE, the Fed’s preferred price gauge, may have increased in February is also hinted by the CPI report, which is due out on March 31. In total, we continue to anticipate that the Fed will increase rates by at least 25 basis points at its meeting on March 21–22 and will maintain them there for the remainder of 2023.
To us, Fed Chair Powell seems to be suggesting a propensity to take high inflation and activity data at face value given spending is proving so resilient while inflation is running so far above target. To be clear, not all of the evidence is consistent: There are some indications of a softening labor market and cooling wages. Even so, they are subtleties, and a 25-basis point hike later this month would indicate that the Fed thinks now is not the time for subtlety.
One piece of news that many are ignoring is California Governor Gavin Newsom’s declaration of a state of emergency in 34 counties affected by storms projected to linger through mid-March. California’s economy is ~14.6% of US GDP, and is the 5th largest in the world. Any news concerning a suppression of California’s economic activity shouldn’t be taken lightly, and while the news didn’t send shockwaves across Wall Street, it may turn out to be significant. The recent spate of harsh weather has prompted residents to expect their power bills to increase by 32% through March. If that causes the February CPI print to surprise on the upside, it may guarantee a 25-basis point hike on March 22nd.
Elsewhere, other data on tap will show that the economy was strong in February, with retail sales (Wednesday) and industrial production (Friday) both expected to show improvement.
Strategy Corner
Are you contemplating a rate cap extension or purcahsing a replacement cap? With rates much lower, now would be the time to do it.
Concerned about where term rates will be when your loan matures 6-months, one-year or two-years from now? With the long-term future direction of rates murky, you should be. Lucky for you, there are ways, using derivatives, to reduce the uncertainy around what rate you’ll pay when you refinance, and ultimately, protect yourself against higher term interest rates over the long-haul.
For a sneak peak into real world results from such a strategy, check out this recent article in the Wall Street Journal (warning, paywall): Chicago Property Developer Scores With Audacious Interest-Rate Bet – WSJ
Structuring a hedge to mitigate future term rate exposure involves careful planning and expert advice. We’ve been discussing this type of strategy for literally years: Swaptions: What Smart Borrowers Are Doing Now – Derivative Logic . Call us to discuss your future funding concerns and for help with planning and executing a strategy that’s custom designed just for you.
Mitigating interest rate risk is dynamic and not static. The complacency of believing rates would stay low forever caught both borrowers and lenders off guard. Now that the paradigm of low rates forever has changed, both borrowers and lenders look for ways to ease the pain that higher interest bring to the table. Interest rate derivatives can provide some with the perfect solution, but it comes at a cost. Another strategy chosen by some is to do nothing. Doing nothing is definitely a strategy, but doesn’t mean borrowing floating or fixed and forget it.
Derivative Logic prides itself in education and structuring hedges that make sense. There are times when we suggest doing nothing, but we provide the analysis of how we came to that conclusion. Our focus isn’t based on earning transaction fees but on doing the right thing. Just ask our clients. Give us a call (415-510-2100) for a complimentary review of your capital structure. We might say your capital structure doesn’t require our services yet. Let us emphasize YET.
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Source for all: Bloomberg Professional
