It's been a little over a year since the Federal Reserve began their aggressive tightening cycle to combat persistent inflation, increasing short-term interest rates from 0% to 5%. The central bank’s actions have resulted in higher long-term interest rates, lower stock prices, and lower real estate values. The sharp increase in interest rates and subsequent rapid change in liquidity conditions were likely key factors in the March collapse of Silicon Valley Bank (SVB) and other regional banks. Facing a slowing economy and higher interest rates, corporate depositors at SVB withdrew cash for corporate needs or reallocated these funds to higher-yielding investment options elsewhere. This activity snowballed into a classic bank run, as confidence in the bank eroded, over $40 billion was withdrawn, and SVB found themselves unable to meet depositors’ requests.
The U.S. banking system is better positioned than in 2008 to handle tougher times.
The fall of SVB invites questions about the health of the U.S. banking system and the possibility of systemic risk to the economy as investors’ thoughts turn to memories of the 2008 financial crisis. Unlike then—when a crisis in the U.S. subprime mortgage market led to a liquidity and credit crunch that spread to all credit and financial markets—the collapse of SVB appears to have been caused by their specific business model (credit specialization and cash flow in the venture capital space) and poor management (which was apparently unprepared for the Fed’s tightening cycle shrinking the value of SVB’s investments). The overall U.S. banking system still appears healthy; it is better capitalized (less leveraged) than before the Financial Crisis and better positioned to get through a recession. In the short term, it is expected and natural for money to gravitate towards higher yields in U.S. Treasuries as banks and custodial banks take their time increasing the interest rates on savings. Bank managements recognize the trend and have been addressing the issue. A factor that is causing additional challenges to small and mid-sized banks is a significant transfer of funds to larger institutions as depositors also seek perceived safety – not just yield.
The Fed's decision tree has gotten more complicated.
The Fed faces a delicate balancing act between controlling inflation and maintaining economic growth. Steering monetary policy towards a “soft landing” is getting increasingly complicated as more branches continue to be added to the central bank’s decision tree. Maintaining the stability and viability of the financial system is imperative to the central bank’s goals. Regional bank turmoil, including deposit movements, is making the Fed’s decisions more difficult. Small and mid-sized banks are major suppliers of commercial and industrial loans, especially for commercial real estate. Many are now pulling back from lending, reducing credit availability across the country. Another variable the Fed needs to navigate is the surprise announcement by the Saudi-led Organization of the Petroleum Exporting Countries and their oil-producing partners (OPEC+) at the beginning of April to cut oil production (after already dramatically cutting output in October). This caused a jump in crude prices and has renewed inflation concerns. Ultimately, we expect more market volatility as the Fed balances the many factors at play.
Are your assets safe?
Some clients have asked us about the safety of their assets. Each client’s investment assets are held by qualified custodians such as Charles Schwab, Fidelity, or a bank custodian. These custodians hold your investment assets apart from their own assets, and they legally cannot comingle them. In plain language, this means that, with the exception of margin accounts, your assets are yours. Any securities maintained on the custodial side of these institutions cannot be taken away from you, even if the institution were to go bankrupt. In most cases, cash is held on the bank side of the businesses and has several layers of insurance.
Maintain a long-term focus and diversify.
Looking forward, we urge our clients to maintain a long-term focus through any additional market volatility – and to remember that investors can find opportunity amid uncertainty. We emphasize the importance of diversification to mitigate risk and smooth returns over time. While stocks and bonds both had negative returns late last year, the end of the Fed’s tightening cycle should restore the traditional inverse relationship between the performance of these asset classes. Beyond diversification benefits, higher yields have made bonds compelling again. Keeping taxes in mind, the rise in yields could present an opportunity to rebalance portfolios.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.