Last week’s market action was supposed to be dominated by the Fed Chairman Powell’s testimony to the US Senate, where he was expected to re-emphasise the need to fight inflation with higher rates. That duly happened and markets were on the back foot as he appeared even a little more hawkish than expected. Then the widely anticipated US jobs report came in stronger than expected on Friday, which again seemed to suggest that this overheating economy needed to be hosed down by even higher rates. Just a few hours later though, the focus shifted abruptly to something that would send rates tumbling.

On Friday morning Silicon Valley Bank (SVB) had been the 16th largest US bank and a successful S&P 500 company, but by Saturday morning it was bankrupt after a sudden run on its deposit base had rendered it unviable. By the end of the weekend another medium sized bank had failed, and the US Federal Reserve, the Federal Deposit Insurance Corporation, and the US Treasury had stepped in to not only insure all depositors (including all those with balances above the $250k level insured by the FDIC), but also to provide generous loans to other medium and small US banks, measures that should, in theory, take away the incentive for depositors to flee and cause more bank runs. At the time of writing no more banks have failed (there are 40,000 so-called Regional US Banks) but the share prices of many of the banks still fell by 50% or more after the measures were announced, indicating that the market is not completely convinced that these echoes from the eve of the GFC won’t amount to a full-blown financial crisis.

SVB was relatively large, but it was still a niche specialist in funding tech companies, and it was uniquely (and unfortunately) exposed to rising interest rates, so if the essential ingredient of any banking relationship – trust – can be restored, then the market volatility will likely pass, especially as post-GFC leverage levels in the US banking system are relatively low and deposit levels are relatively high. It does however highlight the tightrope that the Fed is trying to navigate. On the one hand, there is still a clear need to keep raising interest rates, as evidenced by the overnight release of the US CPI, where core inflation, as expected, declined slightly but remains high and only edging downwards.  On the other hand, the world has just been abruptly reminded of the operational and financial leverage that exists in both the real economy and the financial, following a decade of low rates and abundant financial liquidity.

SVB’s main clients, technology start-ups and venture capital funds, have found it more difficult to borrow or attract equity to fund their growth ambitions recently, and it was their increased demand for cash that forced the bank to realise losses on long dated treasuries that it had carelessly assumed it would hold to maturity decades in the future (thereby avoiding the need to acknowledge the fall in market values experienced as rates rose in 2022). This broader perspective explains why the market has suddenly questioned the ability and commitment of the Federal Reserve to raise rates much further. Or it might be that the market does think this episode will turn into a recessionary bust (1 year inflation expectations have also dropped sharply). Either way, the following graph shows how quickly the market moved from anticipating higher rates last Wednesday to shaving more than a percent off the Fed’s so-called terminal rate (the peak of this hiking cycle) later this year.

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This implies that multiple further rate hikes in this cycle got taken off the table (by the market at least), which is quite big news if that turns out to be the case. Perhaps even more surprising is that this also seems to apply to Australia, underscoring the extent to which our financial system is affected by global funding conditions and particularly those of the US. Long term rates just took quite a big step down, and perhaps explains why markets have actually held up relatively well under the circumstances (as lower future rates mean that future cash flows are discounted by less and are worth more in current dollars).

Interest rate markets have settled, and equity markets have only lost about 4% over the last week or so, with the US market down a bit more, which under the circumstances perhaps shows a degree of resilience. As one might expect financials led the market down, but due to the implications for tech funding in particular, mid to small cap tech stocks were also down by a similar amount. These represent the typical biases of value and growth managers respectively and has given both camps something to think about. The large tech titans remained relatively unscathed, while defensive sectors like utilities and consumer staple stocks were up a few percent. Gold and government bonds were also up by a similar amount, and while credit spreads eased a bit there were few signs of contagion into the corporate bond markets, and most credit portfolios were flat, with junk bond portfolios only down a couple of percent. Volatile oil markets were on the back foot, and most industrial metals were flat or mixed, again suggesting that the impact on the real economy is so far seen to be muted.

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