Stocks entered free fall over the past few trading days as a huge bank (Silicon Valley Bank) failed due to a run on deposits coupled with bond losses resulting from the pace and size of interest rate hikes over the past year. Almost immediately, two other banks suffered the same fate. The Federal Reserve and the U.S. Treasury enacted emergency provisions over the weekend and have put in place a new program to backstop depositors’ money in failing banks. This represents a recognition by the Fed and others that these events may very well be the first crack in a potential systemic threat to the financial system. Bond yields have dropped precipitously in a flight to safety and bet that the Fed will have to stop raising rates in order to prevent a collapse in the banking sector.
I have discussed many times over the past year how extraordinary the rate hikes have been as well as the difficulty they have created in managing risk within portfolios. It is very tough when “safe assets” like treasuries and other fixed income investments are getting hit as hard or harder than stocks. All this has been felt at Cabana and now appears to be coming to light elsewhere. Banks borrow money from depositors and pay those depositors short term interest rates. They then invest that money by loaning it out and receiving interest based on longer term rates. They also buy what they believe to be “safe assets” like longer dated treasuries. The Fed raised short term rates so far and so fast that banks’ investments in longer duration assets became worth less than the value of the shorter-term investments that they were paying interest on. This upside-down condition was discovered, and customers got spooked and began withdrawing money that the bank didn’t have. The bank then had to sell those underwater longer-term investments at huge losses. Ultimately, the bank went broke and did it in a matter of hours. Scary stuff indeed and is the stark reality of what can happen when you obliterate the bond market and create the most severely inverted yield curve in many decades (if not in history). Our central bank has done all this in the name of fighting inflation caused by the printing and distribution of trillions of dollars beginning with the financial crisis and reaching a crescendo during the Covid pandemic. As I see it, too many dollars chasing too few goods = inflation. Ironically, the Fed and Treasury are dealing with this current threat by doing what they always do, which is print some more money, thus creating more inflation.
I will not get overly analytical here but for those of you who want a good lesson in how we got to this point (as well as how our central bank works), I suggest reading The Creature from Jekyll Island.
The broad indices (DOW, S&P 500, Russell 2000) have now broken major technical support at the 50- and 200-day moving average and appear on their way to testing the October lows. The S&P 500 bounced off some support at 3800 on Monday but given all that is going on I suspect that level may fail, and we will see lower prices. The CPI number that came out Tuesday was in line with expectations and suggests inflation is still hanging around. This puts the Fed in a real dilemma leading up to its March meeting next week. Do they stick to their plan and keep hiking, knowing that banks and perhaps lots of other institutions are breaking-or do they back off and hope the breaking that is already baked in will do the job in slowing down the economy? I have seen talking heads all over the place take both sides of this. I certainly don’t know, but it seems to me that anything is possible over the next few days.
At Cabana, we remain bearish and in our Safety Valve Level 2 allocation.