Powell’s Silicon Valley Prayer
We have reached the point of the Fed’s rate hike campaign where things are starting to break. Yesterday it was the Silicon Valley Bank (NASDAQ: SIVB) that “broke” – account holders pulling their money out of the bank to the point that the bank said it needed $2.5 billion in cash right away to stay afloat.
A $267 a share stock at Wednesday’s close, SIVB shares are currently valued at just over $100. That’s a 65% drop in one day. And it’s actually worse than that, because regulators shut the bank down earlier today.
It was a textbook bank run. When account holders get worried that a bank is running cash, they’ll run to get their money out. No bank in the world has enough cash on hand to pay off a surge of withdrawals…
Of course when one bank becomes insolvent, investors start looking around at other banks, wondering which one might be next. And this created an absolute rout for bank stocks yesterday. Bank of America (NSYE: BAC) was hammered 6% lower during yesterday’s session. And earlier today, it hit a new post-pandemic low at $28.92.
If you were around for the 2008-2009 financial crisis, you might be having a little deja vu right now. After all, it was an analyst report from October 31, 2007 that said liquidity problems at Citigroup (NYSE: C) would force the bank to cut its dividend that got that bear market started…
When the Tide Goes Out….
I want to be very clear that I’m not trying to scare the crap out of everybody that some new financial crisis is on the horizon…
My point here is that when liquidity starts drying up, strange things can happen.
Warren Buffett once said that when the tide goes out, that’s when you find out who’s been swimming naked. It’s a perfect analogy for how certain investment behavior might work fine in a bull market, but maybe not so fine in a bear market.
During the few years before the financial crisis, investment banks were making an incredible amount of money with mortgage backed securities. But when mortgage defaults started rising, the value of those bonds crumbled to the point that no one would buy them, banks literally ran out of money.
Of course, banks aren’t allowed to go “all in” on potentially risky assets like that anymore — they are required to keep at least 6% of their cash in liquid assets that are considered cash equivalents. In other words — treasury bonds. This 6% in cash equivalents is known as a banks’ Tier One Capital. Most banks keep their Tier One Capital closer to 10%…
It’s all well and good to have cash tied up in Treasury bonds — until the value of those bonds starts to fall because interest rates are soaring. And that seems to be exactly what happened to Silicon Valley Bank…
A 2-year Treasury bond is paying like 5% interest right now. If Silicon Valley Bank committed its Tier One Capital to bonds issued over the last few years, bonds that pay lower rates, like 2%, well, there’s not much of a market for those…
And a smaller bank like Silicon Valley Bank won’t have the ability to set aside extra cash to cover losses (loan loss reserves) like bigger banks. Over the last year, Bank of America’s loan loss reserves have doubled from $500 million to $1.1 billion.
By raising interest rates, the Fed is taking liquidity out of the system. This will lead to companies firing employees in order to conserve cash. The big problem for the Fed is that raising interest rates also changes the value of the assets that underpin the entire financial system.
And this is the dilemma the Fed faces, this is the problem that could turn a so-called soft landing into a hard one. And yesterday’s trading is a great example of how quickly investor sentiment can shift…
Reversal of Fortune
Yesterday’s trading session started off exactly as we were expecting…
We observed that the S&P 500 had found support at 3,940 and rallied. And even after the selling in response to the incrementally higher target for interest rates that Fed Chair Powell hinted at during his Congressional testimony, the S&P 500 found support on the rising trendline at 3,970…
And I laid out the two possible scenarios: a rally for the S&P 500 over 4,000, or a failure of support at 3,940 that would lead to a quick drop below 3,900.
I’m still a little amazed that both scenarios played out on the same day…
First the S&P 500 made a perfect looking run over 4,000. But the early rally was overwhelmed by the Silicon Valley Bank sell-off that accelerated right from the open. By 2:30 pm, the S&P 500 was slicing through support at 3,940. And here we are today, with the S&P 500 below 3,900…
So what now? Good question, right?
What I can tell you is that this is a bad time to be Fed Chair Jerome Powell.
The failure of Silicon Valley Bank is the clearest evidence yet that rate hikes are doing real damage. And risks will grow exponentially with more rate hikes. The Fed needs to pause. But how can he, given what he just revealed to Congress? If he backs off now, it will look like panic. If he proceeds with a 50 basis point hike at the March 21-22 Fed meeting, he will appear out of touch with risk.
So the answer is: we all bow our heads and pray for some good news from next week’s Producer Price Index (PPI) and Consumer Price Index (CPI) so that the Fed can deliver a small 25 basis point hike. I guarantee you that’s what Jerome Powell is doing right now…
That’s it for me today, have a great weekend and I’ll talk to you on Monday…
Briton Ryle
Chief Investment Strategist
Pro Trader Today
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