April 2023
Market Update

Whirlwind of Events

By Jake Eggett

The month of March produced a whirlwind that left a trail of destruction among several regional banks and will likely impact markets for the foreseeable future. The cause of the whirlwind – a “run on the bank” with depositors attempting to withdraw an astounding $142 billion or ~80% of assets from Silicon Valley Bank (SVB) in just 2 days. After withdrawal requests exceeded SVB’s available liquidity, regulators stepped in and shut down the bank down while also guaranteeing all deposits (even those over the FDIC limit of 250k/per account holder). A few days later, Signature Bank experienced the same demise. Silicon Valley Bank and Signature Bank became the 2nd and 3rd largest bank failure in U.S. history only behind Washington Mutual in 2008.

Why the panic?

A classic “run on the bank” is usually due to the bank making bad loans and investors losing confidence in the solvency of the bank. However, in this case, the issues were multi-faceted with Silicon Valley and Signature Bank both having a very high percentage of uninsured deposits (greater than the FDIC limit of 250k) and a large percentage of their reserve assets in long maturity government guaranteed bonds with no credit risk but exposing themselves to substantial interest rate risk. With the Fed raising rates quickly to tame inflation, the higher rates caused the bank’s reserve assets in bonds to drop in value. Normally the banks would hold these bonds to maturity and get their money back but when everyone started asking for their deposits back at the same time, they had to sell those bonds early, which resulted in substantial losses for the bank and created the ensuing panic. This mismatch of buying longer dated bonds without hedging their portfolio calls into question the bank’s risk management procedures and likely will result in additional regulation in the banking industry.

The True Indicator of Banking Stress

Fears over these bank failures have naturally spread to other regional banks. Determining whether the regional bank crisis is over is the most important near-term issue for markets right now. And while analysts in the financial media often give opposite opinions, luckily, we can look at the data that tells us whether the crisis is getting worse or better.

There are currently two loan programs from the Fed that are specifically designed to help regional banks that are experiencing liquidity issues:

The first is the Fed discount window, where banks can pledge U.S. Treasuries to access liquidity. It’s been around for a long time, although it’s likely very few people have paid attention to it since the beginning of the financial crisis (when all of us were paying attention to it!).

The second program is new, the Bank Term Funding Program, which the Fed just created to alleviate the liquidity issues that brought down Silicon Valley and Signature Bank.

Think of these two programs as “bridge loans” the Fed extends to banks who need cash. These are not facilities that banks use regularly, and just like a company (or person) needs a bridge loan to “stay afloat,” there’s stigma in the banking industry attached to using these facilities. Put simply, if a bank is using them, it’s a sign they are in trouble, which can make the problem substantially worse.

Here’s why this is relevant:

The usage amounts of these two facilities are updated every Thursday after the close. We literally can see how many banks are using both the discount window and the BTFP, and just like any emergency loan program, the higher the usage, the worse the problem!

Figure 1 shows the weekly change in the use of the Fed Bank Facilities over the last 4 weeks.

• As you can see, the usage of the Fed’s discount window spiked $148 billion during the week ending March 17th. The borrowing from the discount window went from about $4 billion (prior to the crisis), up to $152 billion total and has declined over the last 2 weeks down to $88 billion. Part of the reduction in discount window usage was likely a shift to borrowing from the BTFP.

• Since the creation of the BTFP, use has surged from $0 (because it didn’t exist) to $64 billion in total borrowing from the new program. One observation to note is that even though the borrowing increased by $10.7 billion last week from the BTFP, the overall borrowing from the Fed decreased by $11.5 billion showing that banking stress eased from the week prior.

So, between the two programs the Fed has had to lend more than $150 billion in quasi-emergency loans to banks since the beginning of March. As the chart below shows, that dwarfs what was needed during the pandemic, and equals what was needed during the financial crisis!

Now, that does not mean that stocks are going to automatically fall based on this data.

These Fed “bridge loans” are designed to prevent bank runs, and so far, they are working. As we’ve explained, this is more of a liquidity issue than a credit issue and fundamentally banks are in good shape with cleaner loans and high capital ratios. In summary, the decline in Fed bank lending bodes well that the rapid spread of the banking crisis has been alleviated; however, we’ll be watching this closely each week to monitor the stress in the banking system.

If you missed the latest Dave’s Talk video around banking concerns, you can find it through this link: https://youtu.be/hDHHPQ214lQ

Market Performance

The month of March showed mix results with US Mid-cap and Small-cap equities declining due to the banking sector concerns while US Large Cap rebounded nicely the last few weeks to finish positive. The Nasdaq, which badly underperformed in 2022, handily outperformed the first quarter with very impressive returns. That outperformance was driven by a decline in bond yields (which makes growth-oriented tech more attractive to investors) and mega-cap companies were viewed as “safe havens” amidst the late-quarter banking stress. Internationally, foreign developed markets largely traded in line with the US markets and ended the month in positive territory and outpacing the S&P500 for the quarter.

Switching to fixed income, bonds ended the month and the quarter in positive territory, but it was not without stock-like volatility. Given that the banking concerns raised the odds of a recession and market anticipating the Fed is near an end to their rate hikes, this generated a sharp drop in rates and fueled a broad bond market rally to close out the first quarter.

The Bottom Line

Both stocks and bonds rallied the first quarter of the year, but significant uncertainty remains due to rising interest rates, high inflation, a slowing economy, and weakness in the banking system.

The Federal Reserve appears to be nearing the end of its rate-raising cycle with investors expecting just one or two .25% hikes before a pause or even a drop in rates. Will they be correct? Every single rally in stocks since this bear market began has been driven by the hope from markets that a Fed pivot or pause is imminent, and it was that way again over the past month. The rise in interest rates has begun to have the desired effect of decreasing inflationary pressures but has also created cracks in the system. If and when a recession comes is unknown, but volatility is not likely to exit the market any time soon. Navigating these environments can be challenging, but we believe a disciplined, tactical approach makes sense in this environment as part of a portfolio’s overall asset allocation plan.

We continue to remain defensively positioned in our overall equity allocation; although, we recently deployed some of the cash to increase our market exposure. In our Total Return bond strategy, the volatility from the banking stress pushed us out of some our positions a few weeks ago; however, we recently just added exposure to high yield bonds and high yield municipals while maintaining our exposure to treasuries that are yielding more than 4%.

As always, if you are concerned about your risk level, please reach out to us, and schedule a time to review your allocation and financial plan.

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In preparation for this change, you must have access to all your accounts online at TD Ameritrade using the portal www.advisorclient.com. Using your existing login ID and password will help ensure a smooth transition to the Schwab platform. This is the first critical step to take if you haven’t done so already.

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