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Q1 2023 Market Commentary

April 26, 2023

One Foot on the Brake and One Foot on the Gas


“Driving a car while having one foot on the brake and one foot on the gas will make your neck very sore.” – Unknown

Foot on the Brake: Interest Rate Increases

The long and variable lagged impacts of steady interest rate increases since March of 2022 by the Federal Reserve appear to have bubbled to the surface in the first quarter. Here in the U.S., they have manifested in the form of failures of SVB and Signature banks. Meanwhile, in Europe, the shotgun wedding of two venerable Swiss institutions allowed for UBS to rescue its national rival Credit Suisse in a transaction that took place over the course of a weekend in Q1. We have been of the mind that the torrid pace of rate increases would likely have a deleterious effect somewhere in the economy, and the banking sector seems to have taken the most visible brunt of rising rates to date. Historically, as the below Alpine Macro chart shows, the Federal Reserve halts monetary tightening or rate increase campaigns when something breaks. But what is really going on in the banking system? We will attempt to explain.

The Anatomy of a Bank Run

“Confidence is contagious. So is lack of confidence.”
– Vince Lombardi

A bank run refers to a situation where a large number of depositors in a bank withdraw their funds simultaneously due to concerns about the bank’s financial stability. This can lead to the rapid depletion of a bank’s reserves and may even result in the bank’s failure, as was the case with SVB. The anatomy of a bank run typically involves several key elements:

A Trigger: A bank run is often triggered by a specific event or a rumor that creates panic among depositors. This could be news of the bank’s financial distress, rumors of insolvency, or reports of other depositors withdrawing their funds. It was reported in media outlets that a certain high-profile and successful Silicon Valley investor and tech company founder had spread rumors about SVB.

Loss of Confidence: Once depositors start losing confidence in the bank’s ability to safeguard its deposits, they may rush to withdraw their funds in fear of losing their money. This can lead to a snowball effect, as more and more depositors join in the rush to withdraw their funds. A loss of confidence can make bank survival difficult and may spread to other institutions.

Withdrawal Pressure: As depositors demand to withdraw their funds, the bank faces pressure to meet these demands. However, banks typically do not keep all of their deposits in liquid form as cash but rather invest or lend a significant portion of the deposits to earn interest and generate profits. This means that the bank may not have enough cash on hand to fulfill all the withdrawal requests at once. Online and mobile banking has accelerated this aspect of current bank runs and has similarly shortened the timeframe between loss of confidence and withdrawal pressure.

Insufficient Reserves: If a bank does not have enough cash reserves to meet the withdrawal demands of depositors, it may need to sell off its investments or borrow money from other sources to fulfill the requests. However, in a bank run scenario, selling investments or borrowing may not be easy or may not happen quickly enough to meet the demand for withdrawals, resulting in a negative feedback loop with further loss of confidence among depositors.

Since the SVB failure, much attention has been focused on banks and their securities portfolios, which can be used as a source of funding to meet customers’ withdrawals, as mentioned above. The issue has been that the Fed’s interest rate hiking campaign has caused unrealized losses in the bond portfolios across the banking system. If these bonds were sold, losses would be realized. One of the ways the Fed has combated this problem is by loaning $1 against bonds that are in some cases now worth $0.80 as a way for banks to avoid selling bonds at steep losses to oblige customer withdrawals.


Foot on the Gas: The Discount Window

The discount window at the Federal Reserve, commonly referred to as the Fed’s discount window, is a lending facility through which eligible depository institutions – such as commercial banks and thrift institutions – can borrow funds from the Federal Reserve in order to meet short-term liquidity needs. The last time the discount window got this much press was during the Great Financial Crisis in 2008.

The discount window serves as a mechanism for banks to obtain short-term funding from the Federal Reserve when they are experiencing temporary shortages of funds. This can occur, for example, when a bank’s reserves fall below the required level, or when a bank is facing unexpected demands for withdrawals by its depositors. By borrowing from the discount window, banks can access additional funds to maintain their operations and meet their obligations. According to the above chart from Alpine Macro, the recent tremors in the banking sector have caused banks to access the discount window at a rate exceeding that of 2008.

It is worth noting that borrowing from the discount window is generally seen as a last resort for banks, as it may carry a stigma and can indicate financial weakness. However, the discount window serves as an important tool for the Federal Reserve to provide liquidity to the banking system and help stabilize the financial system during times of stress or crisis. In our view, the usage of the discount window is a form of monetary easing that is effectively undoing some of the monetary tightening of higher interest rates, especially since banks can receive 100% of the face value of bonds that are trading far below their par values in the open market.

In closing, the recent stresses in the banking system have come about after more than a year of steady interest rate increases by the Fed. We are encouraged by the response of the Fed to act (foot on gas) to keep the banking system functioning. Returning inflation back to the 2% target may cause the Fed to leave its other foot on the brake until that mandate is achieved. This may result in “fits and starts” for the economy with more volatility ahead in both fixed income and equity markets. Stay tuned!