Federal Reserve Chair Jerome Powell and the rest of the Fed are not looking so great after three banks collapsed in the span of a week. What some people might forget is that the Fed is a key bank regulator, overseeing bank holding companies.
If you ask any bank regulator, they will probably tell you that one of their main goals is to not have a bank failure on their watch. They would especially not want to have the second-biggest (SVB Financial's Silicon Valley Bank) and the third-biggest (Signature Bank) bank failures in history happen on their watch. As a result of these bank failures, the Fed's workload just got a whole lot bigger because not only does the agency still need to get inflation under control but it now needs to stabilize the banking system as well.
The Federal Reserve Board of Governors' next meeting kicks off next week and Powell and the other Fed members are expected to discuss numerous topics, including whether or not to raise interest rates again. It's a decision that puts the Fed between a rock and a hard place. Here's why.
Image source: Federal Reserve.
The last thing banks need
As has now been well documented, Silicon Valley Bank (SVB) failed in large part because the bank invested in lower-yielding and longer-dated government-backed bonds too early in the interest rate cycle before the Fed began rapidly raising rates.
As interest rates soared, these bond values got crushed, resulting in enough unrealized losses to potentially wipe out all of SVB's tangible common equity. As long as the bank didn't have to sell the bonds, it would be OK, but once there was a deposit run the bank likely would have needed to or did sell the bonds for huge losses.
SVB's management team demonstrated extremely poor asset-liability management. While there are lots of other banks sitting on huge unrealized losses, most are not as bad off as SVB. Still, the more deposit outflows there are at other banks right now, the more nervous investors in those banks are going to get. Federal banking regulators are now essentially backstopping all deposits (not just those under $250,000), but investors are still extremely jumpy right now. The first sign of trouble could create wide sell-offs or even more bank runs.
Even before all of these bank failures, most banks had anticipated higher deposit costs and deposit outflows due to the rapidly rising interest rates seen over the last year. Deposit prices rise on a lag and we still likely haven't seen the full impact of all of the rate hikes by the Fed over the last year. The longer the Fed keeps raising rates the more difficult it is going to be for banks to hold onto deposits. Additionally, if the Fed stops raising interest rates or cuts rates, that should lead to a decline in unrealized bond losses, so the Fed can really do banks a solid by ending its rate-hiking campaign.
But what about inflation?
The conundrum for the Fed is that the agency doesn't believe it has fully conquered inflation yet. Prior to the string of bank failures, Powell had publicly said that he thought that interest rates would need to go higher than initially expected. The labor market, which has been seen as a partial cause of persistent inflation, is also still strong. The U.S. unemployment rate was just 3.6% for February.
Furthermore, consumer prices are still not where the Fed wants to see them. The Consumer Price Index (CPI), which tracks the prices on a market basket of consumer goods and services, rose by 0.4% in February on a monthly basis and was up 6% year over year. That's pretty much what economists had expected but prices for certain things like rent remain high.
It's clear that Powell has studied history quite a bit and does not want the U.S. economy to fall into a period of runaway inflation or stagflation like what was experienced in the 1970s. Leading up to the three bank failures, Powell and the Fed seemed to have every intention of continuing to raise interest rates.
Not a lot of great choices
The CME Group's FedWatch Tool suggests that investors are currently split on how they think the Fed will act at its next meeting.
As of March 16, about 33% of traders thought the Fed would leave its key benchmark lending rate unchanged and inside a range of 4.5% to 4.75%. Nearly 67% of traders were betting on a quarter-point hike, although keep in mind this data is constantly changing. Prior to all of the bank failures, some traders actually thought the Fed might do a half-point hike at its March meeting.
Still, this leaves Powell and the Fed caught between a rock and a hard place. If they raise rates, they risk causing more damage to the U.S. banking system. If they don't hike then they risk more persistent inflation. Based on the European Central Bank's recent half-point hike, I think there's a very good chance the Fed moves ahead with a quarter-point hike at its meeting. Investors should be looking for evidence of the Fed ending its rate-hiking campaign because that's when the environment for stocks can get more favorable.
Any indication that the Fed is going to go way beyond a Fed Funds Rate of 5% would be bad news and means there is likely a lot more pain ahead this year. Ultimately, investors at this point should be in stocks they are prepared to hold long-term and through the volatility because trying to time the market is extraordinarily difficult.
