May FOMC: Once More Unto the Breach
A central bank decision preview that's, ironically, more about ordinary banks!
JP Morgan took over First Republic this weekend. Depositors didn't lose any money. The cost to FDIC of a fairly large bank falling is estimated to be ~$13bn. A good outcome for everyone. But, it has not laid to rest speculation around - who's next. This resulted in another large move lower in Bank stocks today, which in turn drove Bonds, Vol, and even XCCY basis.
To me, this theme will continue to drive markets until we get a broad resolution that creates a floor under regional bank stocks. Unfortunately, I think that floor might still be some distance away (or prove to be a lot stickier), although dovish commentary from the Fed tomorrow (with or without a hike) should help. Why?
Looking at the Fed's review of SVB's failure and FDIC's proposals, it's quite clear that the regulatory cost of doing business for banks is going up in the future, both in terms of stricter liquidity/capital requirements and DIF fees (insurance premiums).
Even though depositors have not lost any money so far, stock and bond owners have been wiped out. So, basically, as an investor, your "loss given default" (borrowing this term casually here) is now 100%. So that requires repricing of risk.
Deposit betas are on the rise and will continue to rise, which indicates the cost of funding for banks will rise as well, making a hit to Net Interest Margins inevitable. We have already seen differences in flows of interest-bearing and non-interest-bearing deposits at banks.
The RBA delivered a surprise hike earlier this night (or morning, depending on where you’re based). While what the Aussies do doesn’t directly influence the fate of regional banks in the US, it does bring to light the fact that central banks may not be done raising rates if inflation doesn’t moderate soon enough. And if that is the case then banks may have further losses to absorb on their AFS portfolio
While the authorities have protected depositors so far, there have not been any steps taken yet to create a system-wide mechanism for the prevention of bank failures (like extending the FDIC insurance). Yes, the Fed has created a facility (BTFP) with very generous terms, that only allows banks to sustain without realizing the losses on their under-water bond portfolio, and does nothing to address the hit to NIM, which means banks are still unprofitable.
Finally, there has been a lot spoken about how something like Commercial Real Estate (CRE) would be a major issue for several banks as and when the recession bites. While exposure to CRE varies from bank to bank, the major point here is that so far, banks are only struggling with interest rate risk, and when the recession gets closer, they may have to start dealing with credit risk as well.
Now, the factors that led to the failure of the three banks in the US were partially systemic (higher cost of funding, lower value of duration assets) but also, largely idiosyncratic (terrible risk management because of having grown too fast). So, it’s not clear why more banks must fail. But, the fundamental problem here is that banks are a lot about confidence.
While any business that funds long-duration assets with short-term funding faces the same risks, the unique challenge with banks is that most of their funding can be withdrawn at any moment, if the depositors lose confidence in a bank. And should that happen, any bank, irrespective of how good their liquidity metrics are, can fail. Therefore, the discount built in banks post SVB seems justified.
Monetary Policy
The biggest shift we are going to witness in monetary policy is likely to be from “data dependence” to “monetary policy works with a lag”. In the world of Fed Watching, this translates into going from “some additional policy firming may be appropriate” to “the extent/timing of any additional firming will depend on incoming information”.
As Nick Timiraos wrote in WSJ, “Until now, officials have been looking for clear signs of a slowdown and easing inflation to justify an end to rate increases...But now... Officials could need to see signs of stronger-than-expected growth, hiring, and inflation to continue raising rates”
No one disagrees that the tightening in credit is worth 50-75bps in rate hikes, but would this lead the Fed to cut rates this year, even with inflation above 2%? Tighter credit does some of the Fed’s job for them and there’s no real dilemma between choosing price stability and financial stability stemming from a major crisis. The real risk is under (or over) estimating the severity of the crisis, something which SVB learned the hard way:
Accordingly, the answer to whether the Fed would cut rates with inflation above 2% is - it depends entirely on the severity of the crisis; if it becomes evident that the scale of the crisis is large enough to cause an immediate and deep recession (which would be disinflationary), then yes, rates are going lower. part from the statement itself, how Powell answers what they’re doing to prevent more bank failures and what would the Fed do in case bank failures continue, will determine how we remember this meeting.
Notice that we have not talked about whether or not the Fed should hike tomorrow. This is because it’s really not all that relevant. As long as the Fed orchestrates the shift from data dependence to “lags” in the statement, and if Powell is able to assure the market that they are working to prevent further failures, that should be what the market should care about. And even though I am in the hike camp for tomorrow (the Fed does want credit to tighten after all, just not at the cost of more banks failing), until we have more clarity on the overall bank situation, a face-ripping rally in bonds is always around the corner, so that’s not the tail I am willing to sell.
May FOMC: Once More Unto the Breach
excellent write up, thanks