The SVB Fiasco Does The Fed's Job For It

Interest rates across the yield curve have plunged in the wake of the bank failures announced over the past few days with the 2-year Treasury yield falling a full percentage point from 5% to 4%, while the 10-year yield fell from more than 4% to 3.5%. Normally, declining interest rates would be good for stock prices, but these declines are due to a flight to the safety of government debt, as well as concerns about a recession resulting from the fallout. They also indicate that the Federal Reserve is likely to end its rate-hike campaign well in advance of what was expected just one week ago. Rate sensitive sectors performed well yesterday, but the financial sector continued to be under pressure, as investors are concerned about which of the remaining banks might have similar balance sheet issues. Yet this is no longer an issue after the Fed backstopped the financial system with a facility that allows banks to borrow from the Fed, using government debt as collateral, to meet cash demands from depositors.

In fact, there is some upside to this banking debacle in that it is a deflationary event, largely doing the Fed’s job for it. Financial conditions tightened dramatically overnight, which has been the Fed’s goal for some time, as officials relentlessly attempted to jawbone risk asset prices lower over the past several months. Surely, there will be some unwinding of this rapid tightening, as confidence returns to the banking system and these isolated failures move further behind us.

Still, this temporary period of uncertainty likely prevents the Fed from raising interest rates much higher than it already has to slow the rate of economic growth and bring down the rate of inflation. That is good news, because I don’t think there was any need for additional rate increases, as the 450 basis points of tightening over the past year works with a lag and is just starting to have an impact on less rate-sensitive sectors of the economy. The Fed needed to pause to assess the impact of the rate hikes to date, but Chairman Powell was afraid to do so for fear of the melt up it may cause in risk asset prices. I think the recent bank failures require him to do that now, which is why probabilities of rate hikes moving forward have declined sharply.

Lost in the ruckus of the banking issues over the past few days has been the importance of this morning's inflation report. The consensus expects we will see the headline number fall from 6.4% in January to 6% in February, while the core rate falls from 5.6% to 5.5%. Whether we see slightly higher numbers or not, I do not expect the disinflationary downtrend that started nine months ago to be disrupted, and recent developments should hold the Fed to a 25 basis point rate increase next week. That is increasingly looking like it will be the peak in short-term interest rates.

Yesterday, the New York Fed released a survey that showed consumers expect inflation to drop sharply over the coming year. The median expectation one year ahead called for a decline of 0.8% from 5% to 4.2%, while the three-year expectation held steady at 2.7%. That is vitally important to a Fed that wants to anchor inflation expectations. Additionally, this survey was conducted before the banking turmoil.

The Volatility Index (VIX) rose above 30 yesterday, which is near levels where it has peaked over the past three years. A spike north of 35 would be more convincing, but we are still within a range where its peak has coincided with a trough in market prices.

That means we should be able to see the S&P 500 recoup the losses of the past two days to climb back above the 3,900 level. I still see the index recovering to 4,300 as this year progresses.

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