SIVB Bomb

Things are starting to blow up.  The puppets are running as the bombs go off.  Silicon Valley Bank is the latest victim as the rapid pace of rate hikes is leading to some hairy consequences.  

The SIVB situation has shined a light on how fake those book values are in the banks.  Those hold to maturity (HTM) securities are not marked to market.  A lot of those securities were bought in 2020 and 2021 when 10 year yields ranged from 0.5% to 1.75%.  And when short term rates were hugging zero.  That is the asset side of the banks' balance sheets.  The banks are hanging on to huge unrealized losses on their assets.  Their liabilities are short term deposits, which they are currently paying way below market rates on.  Sure, a lot of the people holding them have balances that are small or are too dumb or lazy to seek higher yields on their cash.  But the smarter ones have started moving most of their deposits out of the banks into money markets, T-bills, and other short term cash alternatives.  QT will slowly suck out reserves, making deposits that much more valuable to banks going forward.  The banks' liabilities, deposits, are where they will have to increase the rates they pay out to keep them from moving out, reducing their net interest margin. 

People were ignoring this side effect of the Fed raising 450 bps in less than a year.  The effects of yield curve inversions have been slow to surface because of all the excess savings from the Covid stimulus and the massive Fed balance sheet.  But those are slowly being drawn down, just as the lagged effect of the rate hikes flow more and more into the real economy.  A poisonous brew that's getting a bit more toxic by the day. 

The yield curve inversion went parabolic this week with Powell's hawkish testimony, opening the door to a return to 50 bps hike in March.  The market has been taking the 2-10s curve inversion in stride, and you even saw articles about the economy being a "Godot" recession, as it seems that the recession is always 6 months away.  Investors got complacent on the potential economic weakness coming later this year. That complacency finally caught up to the market yesterday.  Until we got the SIVB news drop yesterday, the major worry was hot economic data that would force the Fed to hike 50 bps in March and maybe get to a 6% terminal.  Wall Street has such a short memory, little patience, and is so focused on the now, that it loses focus and overthinks as the path meanders towards the eventual destination that most agree on, which is a Fed engineered recession. 

The time lags between rate hikes and its effect on the economy have given equity bulls a false sense of invincibility, almost as if the economy is so strong, it can handle these high rates without a problem.  I even started hearing nonsense from Warren Mosler advocates about how raising interest rates is stimulative for the economy, as it increases interest payments from the government to the private sector.  This ignores all the non government borrowers who have to pay interest from their cash flows, not from printing more Treasuries.  Sure, the rich with big cash holdings will benefit from higher rates, but almost all of their marginal dollars aren't going to be spent on goods and services, but rather put towards stocks, bonds, or cash equivalents.  Those with the most propensity to spend their marginal dollars are the ones who are the most punished by higher interest rates.  Those people in the middle to bottom end of the income spectrum are the ones who are going to get squeezed by higher interest payments and less available credit as lending standards tighten.  You are already seeing that with a rise in auto delinquencies.  

Also don't forget that student debt payments have been suspended, and will resume once the Supreme Court decides on whether its legal or not for Biden to forgive that debt, or June 30, which ever comes earlier.  A ridiculously long suspension for no real  reason, other than thoughtless Covid pork jammed down peoples' throats who loved it. 

Here is a chart showing the lag effect and what the current economy is feeling based on the past rate hikes, assuming the following, from Michael Lebowitz's recent article on the Fed:  

 Rate hikes should affect the economy with the following lags:

• 25% First month
• 50% within three months
• 75% within nine months
• 85% within fifteen months
• 100% within two years

Using those assumptions, the overall economy is feeling like rates are at 2.44%, not 4.5%.  But its rising fast.  By the summer, the lagged effective Fed funds rate will be 3.5%.  Of course, this is a rough estimate, but it points to the speed of this rate hiking cycle, and how the tightening effects will be felt much more later this year than right now.  

It was fashionable to compare the current period to the 1970s, with the high inflation rates conjuring up that stagflationary and sticky inflation period.  But I see more similarities to 2001 and 2008 than 1973.  Its never the same recession.  With the government running huge budget deficits and reinvigorating a big chunk of household balance sheets with ridiculous amounts of money spew, you are not going to have anything as bad as 2008.  But the current situation looks worse than 2001.  Back then, the natural growth rate of the economy was higher, and you didn't exhaust monetary policy by staying at ZIRP and QEing for over a decade.  Greenspan cut rates from 6.50% to 1.00% from 2001 to 2003, even though the economy only had a mild recession, and housing was barely affected during that period.  That was hugely stimulative to the real estate sector, as households could refi to much lower interest rates, and the economy was strong from 2004 to 2006.  

This time, even if the Fed cuts from 5% to 0%, you aren't going to get the same stimulative effect.  Most homeowners won't refi even at ZIRP, because long term yields won't be going down below 1% like it did in 2020.  And you already have a huge chunk of outstanding corporate debt issued at much lower rates than today, unlike in 2001.  So a return to ZIRP won't drastically change the debt profile of corporations and won't have much of an effect on interest expense.  Don't forget, the early 2000s was when the internet exploded into mainstream use, and that was a huge productivity boost to the economy, a deflationary technology that has no parallels today.  You also had offshoring going into overdrive with China, keeping inflation low.  This time, there are no breakthrough productivity game changers in recent years to help keep inflation in check.  Offshoring is almost maxed out and its more likely to go in the other direction.  It will make it that much harder to keep inflation down, making it more difficult for the Fed to keep rates low. 

As soon as I write a post about the market being tamer we get a big move down with the SIVB bomb hitting the tape.  You always have to stay humble in this business, you will be wrong over and over again.  This negative correlation move with stocks diving and bonds squeezing higher was completely out of the blue, so quickly after Powell put 50 bps on the table.  But it reinforces my belief that unlike 2022, you are more likely to see stocks and bonds trade in opposite directions, like it did for most of the QE era.  In the end of a hiking cycle, bad economic data is still good for stocks, but that will only last for a couple months.  If you keep getting bad data, the focus will shift from inflation to growth, and that's when you really get the negative correlation moves in stocks and bonds.  That's probably happening this summer, and yesterday gave a sneak preview of things to come.  I don't recommend entering any short positions here as the bank contagion fears percolate ahead of the weekend, as I don't like to enter shorts when I see blood on the streets.  I also wouldn't be long either, at least until we get closer to the December lows around SPX 3800. Another 1 or 2 days of selloffs could get us to that level, where I would take a shot on the long side for a trade.