In my industry, if the economy is going to have challenges, you can bet it’s while you’re on vacation. Let’s chat about what bank runs mean for you and what to expect moving forward.
The last couple weeks I was on my honeymoon and well—of course a banking crisis erupted. Here is what happened, some reasons why it happened, and what you should plan for next. (Click here for last week’s YouTube live on this topic.)
Bank Runs
Earlier this month, it was reported that Silicon Valley Bank experienced a “run” on deposit accounts, with investors being concerned about the safety of their assets when FDIC regulators responded. As you can imagine, this prompted a number of emails and phone calls from our concerned clients. Over the last couple weeks, other banks have experienced similar challenges.
What happened in a nutshell.
Some of the details are still being uncovered, and oftentimes with these things, the fog of war makes it impossible to clearly identify what the series of events really was or how things got started. There are many powerful actors with competing interests who interact amongst one another privately; details may be relayed publicly but often slowly, and inaccuracies will abound in the first few days.
Liquidity Issues & Interest Rates: Ironically, the biggest issue these banks are having is liquidity. I say ironically because the amount of U.S. dollars in the marketplace is at a historical high (80% of all U.S. dollars currently in existence have been printed in the past two years.) So how can liquidity be the problem when the flow of money has been astronomical in the last few years? Answer: Interest rate hikes and money movement.
Money Movement & Interest Rates: Prior to these bank failures, deposit outflows from banks were accelerating, and relatively recent technology such as mobile banking makes the velocity of these deposits out of the banks much higher than previously imagined. Customers are pulling their money out of banks to reinvest it elsewhere; banks are paying less than money market funds pay at investment houses. As interest rates went from 0%-4% between March and November 2022, inflows to money market funds outside of banks were paltry. However, as soon as rates increased above 4%, the money market flows begin to increase considerably and as rates have since increased, the attractiveness away from banks towards money markets only heightened. So in essence, people seeking yield on their money were relocating it outside of banking institutions and have been doing so at a rapid pace. These two photos below illustrate the vast discrepancy between what money markets versus banks are paying on deposits, and the resulting outflows.
Forced to cover these withdrawals, banks were in a very dicey situation. One large contributor to the strain is that bank assets—particularly U.S. bonds—have suffered large, unrealized losses in recent quarters (as have all investors). In Silicon Valley Bank’s situation, instead of selling these investments at a loss, they attempted to raise funds, an unsuccessful effort that panicked investors and ultimately resulted in its collapse.
Moving forward, there are three choices the banks and the Federal Reserve might take:
Banks may continue not to raise rates on their accounts, remaining noncompetitive, and continuing to bleed deposits.
Banks may raise rates on their accounts, but reduce their profits. (And, if rates continue to increase quickly, their profits could be significantly impacted.)
The Federal Reserve can cut the funds rate (stop raising rates) and risk higher and persistent inflation.
My Prediction
As of the time of this writing, it seems no aggressive action from banks or the Federal Reserve on any front is likely. Just last week, the Federal Reserve increased the federal funds rate by 25 basis points and indicated they plan to pause rate increases soon. Modest increases in the rate, or a pause altogether may risk continuing the inflationary spiral and fail to solve the banking liquidity issues. Given the recent decisions of the Federal government, it is also likely they will continue to backstop banks who face insolvency issues—which will not entice banks to raise rates on their accounts. (Why would banks make an unprofitable decision if they expect the Federal government to bail them out down the road, indefinitely?) This tepid response will ultimately draw out the current crisis.
What Comes Next
Things will be bumpy. The banking crisis is a symptom of the economic challenges the U.S. economy (and even more so, the world economy) will need to work through in the coming years.
The main driver is the dichotomy of inflation and interest rates. To reduce inflation to the targeted 2% (I suspect, soon to be increased to 3%), the Federal Reserve must raise interest rates high enough to stop the velocity of money in the system (there is too much money in the system, and it is being moved around too quickly). By raising rates, the Fed makes it less attractive to borrow and spend money which slows down inflation (reduces the movement of money).
But, by raising rates, the economy slows down, reflected by poor equity returns and potentially high unemployment among other negative consequences. In addition, as the current banking crunch illustrates, even very large financial institutions may be unable to manage their short-term liquidity needs.
The next few years may be very challenging—inflation is likely here to stay until the system corrects itself due to the strain high interest rates are putting on both investors used to borrowing at substantially lower rates and institutions that are unable to navigate such a quick rise in rates on their short-term balance sheets.
It also seems likely that the Federal Reserve or the Federal government is not willing to make any major adjustments that would possibly shock the system into correction sooner rather than later.
My guess (and remember, it’s a guess, because nobody knows): we will be in economic purgatory for another year or two. The news will be disheartening, the returns poor, and many street investors will be disillusioned with their investments. But this is when staying the course matters. It’s easy to say and do when things are going well; it’s when a correction or recession happens—when credit is tight, when investments are down—that it matters. You cannot only have the ups, you must cycle through the downs. See below for a snapshot of what staying the course looks like for your money.
Stay the Course
Paraphrasing a famous Churchill line— No one pretends that the U.S. economy is perfect or all-wise. Indeed it has been said that the U.S. economy is the worst economy except for all those other economies.
We are still the best game in town, but the only way is through. Never short the U.S. market.
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