The US banking crisis entered its third week with no stability in sight. While Federal regulators' decision to insure all deposits at Silicon Valley Bank and Signature Bank ended the deposit flight from those entities, the crisis spread to other institutions, e.g., First Republic Bank, which hold long-maturity loans and mortgage-backed securities backed by fickle short-term deposits. Despite repeated assertions by senior US officials that there is no weakness in the system but only individual bank issues, persistence of runs on different banks suggest structural shortcomings.
Hopes that the deposit insurance ceiling will be raised from the current $250,000, to a much higher level or even cover all deposits, buoyed smaller bank stocks from time to time. Contradictory statements by Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell, on the other hand, brought down investor hopes. Yellen went one step further in confusing matters by providing different statements on Tuesday, Wednesday and Thursday last week regarding how much of the deposits the government would be willing to protect.
Let us start with the Federal Reserve. Just a few weeks after the Federal Open Markets Committee's statement February 1 that there would be "ongoing increases" in interest rates, the decision on Wednesday watered it down to state that "some additional policy firming may be appropriate." With the Federal Funds rate increased by 0.25% last week to a new range of 4.75 - 5%, the "dot plot" by Fed officials signaled a 5.1% rate ceiling, i.e., no more than one hike, if that. That is a significant shift in policy in seven weeks! Markets now expect the rate would be cut several times before the end of 2023.
The interest rate decision and the new dot plot boosted equities after the announcement at 2 pm Eastern time. The rally continued as Powell said during Q&A that tighter credit conditions resulting from the banking crisis were acting like rate hikes. In other words, not much more tightening by the central bank was necessary. Providing more soothing words, the Chairman indicated that authorities had the tools to protect depositors.
Despite his assurances, equity prices sank by the 4 pm market close on Wednesday. The major contributor was the Treasury Secretary who was speaking to a Senate committee at about the same time as when the Chairman held his press conference.
Contradicting Powell, Yellen indicated that she has "not considered or discussed anything having to do with blanket insurance or guarantees of all deposits." This was just a day after she had suggested that backing deposits over $250,000 would "be warranted" in case of runs on deposits. She pivoted yet again on Thursday, telling a House committee that she would take "additional actions, if warranted," to ensure that Americans' deposits are safe.
So the Secretary suggested further steps to support banks a day after denying that there would be such guarantees which, in turn, had followed her position at the beginning of the week that supporting larger deposits may be justified. You understand? I certainly do not.
The Yellen pivot – involving three different positions on three successive days – would be the envy of a ballet dancer!
Amidst the chaotic management of the bank crisis, equities rose and fell based on investors' views on bank runs and what they perceived to be the latest US position on bailouts. However, the trend in Treasurys was clear. 10-year Treasurys, which traded at a yield of over 4% on March 2 dropped to 3.38% last night. The decline in two-year Treasury yield was even more impressive from over 5% on March 8 to 3.77% yesterday.
What does the huge rally in Treasurys signal? The drop in the 10-year Treasury yield is a safe haven play as investors believe that the banking crisis is still on with authorities having no clear plan regarding how to resolve it. It also reflects the expectation that a recession will begin a few months from now.
The implication of the decline in the two-year yield is even more significant. Markets simply do not believe that the Fed can tighten further in light of the interest rate increases that gave rise to the crisis in the first place. Even at the lower 10- and two-year yields, Treasury returns may prove to be a headwind for equities that are anticipating a hit on corporate earnings from the recession.
Lower market yields on Treasury securities were not the only sign of easing in market conditions due to the banking crisis. The Fed's balance sheet, which is supposedly experiencing Quantitative Tightening – a reduction, in plain English – has undergone two successive weeks of increases. It rose from $8.4 trillion on March 8 to $8.6 trillion on March 15, and further to $8.7 trillion on March 22. The latest increases have canceled the cumulative QT that has taken place since last October.
At his press conference last week, Powell claimed that the latest increases in the central bank's assets are a consequence of "temporary lending to banks," and do not represent a shift in policy. Paraphrasing the Chairman, this is not Quantitative Easing even though it has expanded the Fed's assets.
That introduces a new concept in monetary theory that none of us learned in graduate school: QE is not QE unless Chairman Jerome Powell says it is!
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California