I expected the Fed to keep hiking interest rates until unemployment rose to at least five percent. I knew the Fed would continue along this path until it broke something though I imagined that something would be the labour market.
It appears that something may have been Silicon Valley Bank. It seems almost impossible that the Fed continues on the path of interest rate hikes it has implicitly announced with its "interest rate forecast" now that this has occurred. (It turns out it is pretty nice to forecast something you yourself play a role in determining, it makes things much easier. My ex-girlfriend also forecasted we would last only a couple months.)
I anticipate a 25 bps cut or, what I consider to be the most likely outcome, no change the next time the Fed announces interest rates. Of course, this is pure gut---I might revise this estimate once I get to do more reading. The talk I have heard about a cut of 100bps seems, however, unrealistic given the concerns surrounding inflation. It has to be understood that inflation itself places downward pressure on bond prices. So, the Fed needs to continue to show resolve on the inflation front: Accelerating inflation could also cause more situations like the one we saw at SVB bank. The Fed finds itself facing a Catch-22.
While the interest rate hikes are necessary, the current path seems much too aggressive. The banking system holds too much of its reserves in the form of bonds to continue along this path. Of course, as we said above, it also holds too much of its reserves in bonds to abandon the fight against inflation entirely. The Fed must walk along a steep and narrow path.
What is esp. difficult is that the fight against inflation may require the Federal government to reduce its own spending even though tensions with Russia and China call for a significant military build-up. Parts of the government not related to defence need to be meaningfully reduced, esp. those that employ people with skills that are currently in short supply in the private sector. While the tight labour market is not the primary driver of this inflation, it is certainly a contributing factor. Freeing workers to deal with the labour shortages could further ease inflationary pressure without putting undue stress on the banking system---over and above the effects a tighter fiscal policy would have on its own.
All this notwithstanding, SVB played a role in its own downfall. It appears to have put the philosophy of diversity and inclusion into practice: And the result was one of the largest bank failures on record. No competent risk managers would have left their balance sheet so completely unhedged. This bank is a perfect example of what happens when you allow politics to triumph over meritocracy. We can only hope that other banks have hired the most competent risk managers possible, without concern for quotas or any other political ideology beyond the soundest principles of economic and financial science.
That said, there are a number of banks that appear to be similarly exposed to duration risk. The ones with better insured deposit bases, like B of A, are likely to survive. But a number of smaller ones could be in trouble. There will be more bank failures even if the catastrophe does not stretch across the entire banking system.
We can, of course, expect Biden to blame Trump for this problem, claiming that his decision to loosen regulation on smaller banks allowed SVB to act as it did. However, I consider this argument to be incredibly specious. Not only did Biden have time to reverse these regulatory changes during his first two years in office, but Moody’s did not catch this problem when rating SVB’s own bond issuances. It is very unlikely that the Fed would have found something wrong in SVB’s financials that Moody’s missed.
Biden should have, aware of the Fed’s decision to hike up rates, reinstituted these regulatory requirements. He didn’t. Trump was instituting rules suited to the pre-pandemic world. Biden failed to critically re-examine them.
I expect that this pause in interest rate hikes should help to stabilize home prices. This, to my mind, is the silver lining on what is otherwise a pretty scary looking storm cloud.
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