Market Miracle Ended Due to Systemic Angst Caused by SVB

It's one thing for a fired-up Federal Reserve to crush bitcoin, or for moonshot web stocks to crash when rates rise. Nevertheless, when central bank policy begins to bite into banks, investors realize they have greater problems on their hands.

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Fear of systemic risk wreaked havoc on markets this week, as investors who believed they'd weathered the brunt of Jerome Powell's inflation-fighting campaign experienced their worst streak of losses in five months. Bank stocks, thought to be safe havens in a rising-rate world, led the decline, marking their worst week since the Covid crash.

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While the judgment is yet out on whether SVB Financial Group's bankruptcy foreshadows widespread risk to the financial system, signals that it did were enough to frighten investors who were sitting on returns reaching 10% for 2023 only a month ago. The advance had fallen to less than 1% by the end of Friday, leaving bulls with the warped optimism that things are awful enough that Powell's Fed won't dare to increase rates much more from here.

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"This circumstance will push the Fed to move more progressively," Alec Young, chief investment strategist at MAPsignals, said. "Everyone was concerned in the back of their thoughts that something would break — people think, 'Well, this is the item that's breaking.'"

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Last week's events shattered a key tenet of the bull thesis for equities, namely that increasing interest rates didn't affect anyone much. The story went that consumers and major corporations shielded themselves from Jerome Powell's fervor by locking in loans when yields were nothing. Banks, on the other hand, have emerged as an exception to that notion, as rising rates burden lenders with paper losses on bond holdings and entice depositors to flee. If there are too many defects, paper losses might swiftly become realized losses.

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For investors in general, the issue is whether investor concern about the banking sector is sufficient to spark another significant down leg in a bear market that began 14 months ago. Skittish traders are aware that the 2008 financial crisis disaster did not have its worst stretch until roughly a year into the selloff when the failure of Lehman Brothers brought the S&P 500 down 30% beginning in September of that year.

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Few are forecasting such devastation this time, but nothing raises the ire of bulls more than the mention of systemic danger. Spectra Markets' Brent Donnelly says the S&P 500's loss from 4,100 this week might be the start of a quick selloff aiming for 3,650 to 3,700 during the next week - a decrease of more than 5% from the Friday finish of 3,861.59.

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"It's ready to shoot and aim right now. "You can't sit there as a depositor and consider things — you simply get out," Donnelly said of SPDR S&P Regional Banking ETF investors. "If you're long KRE, you just exit and consider your options."

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Silicon Valley Bank became the largest bank failure in the United States in more than a decade, brought down by a cash outflow from the software firms it had served for 40 years. The failure occurred only days after crypto-friendly Silvergate Capital Inc. declared its intention to liquidate and wind down operations.

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The comparable drop in bank equities, along with contagion worries, pulled the S&P 500 down 4.5% this week, its lowest performance since September. Although anticipation that the Fed was nearing the conclusion of its tightening cycle spurred a strong run at the start of 2023, the index's year-to-date gain is nearly gone.

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Traders are already pricing in the potential that the Fed may soon reverse its rate rises and instead decrease rates before the end of the year. After breaching beyond 5% for the first time since 2007, the two-year Treasury yield fell the most in two days since 2008.

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But, this rebalancing is of little comfort to equities bulls this time around.

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They keep moving until something breaks, particularly in an inflationary environment, according to Michael Collins, senior portfolio manager at PGIM Fixed Income, on Friday. I contend that the chance of anything breaking is now somewhat greater than the chance of uncontrolled inflation.

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SVB's struggles served as a warning that banks may find it difficult to create profits even in a rising rate environment, even if no systemic danger materializes. Given that experts predict the group will have the second-highest profit growth among S&P 500 industries this year, it might cause problems for everyone.

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While higher interest rates are normally assumed to boost interest income, the problem is compounded in 2023 by a sharply inverted yield curve, which lowers returns on longer-dated assets against short-term obligations. Keeping deposits is difficult when money market rates are up to 50% higher than savings account interest rates. If deposits vanish, banks may be obliged to record what were previously simply paper losses on mortgage bonds and Government assets they must sell.

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SVB ultimately became the face of the issue because it catered to the type of venture capital-backed businesses and startups that are experiencing cash flow problems as the Fed tightens its belt.

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"This is simply another example of things going wrong in an economy that has grown quite used to low-interest rates for a decade and a half," said Ellen Hazen, chief market analyst, and portfolio manager at F.L. Putnam Investment Administration. Because whole business models were based on free money, everything will fall apart when nominal and real interest rates start to increase, which has been the case for the past year.

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