March 2023 Market Commentary

The collapse of Silicon Valley Bank (SVB), Signature Bank and Credit Suisse, a large Swiss bank, triggered significant volatility in March. Notably, the divergence of different asset classes was quite unusual. On the positive side, bonds rallied in anticipation of the end of the Federal Reserve’s rate-hiking cycle. The Bloomberg U.S. Aggregate Bond Index gained 2.5% for the month while yields dropped across the board: 2-year Treasury yields, which began the month at 4.89%, dropped to 4.04%, and the 10-year Treasury yield fell from 4.00% to 3.47%. Growth stocks, which are especially sensitive to interest rates, soared 6.8% as measured by the Russell 1000 Growth Index. Small- and mid-cap stocks fell 4.8% and 1.5%, respectively, as concerns grew that the economy is inching closer to recession and due to their increased exposure to regional banks. The KBW Bank Index dropped 24.9% for the month as investors fled the sector. International markets ended the month with moderate gains, underperforming the U.S. market.

The Fed raised rates another 25 basis points at its March meeting and said that “some additional policy firming may be appropriate.” Federal Open Market Committee members indicated that only one member thought that rates should stay where they are, 10 thought they should be raised another 25 basis points and seven wanted even more tightening after that. Chairman Powell said he did not anticipate any rate cuts this year, but the market does not believe him. Currently, the futures market is forecasting a fed funds rate of around 4.00% this year, which implies several rate cuts.

Did the Fed Finally Break Something? 

Markets were rocked in March by the collapse of SVB, Signature Bank and Credit Suisse. It is important to point out that the primary problem in the banking sector is not bad loans or credit risk—which was the case during the Global Financial Crisis—but a crisis of confidence triggered by a mismatch of assets and liabilities.

Banks take deposits and use them to fund loans and make investments. Over the last year, the Fed’s aggressive interest-rate hikes have inflicted big losses on bonds bought by banks when interest rates were much lower. This “interest rate risk” is something well-run banks tend to carefully manage. SVB and Signature were banks that were widely considered to be poorly run (while Credit Suisse is a bank that has been rocked by multiple scandals in recent years), and both SVB and Signature Bank saw their deposits drop as the technology and crypto companies they primarily serve struggled.

Once the market learned that SVB had done a poor job managing its bond portfolio, this led to a “run” on the bank (too many depositors withdrawing their money all at once). The Federal Deposit Insurance Corporation (FDIC) was created during the Great Depression for the primary purpose of avoiding a run on the bank.

The Fed has created a backstop it calls a new Bank Term Funding Program, which allows eligible banks to borrow for up to one year pledging Treasuries and agency MBS, which will be valued at par, as collateral. That plugs a $620 billion hole created by the unrealized losses on banks’ securities holdings. Any losses to the FDIC will be covered by a special assessment on banks, not taxpayers. Additionally, the government will fully protect both insured and uninsured depositors of SVB and Signature Bank, which have both been closed.

The Fed has never defined “sufficiently restrictive,” but the view that is widely held in the markets is that three bank failures in a week will likely mark the end—or nearly the end—of the Fed’s rate-hiking cycle. Market rates across the yield curve fell abruptly this month in anticipation of the Fed backing off and a slowing in economic growth.

The Fed revised down its projection for real GDP growth this year to 0.4% from the 0.5% it had forecasted in December. Given that the GDPNow Model from the Federal Reserve Bank of Atlanta is currently tracking at a 3.2% annualized growth rate for Q1, this implies negative average real GDP growth for the rest of the year. The Fed also projects the unemployment rate to rise to 4.5% at the end of the year from 3.6% currently. Assuming no change in the labor force, this implies an increase of more than 1.5 million in the number of unemployed. Additional tightening in credit conditions in response to bank deposit outflows further magnifies the risk of recession.

Outlook

Historically, the S&P 500 has peaked about seven months ahead of recession,² which helps explain the poor performance of the stock market over the past 12 months. In other words, the market leads the economy both in and out of recessions. These moves are impossible to predict with any precision. For that reason, we continue to believe the best advice for investors with long-term goals is to stay the course, stay invested and be ready to take advantage of any opportunities that might arise in a market decline.