There is a saying on Wall Street When Feds Raise Interest Rates - Something Breaks

Mar 23

There’s a saying on Wall Street that when the Fed raises interest rates, something breaks.

The Latin American debt crisis of 1982, the 1987 stock market crash, the failure of Long Term Capital Management in 1998, the 2000 dot-com crash and the subprime mortgage debacle of 2007 all followed periods of rising rates, and generally marked the end of Fed tightening cycles.

It’s too early to say for sure whether the collapse of Silicon Valley Bank and Signature Bank and life-threatening ailments at First Republic Bank will force the Fed to back off its aggressive – but in our opinion long overdue – campaign to slow the economy by raising the federal funds rate at the fastest pace in 40 years. But we think it will result in regional banks being required to hold more capital as a percentage of assets, which will reduce lending and put a brake on the economy. That would allow the Fed to slow down its pace of rate increases, which could lead to a bottoming in the stock market.

It’s important to realize that SVB was unlike other banks. Its clients were primarily venture-backed technology and life-science startups. In 2020 and 2021, these firms were flush with cash and SVB's deposits soared – far faster than its loan demand – at a time when short-term interest rates were near zero.

SVB plowed a lot of this excess cash into longer-term Treasury and mortgage-backed bonds because at that time, they yielded more than short-term securities. When the Fed started raising the federal funds rate in March 2022, these funds lost value. As tech turned south, cash-burning clients wanted their money back and SVB was forced to sell bonds at a huge loss. When news of the loss and a planned stock sale came out, depositors panicked and a run on the bank ensued. SVB was taken over by regulators, who agreed to guarantee all deposits, including ones over the $250,000-per-account insurance limit.

At least 90% of SVB’s deposits were uninsured, compared to 40% for all U.S. banks. About 90% of deposits at Signature Bank, the New York bank seized by regulators, were uninsured. At First Republic, a San Francisco bank serving wealthy clients on the East and West coasts, about two-thirds of deposits were uninsured and those too have been fleeing.

Like SVB, First Republic is sitting on significant unrealized losses in long-term bonds. Unlike SVB, First Republic is much more a mainstream bank with a more diversified client base. It received $30 billion in deposits from 11 large banks to prop it up.

These recent bank debacles have complicated the Fed’s inflation-fighting battle. In February, inflation clocked in at 6%, well above the Fed’s 2% target.

Before the bank failures, some economists were predicting the Fed would raise the funds rate by a half-percentage point at its March meeting to quell stubborn inflation. Afterward, some were calling for no increase to prevent further bank failures. On March 22, the Fed threaded the needle, raising the rate by one-quarter point, to a range of 4.75% to 5%.

Chairman Jerome Powell said that since the Fed’s previous rate-setting decision on Feb. 1, “economic indicators have generally come in stronger than expected, demonstrating greater momentum in economic activity and inflation. We believe, however, that events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.”

The Fed appeared to soften its stance on future rate hikes, changing its language from “ongoing rate increases” to “some additional policy firming.” Members of its rate-setting committee are now forecasting one more quarter-point rate increase this year.

Whether that decision leads to more bank failures, a recession, higher inflation or the hoped-for soft landing remains to be seen. Meanwhile, there are other issues of concern.

One is the debt ceiling. The U.S. Treasury has been using extraordinary measures to meet its obligations since January, when the government hit its debt limit. If Congress hasn’t reached an agreement to raise the debt ceiling by the time those measures are exhausted, the government could technically default on some obligations, like it did in 1979 when the U.S. Treasury was forced to delay payment on some Treasury bills. The Treasury could exhaust its temporary measures as early as June, but Congress has not yet put forward any proposal to prevent a default.

With all this in play, it’s hard to see through the fog. When the Dow Jones industrial average is down 600 points one day up 400 the next, it’s a sign that investors are trading on emotion, not reason.

We are not traders or speculators. As long-term investors, like Warren Buffett, we are looking to buy well-managed companies that make good profits at the right time and price.

During the first quarter, we maintained our defensive stance. We added a couple companies in some portfolios, such as Walt Disney, and trimmed a few, but did not add to our overall equity positions.

Our equity portfolios generally range from 40% to 60% in blue-chip stocks, the rest is in Treasury bills maturing in one to six months.

Our fixed-income portfolios are in high-quality bonds with an average maturity of 3 to 3.5 years.

The good news is that times like this often lead to a market bottom. We are still cautious but looking for opportunities to expand our equity holdings. In the meantime, we will continue to use Treasury bills to protect your portfolios.

We are always ready to provide answers and advice If you have questions about SVB, First Republic Bank, other commercial banks. Or to discuss the safety or composition of your portfolios, please reach out to us. We are here to help in any way we can.

All the best,

Bruce and Leon

Bruce Nollenberger

415-287-5100

brucen@nollmac.com

Leon Wiatrak

415-956-8700

lwiatrak@nollmac.com