Banking on Quality
What happened last week?
The Fed raised rates by 0.25% to likely end its hiking cycle. The unemployment rate for April was 3.4% as the economy created a higher-than-expected 253k jobs but the prior two-month tally was revised 149k lower.
- The S&P 500 shed -0.80%
- The Dow Jones sank -1.24%
- The Nasdaq composite ticked up 0.07%
Oil prices have given back all their gains since OPEC+ announced production cuts in April and this has impacted the relative performance of Energy shares. Markets are concerned that curtailed bank lending could slow non-financial areas of the economy.
3 Things to Know
The latest bank equity selloff
Regional US bank stocks fell 5% on May 4, 2023, led by those banks most targeted by short sellers in recent weeks. These shares are now down 39% year-to-date, while large banks considered “too big to fail” have outperformed, “only” 17% lower this year.
While concerns around unrealized losses on loan portfolios and balance sheet securities are partially to blame, we see the latest decline as a panic that was initiated by meaningful deposit outflows.
Markets have been in a short-selling spiral, where weaker, individual banks are targeted, their stocks decline, and headlines trumpet broader concerns about deposits.
Targets include banks with relatively homogenous and geographically concentrated deposit bases, and in some cases with lending concentrations in commercial real estate. And as institutions fail, “systemic confidence” is eroded.
Rapid declines in regional bank shares have begun to impact consumer confidence and their perception of deposit safety. A Gallup survey released May 4 found that nearly half of participants were either “very worried” or “moderately worried” about the safety of their bank deposits.
Impact of the Fed rate hike
The Fed last week made the historic choice to raise rates again in the face of an inverted US yield curve and a shrinking supply of money and credit (apart from a new emergency Fed lending facility).
Beginning last year, the US central bank moved from increasing its balance sheet to shrinking it within the space of three months. The Fed abruptly set its sights on attacking inflation after seeing its credibility threatened because of an extended easing cycle that lasted through an economic boom in 2021.
The Fed’s economic and balance sheet stimulus during and after the pandemic was too strong and it is possible that the strength of its inflation fighting medicine will be as well.
Put simply, recent macroeconomic policy has been reactive and sub-optimal. Just as higher rates attracted capital to move from deposits to money market funds and T-bills, so too have higher rates caused the held-to-maturity values of bank assets to fall precipitously.
Risks for markets and the economy
Markets, the banks and the economy face several incremental risks. Banking turmoil is causing a decline in available credit in the economy. Bank lending is likely to tighten further with negative and imminent repercussions for the real economy.
Second, reserves for commercial real estate loans are likely to rise as more heavily exposed banks prepare for restructurings.
Third, market attention will soon focus on credit deterioration that will occur in the future.
Fourth, greater regulation of small banks is in the mix, even if imminent action from Congress is improbable.
And finally, further consolidation in the US banking sector is likely, with smaller regionals across the country teaming up to diversify their localized pools of deposits and loans.
See our weekly CIO Strategy Bulletin for more details