BANKS, INTEREST RATES AND THE MARKET

The recent problems in the banking sector have added more volatility to an already unstable stock market. And problems in the banking/financial sector usually lead to problems in the stock market. So far, the banking issues seem to be isolated but there are likely to be more surprises ahead.

The issues with the regional bank collapses (Silicon Valley Bank, Signature Bank, etc.) seem to be driven by management failures and do not appear to be widespread at the moment. At SVB, they made bad decisions on the deposit side and the investment side of their operation. Their depositors were too concentrated among a small number of businesses and individuals, and they made poor investment choices. Prior to the interest rate increases in early 2022, they had most of their depositor’s money invested in long term bonds. Most individual investors were smart enough to avoid long term bond investments at this time. In January of 2022, long term bonds were yielding less than 2% per year. For a measly 2% return, SVB was exposing itself to huge losses if interest rates increased – which they did. You know the rest of the story.

While there have been other regional banks that have collapsed, the problem seems to be limited to the regional banks that have had less oversight. Credit Suisse is a much bigger international bank, but Credit Suisse has been in trouble for many years. Their problems aren’t new and European regulators and UBS have backstopped that problem. Even though the bigger US banks do not appear to have the liquidity problems of the regional banks, look at the stock price of Bank of America compared to the regional banks. It has not fared much better than the smaller banks.

The Bank of America stock price is more representative of the bigger problem going on in the banking sector which is directly tied to inflation, interest rates and the actions of the Federal Reserve. The Federal Reserve has raised interest rates faster and higher than any other time. They were ridiculously late in reacting to the increase in inflation and, as a result, were forced to raise rates significantly over a short period of time. Banks and our financial system are obviously impacted by changes in interest rates. And big changes in rates that happen rapidly are difficult for banks to manage. The regional banking problem is one of those “unintended consequences” that result from government interventions like this.

Inflation has been driving these interest rate hikes. Here is what has been happening with inflation over the last two years. You can see that the inflation rate started to rise rapidly in the second quarter of 2021. It reached 8% at the beginning of 2022 and peaked at 9% in May of 2022. But the Fed waited until the first quarter of 2022 to start fighting inflation with a higher federal funds rate. They made really dumb arguments as to why inflation spikes were going to be temporary. This is yet another example of when you should not believe anyone that tells you that “this time is different”. Because they were nine months late, they were forced to raise rates rapidly. It is highly likely that there will be more unintended consequences that appear as a result of the rapid change in interest rates.

You can also see from the previous chart that inflation rates are declining. This is good news. But you also need to be aware that inflation rates are calculated on a trailing 12-month basis. So, the January 2023 inflation rate of 6% is the increase in prices since January 2022. January 2022’s 12-month inflation rate was 7.9%. So, prices in January 2023 are roughly 14% higher (6% plus 7.9%) than they were in January of 2021. The May 2023 inflation reading will be very interesting since the May 2022 rate was 9%. Inflation has always been very stubborn and takes a long time to subside.

Even though the regional banking issue seems to be contained at the moment, we should all be prepared for more unintended consequences.

Happy Investing,

Phil

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