AE Wealth Management: Weekly Market Insights | 3/19/23 – 3/25/23

Weekly Market Commentary

THE WEEK IN REVIEW: March 19 – March 25

Fed bumps rates another 25 basis points while banks continue to make markets nervous

The Federal Reserve raised interest rates at last week’s meeting by another 25 basis points (0.25%), bringing the federal funds rate to 4.75%-5.0%. This was the ninth increase since the Fed began raising rates last March.

There was some talk of a potential hike of 50 basis points (0.50%) going into the meeting, as inflation data remained stubbornly high. However, when Silicon Valley Bank (SVB) and Signature Bank imploded, the discussion shifted to an immediate pause as the banking sector came under pressure. When things settled a bit, the Fed ended up moving one-quarter point — and it may be the last rate increase this year. In fact, it’s entirely possible we will see rate cuts well before we see another hike.

If the Fed had raised rates by 50 basis points to fight inflation, it would likely have been another severe blow to an already reeling banking sector, but it might have gone a long way toward lowering inflation closer to the Fed’s target inflation rate of 2%. If it did nothing, markets would have assumed there was something deeply wrong with the banking sector and sold off dramatically. The market did sell off but managed to remain orderly.

U.S. Treasury officials have stated it will guarantee deposits above the $250,000 FDIC limit, a statement which seems to have calmed depositors across the banking system. But the central issue remains: Higher rates are not only stressing banks, but they are impacting the economy. The current banking concerns seem to be more of an emotional reaction than a true financial system crisis. Banks, in general, are in far better shape than they were in 2008.

Sure, a few banks have mismanaged their book of business, but that’s always the case. Plus, SVB has a really high profile, catering to the tech sector, which is a very specific part of our economy. As funding dried up for tech companies, SVB clients leaned on the bank for liquidity. The bank had its assets tied up in lower-yielding securities that it would have to sell at a loss to come up with the money to pay back its customers. Once a bank signals it might have a tough time coming up with the money, you get a bank run and subsequent insolvency.

The government stepped in and guaranteed all the deposits because they said the depositors weren’t at fault. That’s really generous — except now all banks will have to pay higher premiums for FDIC insurance and the rest of us will have to pay higher fees to our banks. The moral hazard before us now is that banks may not have learned a lesson from the SVB mess and could potentially continue to behave badly, knowing there won’t be consequences for their bad decisions.

The markets were digesting the whole situation last week, and so far it isn’t going down well. Hopefully, the banking dust-up will settle down over the next few weeks. Plus, if we’re done with rate hikes for a while, maybe the markets can get back on the road to positive returns.

Powell’s balancing act

Ever heard of a “Jacob’s ladder”? It’s a notoriously difficult sailing ship apparatus that requires finesse to use effectively. One small shift in body weight, and you get all twisted around (if you don’t fall completely off). Federal Reserve Chairman Jerome Powell seems to be grappling with his own Jacob’s ladder, balancing between raising rates to tame inflation and supporting banks under increasing pressure due to the Fed’s rate hikes.

What makes the balancing act more challenging is that Chairman Powell doesn’t have the counterbalance the Fed had in 2008. Back then we had low inflation, so all the Fed had to do was save the banks. Today, if the Fed forges ahead with more rate hikes to tame inflation, it risks weakening the banks and pushing us into a recession. But if the Fed abruptly stops raising rates, it wouldn’t flatten inflation and could trigger a financial confidence crisis.

Right now, it appears Chairman Powell could not only lose his balance, he may run out of the metaphoric rope he is traveling on. The truly tragic part of all this is that it’s a problem of the Fed’s own making. Keeping rates artificially low for a prolonged period fueled borrowing (both personal and governmental) and allowed inflation to blossom. Plus, it also encouraged people to look for yield in a lot of unsavory places.

Then the Fed raised rates nine times in 12 months. (In late 2021, they said to expect maybe three rate increases by the end of 2022.) Banks borrowed longer based on the Fed’s guidance, and now their assets aren’t yielding what their current counterparts are. Financial institutions can sell their existing bond holdings with a loss of principal and invest at more competitive rates, or they can hold their bonds to maturity, collect a meager yield and get clobbered by inflation.

The situation was caused by the Fed’s inaction and then action, which should have taken place and then laid back. Instead, the Fed did the opposite — and the economy will pay the price going forward.

Coming this week

• With all the inflation data and the Fed meeting behind us, this week will be somewhat mundane. The headline economic data will be more of a run-of-the-mill variety, subject to the whims of the macro news cycle focused on more talk around interest rates, inflation and the banking industry.
• Tuesday will be a big data day; we’ll see consumer confidence, retail and wholesale inventories, the Richmond Fed manufacturing index, Case-Shiller home numbers and FHFA house prices indices.
• Additional data this week includes mortgage applications and pending home sales (Wednesday), the third and final reading of fourth-quarter 2022 gross domestic product (GDP) (Thursday) and consumer sentiment and spending (Friday).

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