Fed “may’ In May—powell No Rate Cuts This Year-- Markets Look For Cuts At Every Fed Meeting— Systematic Cause For Bank Deposit Runs, The Fed Itself-- Reduced Mid-sized Bank Deposits Restrain Credit And Economic Growth--a Shortage Of Growth Favors Growth Equities—focus On Upcoming Banks Quarterly April Earnings Releases—commercial Real Estate Loans Dominate Mid-sized Banks—most Mid- Sized Banks Meet Federal Risk Tests——fed Needs To Catch Up To Systematic Communications Revolution

Fed “may” In May, Rates Peak, Powell No Rate Cuts This Year, Financial Futures Markets Look For Rate Cuts At Every Fed Meeting Post May

The Fed indicated at its March meeting that, “if appropriate,” it will raise the funds rate at its next meeting in May another 25 bps to 5.0-5.25%. The Fed’s policy statement in March also shifted from anticipating “on going increases” to a more dovish “some additional policy firming may be appropriate.” At his post-meeting press conference, Chair Powell anticipated that he does not see rate cuts this year. In contrast, financial futures markets price in rate cuts at every meeting for the rest of the year. Equity markets fell into line with the futures markets by showing positive performances during March despite banking system turmoil. For the month, the S&P 500 Index increased 3.5% while NASDASQ rose 6.7%. Siding with Chair Powell, financial history shows that once the Fed reaches its peak rate, it usually pauses at that level for some time (see Figure 1.) At the same time, once rates peak, equities likely will rally near-term assuming the economy does not quickly enter into a recession.

Figure 1
Time Between Peak Rate and First Cut

Source: Bloomberg

Smaller And Mid-size Banks Lose Deposits—restrains Credit Growth—Focus On Banks’ Upcoming Quarterly Earnings Releases In Mid-april

With the banking system under turmoil, deposits shifted from small to both large U.S. banks and money market mutual funds (see Figures 2 and 3.) The result puts smaller and mid-sized banks under liquidity pressures. Those pressures will likely restrain small business credit, act as a partial substitute for funds rate hikes, and slow current economic momentum (see Figures 4 and 5.) With pressures swirling through parts of the bank industry, investors will be closely examining the upcoming issuance of their first quarter earnings results beginning in mid-April. Particular focus will be placed on their balance sheets, including, importantly, losses on securities held to maturity. Those results will help to determine stability of individual banks and the system as a whole.

Figure 2
Growth Rate of Deposits at Large and Small U.S. Domestic Banks
(4-week average annualized growth of seasonally adjusted values)

Source: Federal Reserve; Bloomberg; RSM US calculations;
Figure 3
Monthly Percent Change in Money Market Assets

Figure 4
Net Percent of Banks Reporting Tighter Standards for C&I Loans

Source: Federal Reserve, Haver Analytics, BofA Global Research
Figure 5
Net Percent of Banks Reporting Tighter Standards for Consumer Loans

Source: Federal Reserve, Haver Analytics, BofA Global Research

Mid-sized Banks Dominate Commercial Real Estate Loans—one-quarter Of The Office Loans--$270 Billion Of Cre Loans Expire This Year—most Regional Banks Meet Federal Risk Tests

Mid- sized banks generate about 80% of commercial real estate and 50% of commercial and industrial loans (see Figures 6 and 7.) They hold about $2.3 trillion of commercial real estate mortgages (CRE) or about 80% of the mortgages held by all banks. Roughly one-quarter of that total represent office loans. According to The Wall Street Journal, $270 billion of commercial mortgages expire this year. Banks with less than $250 billion in assets hold most of these loans (see Figure 8.). Federal guidelines define the following tests to determine a bank’s commercial real estate concentration risk.

1. Test: Loans for commercial real estate exceed 300% of a bank’s capital. Result for Median Regional Banks—124%

2. Test: Loans for commercial real estate grew more than 50% over the past 36 months. Result for Median Regional Banks—41%.

3. Test: Loans for construction and land development growth exceed 100% of bank capital.

Result for Median Regional Banks—29% Despite overall median regional bank results falling well within these tests, in a recent Barrons article, over a dozen such banks exceeded one or more of these test measurements. With the recent issues facing the bank industry and questions about the Fed’s supervisory stress testing, no doubt regulators will be paying close attention to this potential problem.

Figure 6
Small and Medium-Sized Banks Total Commercial Real Estate Lending

Source: Goldman Sachs

Figure 7
Commercial and Industrial Lending

Source: Federal Deposit Insurance Corporation, Goldman Sachs
Figure 8
Value of Commercial-Loan Maturities Coming Due. $Bn

Source: Trepp, Federal Reserve, The Economist

Fed Also Suffers Losses From Asset-liability Mismatch

Regulators, the press, and Congress blame the recent collapse of Silicon Valley Bank (SVB) on mismanagement at the highest level. Others also point to the failure of the San Francisco Fed to effectively and timely supervise the financial positions of SVB. Further broad criticism of the Fed focuses on their unsuitable stress tests applied during a period of rapidly accelerating interest rates. The asset/liability maturity mismatch at many banks resulted in unrealized investment securities losses of over $600 billion on the banks’ balance sheets systemwide (see Figure 10.) It should also be noted that the Fed’s own asset-liability maturity mismatch produced operating losses of $42 billion since September 2022. The next part of this Commentary looks to a systematic cause for bank runs stemming from Fed policies.

Figure 10
Unrealized Gains (losses) on Investment Securities


Systematic Cause For Bank Deposit Runs—the Fed Itself

A study presented at last year’s Kansas City Fed’s Jackson Hole Conference, Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets (1), points to a more systematic cause for the recent bank run, in effect, the Fed itself. This study concludes that QE reintroduced during the pandemic caused uninsured bank deposits to shoot up to over $10 trillion early in 2022 from about $5.5 trillion in 2019 (see Figure 11.) In the same period, uninsured deposits at Silicon Valley Bank showed an extraordinary increase when they rose from under $5 billion to an average of $14 billion per quarter during COVID. The Fed’s QE purchases of treasury and agency paper from the public resulted in these sharp increases for uninsured deposits at commercial banks. To generate profits from those deposits, the banks then increased claims on those deposits such as upping lines of credit and credit card borrowing limits. Then, when the Fed attempted to reduce its balance sheet using QT, commercial banks did not pull back those claims sufficiently to reflect the reduced liquidity. This mismatch resulted in the systematic liquidity stress such as recently experienced as claims came due. The application of QE over the last decade and during the pandemic resulted in the growth of rate sensitive uninsured deposits. This expansion of uninsured deposits puts the banks more dependent on readily available liquidity. This bank dependency could produce increasing difficulty for the Fed when it needs to tighten monetary policy such as fighting inflation. Ultimately this also brings into question the long-term role of QE if it leaves the banks heavily dependent on the equivalent of a monetary liquidity “fix.”

(1) Authors: Viral V. Acharya (NYU Stern School of Business,) Rahul S. Chauhan and Raghuram Rajan (Chicago Booth School of Business,) and Sascha Steffen (Frankfurt School of Finance & Management.)

Figure 11
Uninsured Deposits at all FDIC Institutions

Source: ProMarket

“Lazy Depositors” No More—massive Uninsured Deposits Flee Using Systemwide Communications Revolution—the Banking World Changed—the Fed Needs To Catchup

In the past, banks depended on “lazy depositors” not withdrawing their deposits to chase shifting interest rates. Combining rapid interest rate increases with the questioned financial viability of specific banks sent massive uninsured deposits fleeing those banks. At the Silicon Valley Bank (SVB,) uninsured deposits represented 88% of the bank’s roughly $190 billion in deposits. Their size exacerbated the bank run. The close community of venture capitalists with deposits at SVB used the social media to warn their colleagues of the bank’s vulnerability. Taking advantage of the systemwide financial communications revolution, depositors then made “instantaneous” withdrawals that totaled $42 billion in one day or more than 20% of the bank’s total deposits. That event changed the banking world. The Fed and the financial system will now need to catch up to the system wide communications revolution impacting the financial networks. To meet that challenge, the Federal Reserve’s Discount Window and the Federal Home Loan Bank, among others, must be able to provide speedier responses at all times.

Investment Conclusions

Equity Markets: Timing of Peak Short-term Rates Key to Financial Markets--Milton Friedman theorized that monetary policy impacts demand and inflation with “long and variable lags.” That theory will now be tested over the next 12 months as the economy meets the reality of last year’s series of steep Fed funds rate increases. Further economic headwinds will come from the likely credit tightening this year which will principally affect mid and small-sized businesses. Current economic momentum will likely slow as a result. With the peak in Fed rate hikes near at hand, equities tend to rally following that peak for some period. Ultimately, financial market performance will depend on whether the economy retreats into a recession or a more favorable soft-landing.

Equities: A Shortage of Growth Favors Growth Equities--Whether the economy experiences slow growth or a recession, either will result in a shortage of growth. Recently, growth stocks experienced market outperformance, according to some strategists, due to lower long-rates. Lower long-rates also suggest economic slowing. In that case, a shortage of economic growth provides the fundamental reason to look to growth stocks. In doing so, investors should select those quality companies with attractive returns on their equity that produce a sustainable growth outlook. Growing dividends provide one important sign of meeting those characteristics.

Fixed Income—“Income” in fixed income now carries real meaning. With that, employing cash, using short-duration Treasury notes and bills, provides investors with both real income as well as a counter against the high level of economic and financial market uncertainties. As 2023 progresses, lengthening bond duration, by degree, will likely prove increasingly attractive when and if the economy slows and inflation comes down from its current elevated levels. Alternative investments can also be used for that portion of the portfolio. historically committed to fixed income; alternatives tend to be less correlated with stocks and bonds. That diversification will also prove particularly valuable with the current investment uncertainties.