Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett considers the collapse of Silicon Valley Bank, the risk of contagion, the action taken by the US authorities, the market reaction and the potential implications for the interest rate hiking cycle.

14 March 2023

It is striking that Silicon Valley Bank (SVB) suffered from being at the nexus of the three biggest bubbles to burst in 2022:

1. Bonds – write-downs on SVB’s bond portfolio caused the deposit flight
2. Technology stocks – 2022 saw huge drawdown in share prices last year in the technology sector, and as the sector has come under increasing pressure, its liquidity requirements have increased, also putting greater pressure on SVB
3. Crypto – many of the stable coins held deposits with SVB

What is the risk of contagion in each of these areas?

Bonds: The key consideration is which institutions have correctly marked-to-market their bonds and which have further losses that they may need to take on bonds if they experience deposit outflows as a result of uncertainty about SVB? US regional banks, rather than mainstream banks, are likely to be the sector put under most pressure. We saw First Republic Bank drop on Monday after Signature Bank dropped over the weekend. Estimates are for a USD 600 billion mark-to-market loss on US bonds as a result of everything that happened in 2022. Has that been accounted for effectively? There are other areas globally where there have been large losses on bonds as a result of the events of 2022, such as Asian insurance companies, but crucially they are not experiencing the same level of short-term pressure.

Technology: The liquidity needs that SVB provided to the tech sector were very large and that is why we have seen action such as HSBC buying the UK entity of SVB. There are reports that Roku has USD 500 million in uninsured deposits at SVB. The challenge to make payroll in the short term for a lot of technology companies is real and it is still unclear how this will play out.

Crypto: Arguably, the sector has imploded already and therefore there should not be too much contagion risk from it. With that said, Signature Bank, which had to close over the weekend, was exposed to crypto.

These represent the three angles of potential contagion we have to monitor and which I expect to be played out in the regional bank sector in the US, rather than becoming a systemic issue. I expect this to be a largely idiosyncratic event, given that SVB was exposed to each of the above areas in a way that virtually no other bank is. But banking crises have a habit of beginning with one bank and extending to others. Some have drawn the parallel with Continental Illinois, which went down in the 1980s. That was a large US bank triggered by a much smaller bank. So we need to pay close attention.

Sensible short-term action taken by the US authorities

In terms of the measures introduced by the US authorities, I think they are sensible in the short term. They have guaranteed that depositors will get their money back from SVB, which is important to preclude deposit flight from other institutions. There is, however, a risk of precedent setting if the crisis becomes more widespread and legally they cannot guarantee all deposits. The Bank Term Funding Program (BTFP) that the Federal Reserve (Fed) introduced on Sunday to allow banks to lend or to borrow at a discount window from the Fed and to get par back on their collateral for terms of up to one year is also a good short-term move to stop banks having to take mark-to-market losses on bonds while also providing some assurance of liquidity.

Very large market moves

The market moves as a result of these events have been very large. As at Wednesday (8 March), the two-year bond yield in the US was 5.07% and on Monday (13 March), it was 4.31%, essentially a 70 basis point (bps) decline in two days. The 10-year has fallen by 40 bps. In Europe, the two-year bund yield has fallen by 50 bps and the 10-year by 40 bps. Further, last week, the S&P 500 was down 4.5%, KBW (which is the banks’ index) down 16%, Bank of America down 11%, JP Morgan down 7%, Citigroup down 7% and the US high yield index was 65 bps wider, representing very dramatic moves in a two-day period. This is serious event, with very important implications that need to be worked through.

Does this mean the Fed is done raising interest rates?

The two-year is suggesting that the Fed will not hike rates further, but I do not think I would go that far yet. The Fed is unlikely to want to stop raising interest rates given the relatively strong economic data. Clearly, however, if more institutions collapse, then the Fed is done raising rates. You cannot have a central bank raising interest rates when a number of financial institutions are failing. Goldman Sachs has said that the Fed will not raise interest rates in March, but I think it will be important to see the latest CPI data before drawing that conclusion. It is notable that only last week, there was a lot of speculation that the Fed may move by 50 bps at the March meeting.

On Friday, the latest payrolls data was stronger than expected, with 311,000 jobs added, although unemployment did rise and average hourly earnings were a bit weaker. So, on balance, that is a dovish number. A higher CPI number against this backdrop of uncertainty would be a very tricky path for markets to navigate.

The European Central Bank (ECB), which has been fairly hawkish, is due to meet on Thursday. In the past, the ECB has shown itself to be dogmatic in the face of changing news. This caused problems in mid-2008 when it raised rates as the banking situation was deteriorating in the US.

In summary, I do not think the collapse of SVB is systemic. At the beginning of the year, we talked about a generally stabilising picture where we may have further challenging, short-term, episodic events. I believe this is one of those, rather than an event which derails the market outlook for the year and means we have to reconsider everything. With that said, clearly the next few days are important.