submitted by
Uric Dufrene, Ph.D., Interim Executive Vice Chancellor for Academic Affairs, Sanders Chair in Business, Indiana University Southeast
Since the Covid pandemic, it seems that there is never a dull moment when it comes to economics and the financial markets. We’ve taken quite a few roller coaster rides along the way, and over the past couple of weeks, a new ride was added to the park.
The latest to hit financial markets is the emerging banking crisis, as it has been defined by some. I’m far from a banking expert but will try to summarize the gist of the problem. Over the past year, the Fed has increased interest rates at the fastest pace since the 1980s. We saw four consecutive increases of 75 basis points, and the most recent meeting saw another increase of 25 basis points.
One effect of these interest rate increases is the impact on the value of existing bonds. For example, the traditional 60/40 portfolio had a bad year, and this was due to a combination of sinking equity prices, and declining bond values. Traditionally, when stocks are declining, we might expect to see gains in bonds, due to declining interest rates in anticipation of a slowing economy. But in the past year, we saw an escalation of interest rates, and this was done to stamp out inflation, which was running at a 4-decade high. So, in addition to declining stocks, we also saw declining bonds (due to increasing interest rates).
What is the connection to the bank turmoil we’ve been hearing about? Let’s take Silicon Valley Bank and use it as an example. Silicon Valley Bank (SVB) was very focused on the technology industry, which makes sense with a name like Silicon Valley Bank. Remember what was happening to the stocks of some of these technology companies during the pandemic? We were seeing sky-high stock prices, and these companies were generating lots of cash. When you have a lot of cash, you deposit it at the bank. Banks take deposits and lend to businesses and consumers in the form of loans (assets to the bank). The bank could only lend out money so fast and could not keep up with the amount of cash being deposited in the bank.
So, with all this cash, the bank purchased assets in the form of bonds, Treasury bonds and mortgage bonds backed by government agencies. When investors seek a safe investment, they typically look to government bonds, and this is what Silicon Valley Bank did. These investments were safe from a credit risk perspective because of the backing of the U.S. government. Credit risk is one type of risk when you buy a bond, but another type of risk is interest rate risk. Interest rate risk occurs when a bond value declines due to increasing interest rates.
All these bonds that were purchased by Silicon Valley Bank declined in value due to higher interest rates. These losses then necessitated the company to announce that it would issue more equity, to basically cushion the losses from the bank’s bond portfolio. Theory and evidence show that when a company announces an equity offering, stock prices usually decline, and that is what happened to SVB. The stock price plummeted, and the social media world erupted around the safety of the bank. The bank also had a very high level of uninsured deposits. Depositors began to panic, and a “new-fashioned” bank run ensued. I use the term “new-fashioned” because it was a bank run, not like the one you see in It’s a Wonderful Life, but one that came through mobile phones and laptops.
These developments, along with higher interest rates, will curtail investment. We are already seeing a big slowdown in capital expenditures, compared to the past couple of years. A constrained investment environment will work to also produce an overall slowdown in the economy, which is what we have been expecting for this year. Financial markets are now predicting the Fed will begin to lower rates later this year as a result of the anticipated slowing of the economy. We’ll likely continue to see decelerating inflation, even though the past couple of reports came in a little stronger than expected on some measures. As we mentioned in our outlook last November, we can still expect a shallow recession, even with the latest ride.