Silicon Valley Bank’s Failure May Lead to Smaller Fed Rate Hike

Stocks fell again in the week just ended, led lower by financial issues, most notably regional banks. At the same time, the signs of distress in the financial sector sent yields on Treasuries—especially shorter maturities—tumbling, as expectations of near-term Fed hikes fell sharply.

Indeed, the failure of Silicon Valley Bank—with over $200 billion in assets, second only to the collapse of
Washington Mutual
with $300 billion during the financial crisis in 2008—superseded what had been the most highly anticipated events going into the week. Those were Fed Chairman Jerome Powell’s congressional testimony on the economy and monetary policy, and Friday’s release of February’s employment data.

Were it not for the financial turmoil—which started with the liquidation of the small Silvergate Bank, a unit of
Silvergate Capital
(SI) that focused on cryptocurrency-related lending—Powell’s hawkish rhetoric, along with relatively strong job numbers, would be pointing to a 50-basis-point (one-half of a percentage point) hike in the central bank’s federal-funds target at the next meeting of the Federal Open Market Committee, concluding on March 22.

But after putting a near-80% probability on such a move, fed-funds futures dialed that back by week’s end and placed about a 60% probability on a 25-basis-point rise from the current 4.50% to 4.75% target range, according to the CME FedWatch site. Moreover, the futures market was pricing in Fed rate cuts starting as early as November.

This ratcheting down of rate expectations was the counterpoint to the decimation of financial stocks. Almost every description of the Silicon Valley debacle termed it idiosyncratic, because of that institution’s concentration on the tech sector, in which many of its customers are burning cash.

But that notion was belied by the plunge in an array of financials, which dragged down the overall market. That was highlighted by the
SPDR S&P Regional Banking
exchange-traded fund (KRE), which fell 16% on the week, including 4.4% on Friday. Smaller stocks, many of them financials, also took it on the chin, with the
iShares Russell 2000
ETF (IWM) off 8% on the week and almost 3% on Friday.

Rightly or not, some individual bank stocks were pummeled for perceived similarities to SVB.
PacWest Bancorp
(PACW) plunged 37.9% on Friday and 55.3% on the week, while the hits were 20.9% and 34.8% at
Western Alliance Bancorp
(WAL). Elsewhere,
Charles Schwab
(SCHW) fell 11.7% on Friday and 24.2% on the week.

In the flight from financials, the yield on the two-year Treasury note—the maturity tied most closely to Fed rate expectations—plunged by 31 basis points (0.31%) on Friday, to 4.59%. That brought its decline since Wednesday to 48 basis points—a move comparable to the massive reactions to the October 1987 stock market crash, Lehman Brothers’ failure in September 2008, and the 9/11 terrorist attacks, Jim Bianco, the eponym of Bianco Research, tweeted on Friday. But he doubts that Silicon Valley Bank’s failure is comparable to those episodes.

Still, the reactions in the stock and debt markets show what can happen when the Fed is singularly focused on fighting inflation by tightening monetary policy, wrote Paul Ashworth, chief U.S. economist at Capital Economics, in a client note late on Friday.

SVB’s woes stemmed from being hit with $1.8 billion in losses as it liquidated about $21 billion in Treasury and mortgage-backed securities, which dove in value because of the Fed’s rate hikes over the past year. If other banks also have to sell off securities at losses or pay up to hold on to deposits, either action would, at minimum, be negative for their profits.

“Even if SVB doesn’t trigger a broader financial contagion, it could still lead to a further tightening of credit conditions that tips the economy,” Ashworth concluded. The Fed’s most recent Senior Loan Officer Opinion Survey, released in January, indicated that standards for lending to businesses and consumers already have become more stringent.

All of which reduced the relevance of February’s jobs data for the market. The headline rise in nonfarm payrolls of 311,000 once again was far ahead of economists’ consensus guess of 215,000, but the rise in average hourly earnings of 0.2% trailed forecasts. And the unemployment rate, derived from a separate survey of households, ticked up to 3.6% last month from 3.4%, but in a good way, because of a rise in labor-force participation.

The big number for the coming week will be Tuesday’s release of the consumer price index for February. An increase of 0.4%, both overall and in the core measure excluding food and energy, is projected. That presumably would keep the Fed on course for the anticipated 25-basis-point hike later this month. But the focus is likely to be more on the banking sector.

Write to Randall W. Forsyth at randall.forsyth@barrons.com