$SVB Financial Group(SIVB)$ went bankrupt, and the European and American banking sectors have been shaken, causing a significant shift in recent market narratives.
As shown in the following chart, the expected peak of the Fed's interest rate hike has risen from 5.5% to nearly 5.7%, then dropped to around 4.8% as of the close on March 15, meaning that there is at most one more interest rate hike left in this cycle.
The expected level of the US benchmark interest rate in January next year has also undergone the same ups and downs. As of the close on March 15, it has been priced by Fed rate futures traders to decrease by four times compared to the peak interest rate hike.
Therefore, although Fed officials have not yet made a clear statement, the crisis in the European and American banking sectors will obviously disrupt the Fed's plan to suppress inflation back to 2% through continuous interest rate hikes. This makes the market extremely eager to see how the Fed will choose between the dual missions of "resisting inflation, maintaining employment" and the hidden mission of "maintaining financial market stability" in the FOMC meeting this Wednesday.
I. Review of Asset Performance from February 22 to March 15
1.Global Major Asset Returns
Gold and US bonds performed well in all assets due to their safe-haven properties. Stock assets generally fell, but the differentiation was particularly evident in US stocks, with the small-cap Russell 2000 index, which has a high weight in small banks, suffering heavy losses, while the $NASDAQ 100(NDX)$, which is far from the banking storm, recorded positive returns due to the expectations of Fed's shift and therelease of GPT-4.
2. Performance of Major Investment Strategies
In the recent volatile macro environment, JPMorgan's global macro strategy fund has performed well, while other strategies focused on long positions in stocks have been impacted to varying degrees.
II.Market Interpretation
1. The Root Cause of Bank Crisis
The rapid bankruptcy of Silicon Valley Bank was ostensibly caused by floating losses of $17 billion in MBS and US Treasury investments,which was further exposed due to the issuance of stocks to cope with short-term liquidity pressures, leading to bank runs.
However, the root cause lies in the ability and experience of small and medium-sized US banks to cope with the risk of maturity mismatch. They are unable to respond to the shift from an extremely loose monetary policy in 2020 to an extremely tight one in 2022.
We will analyze this from the most basic balance sheet perspective.
During the period of loose monetary policy in the United States after the pandemic, the balance sheets of the Fed, the US Department ofTreasury, banks, money market funds, and US enterprises and residents all expanded significantly. US enterprises and residents in the real economy, as well as banks and money market funds in the financial system all needed to deal with unprecedentedly expanded assets.
As shown in the figure below:
made by Tiger_Insights
However, some individuals and institutions with little knowledge of finance do not know how to efficiently use their funds when they have a lot ofcapital. They are not prepared for the inverse impact that the rapid interest rate hikes and balance sheet reductions of the Fed will have on their investments, as shown in the figure above.
The commercial model of banks has always been to hold long-term assets to earn high interest rates, with their funding costs being the relatively short-term, low-interest deposits held on the liability side from customers, in order to earn an interest rate spread. Therefore, mismatched maturities are both a source of bank revenue and a risk they must bear.
The table below shows the situation faced by small and medium-sized banks in the US, represented by Silicon Valley Bank.
After the Fed raised interest rates sharply last year, these banks had low interest rates on the asset side, resulting in insufficient returns on their long-term investments and credit assets. On the liability side, they faced pressure to raise deposit rates in line with the Fed's benchmark rate.
After all, if depositors are savvy enough, they can invest in money market funds that has equivalent risk but higher interest rates. Therefore, they face not only a narrowing or even negative interest rate spread, but also the risk of asset contraction due to deposit outflows.
made by Tiger_Insights
On the other hand, even if these banks can cope with the liquidity pressure caused by deposit outflows in the short term, their interest rate spreads will continue to be squeezed in the short term due to the inversionof yield curve .
Since the end of October last year, the three-month US Treasury yield has been inverted with the yield of 10 years or more. As of March 15, 10-year US Treasury yield was still more than 1% lower than that of 3-month Treasury. The last time such a large inversion occurred was in the early 1980s.
Source: Bloomberg
Therefore, even though the Fed and large banks have temporarily solved the liquidity problems faced by small and medium-sized banks through a series of tools, in an environment where the Fed continues to raise interest rates and yields continue to be inverted, the short-term interest rate spread squeeze in the banking business will not be fundamentally solved. More banks mayface bank runs likeSilicon Valley Bank and First Republic Bank in the future.
The only solution is the Fed to begin a rate-cutting cycle.
2. How will the Federal Reserve choose?
On one hand, there is the explicit goal of controlling inflation to 2%, and on the other hand, there is the implicit goal of maintaining financial system stability. What will the Federal Reserve choose?
Regarding inflation, the year-on-year growth of the US CPI in February met market expectations, falling to 6%; however, the core CPI, which excludes food and energy, remained at 5.5%, and the sticky CPI calculated by the Atlanta Fed remained as high as 6.7%.
The speed of inflation's decline does not indicate that the Fed can control inflation to around 2% by the end of this year. This means that if the Fed is caught up in the current bankcrisisand turns to rate cuts, it would temporarily abandon its 2% average inflation target.
Source: Bloomberg
In fact, the BTFP project recently launched by the Fed has greatly offset the effect of its balance sheet reduction. This project allows banks facing liquidity pressures to obtain loans from the Fed by pledging their US Treasury and MBS that generatefloating losses. The loans value equal to the collateral value of these assets andhasan interest rate of OIS+10bps. This is actually a re-expansion of the balance sheet, reflected in the increase of assets on the primary credit and BTFP project assets on the Federal Reserve's asset side.
According to the latest Federal Reserve balance sheet as of March 15th, its total assets increased by nearly $300 billion in a week, close to half of the total balance sheet reduction scale of $625 billion since mid-April last year.
Source: Bloomberg
We believe that given the current situation where liquidity problems in small and medium-sized banks have been largely resolved and do not pose a systemic risk, the Fed is unlikely to immediately shift its policy at the March FOMC meeting. It is very likely thatFed will continue to raise interest rates by 25bps.
However, the dot plot and Summary of Economic Projections (SEP) that will be released after the March FOMC meeting, as well as the Fed's explanations, will determine the market trend going forward.
As a reference, ECB raised interest rates by 50 bps as expected on March 16th, even as Credit Suisse faced a crisis. However, they did not provide guidance on future benchmark interest rates. We believe that Powell will also try to play down the guidance effects of the dot plot and SEP as much as possible, and adopt a "wait and see" approach after raising rates by 25 bps. Only after more risks have fermented and inflation data has further declined will they make a decision on whether to temporarily abandon the 2% inflation target.
As a result, the expected rate cut by Fed rate futures traders may be revised at the March FOMC meeting, which could have a short-term negative impact on the US bond market.
3. How to invest under the current market background?
Given the enormous uncertainty surroundingthisweek's FOMC meeting, we do not recommend placing heavy bets this week. We suggest putting most of the funds in a money market fund to benefit from high interest rates with very low risk.
In our article last week, "Higher For Longer, Cash Is Your Treasure," we briefly introduced Fullerton Fund as a good alternative to bank deposits.
This week, we interviewed Darren and Jocelyn, the fund managers of the Fullerton Fund, regarding the Silicon Valley Bank incident. Their response is as follows:
1.We do not hold assets that are directly exposed to the risk of Silicon Valley Bank, and the indirect risk exposure from the incident is also very small. Fullerton will continue to mpnitor and track the rating of Singapore registered bank and promptly remove bank deposits with potential downgrade risks from the investment portfolio.
2.Our investors have not been affected by the Silicon Valley Bank incident. Our money market fund investors are diversified and mostly located in Singapore, and are less affected by the US financial system.
3.Our money market fund has an average duration of about 20 days, and therefore has very good liquidity.
In addition, we continue to be bullish on AI concept stocks with long-term investment value. The release of GPT-4 last week further demonstrates that AI will greatly improves productivity like computersin the near future.
As indispensable semiconductor stocks for AI computing demand, $NVIDIA Corp(NVDA)$ and $Advanced Micro Devices(AMD)$ have performed well in the past week despite the bank crisis. Therefore, we still recommendto invest in AI-related stocks in your investment portfolio.
Allocation recommendation: 70% money market fund + 20% Greater China equities + 10% AI concept stocks.
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