Wall Street slid on the concern of bank crisis contagion

Wall Street slid Friday on the concern of U.S. regional bank crisis contagion. As per some WSJ reports, economists found 186 small and dozens of mid-size regional banks may face risks similar to SVB. Also, the quarterly quad witching/OPEX event has affected the risk-on sentiment, while hopes for Fed pause next week also buoyed Gold; USD slumped.

Wall Street Futures were already under the stress of the growing banking crisis amid synchronized tightening on both sides of the Atlantic (U.S.-Europe). As a recapitulation, On Wednesday, after the Credit Suisse (CS) fiasco and subsequent ‘dooms day’ scenario across global markets, reminding the 2008 GFC (Lehman moment), the U.S. and also some other G7 countries/central banks reportedly reached (pressurized) Swiss authority/SNB to bail out CS (as U.S./Fed bailed out SVB/other small/regional banks) and stabilize the financial market.

Subsequently, the Swiss government/SNB blinks and assured to bail out CS. The SNB and the Swiss regulator FINMA said Credit Suisse (CS) meets the capital and liquidity requirements imposed on systemically important banks (too big to fall) and that the SNB will provide the bank with liquidity if necessary. Subsequently, Wall Street Futures recovered and GOLD, USD, and US bond yields stumbled.

Meanwhile, late Thursday, in the U.S., a consortium of 11 big banks announced that it will rescue FRB (First Republic Bank) by infusing $30B. The Treasury Department, the Federal Reserve, the FDIC, and the OCC confirmed the decision describing the move as a sign of the sector's resiliency in the country. Wells Fargo, Citigroup, JPMorgan Chase, and Bank of America will each contribute $5 billion. Meanwhile, Morgan Stanley and Goldman Sachs will do it for $2.5 billion. PNC, US Bancorp, Truist, State Street, and Bank of New York Mellon will deposit around $1 billion each. These banks said in a joint statement:

"America's financial system is among the best in the world, and America's banks – large, midsize, and community banks – do an extraordinary job serving the banking needs of their unique customers and communities. The banking system has strong credit, plenty of liquidity, strong capital, and strong profitability. Recent events did nothing to change this”.

The US Treasury Secretary Yellen, Fed's Powell, and FDIC said:

·         This demonstrates the resilience of the banking system

·         We stand ready to provide liquidity to eligible institutions

·         First Republic deposits show resilience

The model of big U.S. banks rescuing regional/small banks along with active support of the central bank/government is like India’s example of the Yes Bank bailout, which will be eventually followed in Europe too directly/indirectly. The Swiss government/SNB may also request/force UBS to merge/buy out Credit Suisse, resulting in further consolidation of the banking sector in Europe/EU.

As a result, Wall Street jumped late Thursday. On early Friday European session, Wall Street Futures were also buoyed by (expected) Chinese/PBOC CRR cut of -0.25% as it may spur economic growth in the 2nd largest economy of the world. But Wall Street Futures led by Dow soon stumbled as the market may have viewed the Chinese RRR/CRR cut and injection of over $70B in liquidity (monetary stimulus) as some ‘bad development’ in the Chinese banking sector (shadow lenders like U.S. regional banks) and a step that China is preparing to ‘ring fence’ its fragile shadow banking sector.

On Friday, the PBOC cut the reserve requirement ratio (RRR) for financial institutions by -25 bps (effective from 27th March), the 1st cut since Nov’22 in an attempt to stimulate the economy, keep liquidity reasonably ample and better supply key areas, weak links (after Chinese economic growth suffered due to ZERO COVID policy in the last three years). The RRR for big banks now stands at 10.75%, a fresh low since mid-2007 while the weighted average ratio for financial institutions stands at around 7.6%. The move was in line with market expectations after PBOC governor Yi Gang recently said that "a reduction in the reserve requirement ratio would be an effective way to inject liquidity", but he also pointed out there was limited room for policy/repo rate cuts.

On Friday, Wall Street Futures were also affected by a quad witching event and $2.9T OPEX (option expiries). As the immediate concern of financial stability eases, both Fed and ECB may go for their planned rate hikes in a calibrated manner to ensure price stability. Although Fed is providing liquidity support to some regional banks directly and expanding its balance sheet (back door QE), this is a temporary emergency measure for the sake of Financial stability and thus may continue to hike rates for price stability. As per Fed’s latest data, its B/S expanded by almost $300B in one week (to bail out regional banks), which is equivalent to 4-months of QT or almost 50% of the total QT done so far; i.e. Fed will ensure Financial Stability at any cost, but also have to ensure Price stability by further calibrated hiking. The same is also true for ECB. This in turn is also affecting Wall Street.

Overall, Wall Street recovered from a multi-month low on the easing of the global banking crisis as Central Banks will not allow any big or small banks to fall/fail for the sake of financial stability and too big to fall strategy; i.e. the Lehman moment of 2008 GFC may not occur this time. But despite the $30B bail out of FRC (First Republic Bank) by big US banks, the market is now concerned about the viability of the rescue model if contagion spreads to many other regional banks.

FRC stumbled late Thursday after market close, as the California bank discloses its borrowing from the Fed ranged from $20B to $109B in the last week. The U.S. regulator (FDIC) is now trying to sell other vulnerable regional banks such as Signature Bank, Silvergate, and also SVB, which filed bankruptcy protection on Friday. Meanwhile, despite the CS bailout by SNB, several major global banks are now not accepting any fresh CS dealings and also cutting unsecured exposures.

On Friday, Gold jumped, but USD slumped despite lower than expected 1Y inflation expectations data (UM), as WSJ’s Fed journalist (trusted Fed insider) Timiraos indicated either a +25 bps rate hike or a pause by Fed on 22nd March. Timiraos said in an interview:

·         The Fed's decision likely be dependent on market response in the coming day

·         25 bps hike because skipping the hike risks a market melt-up

·         The Fed's decision is likely to be dependent on market response in the coming days

After Timiraos hinted at a smaller rate hike or pause by Fed, Wall Street Futures were somehow stabilized from falling continuously.

On Wednesday, a group of Democrat lawmakers led by Sen. Warren and Rep. Porter proposed a bill to restore bank regulations that were undone by former President Trump. The proposed bill seeks to repeal a law passed on a bipartisan basis in 2018 that eased Dodd-Frank regulations on midsized banks by increasing the ‘too big to fail’ threshold to $250B in assets from $50B. The Warren-Porter bill would roll back the threshold about enhanced capital requirements.

Meanwhile, Fed is evaluating tougher rules for midsized banks after the failures of Silicon Valley Bank (SIVB) and Signature Bank (SBNY). It is looking at tougher capital and liquidity requirements and could beef up annual ‘stress tests’ that assess banks' ability to weather a potential recession. Meanwhile, U.S. regulators are investigating the failure of SVB, including potential misconduct by officers over insider stock sales. No one at the bank has been accused of wrongdoing and no one may be charged. In addition, DOJ investigators had been investigating Signature Bank's work with cryptocurrency-related clients before the bank was shuttered.

On Thursday, during Congressional testimony, U.S. Treasury Secretary Yellen made it clear that not all uninsured deposits will be protected in any future bank failures unlike SVB and Signature bank, which were classified as ‘systematically important bank’’ i.e. too big to fall. A majority of SVB’s customers were small tech companies, venture capital firms, and entrepreneurs (startups) who used the bank for day-to-day cash management to run their businesses. Those customers had $175B on deposit with tens of millions in individual accounts. That left SVB with one of the highest shares of uninsured deposits in the U.S. when it collapsed, with 94% of its deposits landing above the FDIC’s $250K insurance limit.

The U.S. Congress is currently weighing several legislative proposals intended to prevent the next SVB-type failure. One of these is an increase in the $250K FDIC insurance limit. Following the 2008 GFC, U.S. Congress raised the FDIC limit from $100K to $250K and approved a plan under which big banks contribute more to the insurance fund than smaller lenders.

Conclusion:

After SVB/regional banks' fiasco, the market is now expecting a +25 bps rate hike on 22nd March and a pause. Further, some market participants are now also expecting Fed may prefer financial stability over price stability and may not even go for any hike on 22nd March. A few market participants are also expecting rate cuts to the tune of -75 bps by Dec’23 for the sake of financial (Wall Street) stability. Thus Gold jumped, while USD slumped.

As a debt manager of the U.S. government, Fed along with Treasury has to ensure lower borrowing costs, whatever may be the narrative, and thus US10Y bond yield of around 4.25-4.50% is a red line for Fed. U.S. is now paying almost 10% of tax revenue as interest on public debt and CBO projected around 13% and 15% for 2023-24 even after assuming an average 10Y US bond yield of around 3.80-3.90%. This is a red flag for U.S. fiscal math. China and the EU’s debt interest/tax revenue is currently around 5.5%, while Japan’s is 15%.

As a debt manager of the government, every central bank including Fed has to ensure lower borrowing costs for deficit spending, whatever may be the narrative. Thus Fed will take a balanced approach to control inflation, employment, and bond yields. Fed may not allow a US10Y bond yield above 4.25-4.50% under any circumstances (recent high around +4.08%) whatever may be the narrative.

Fed also has to ensure a softish landing, if not soft (mild employment/economic recession and 2% price stability); i.e. financial and price stability at any cost, If Fed does not hike on 22nd March for SVB/small banks crisis, it may affect its credibility and show Fed is panicking.

Bottom line:

Fed may go for calibrated +25 bps rate hikes each on 22nd March, 3rd May, and 14th June for a terminal rate of +5.50% and then pause. Fed has to ensure price stability, financial stability, and also its credibility. As the immediate concern of financial stability eases, both Fed and ECB may go for their planned rate hikes in a calibrated manner to ensure price stability as well as credibility. Both Fed and ECB will ensure financial stability with liquidity tools and price stability with interest tools as unlike during 2008-10, core inflation is still substantially higher than the +2% targets.