My Bet on the Fed’s Massive Decision Due Tomorrow

Stocks Could Rally… or Crash Based on What Happens.

This week could very well be one of the most consequential weeks for the American economy.

The Federal Reserve meets today and tomorrow to determine the next step in interest rate policy—up, down, or stagnant.

The meeting, and the subsequent decision, comes amid quite a dark background.

Three banks collapsed earlier this month, as I am sure you’re aware, and two of them tumbled into Federal Deposit Insurance Corp. receivership.

The collapses were of such consequence that banking regulators stepped in to backstop all deposits at those two banks beyond the $250,000 FDIC insurance limit. The reason: Government fears that the crisis would spread to other banks if all deposits weren’t guaranteed.

That fear of contagion says more about the banking industry than the collapses themselves.

It says that a great portion of the U.S. financial system is not healthy. It says that fractional banking—in which banks only keep a fractional portion of customer deposits available while the rest is loaned out or invested—is flawed at its core.

And it says that even when banks own the safest of investment assets—U.S. Treasury paper—they are not immune from collapse… which is potentially the biggest bugbear the Fed now has to confront.

See, Silicon Valley Bank, the California bank that started the dominoes falling, was not making speculative loans. It wasn’t taking client deposits and putting them to work in risky assets.

It wasn’t doing anything remotely shady.

It was simply following basic federal banking guidelines by holding its reserves in U.S. Treasury bills, notes, bonds… assets that are supposedly 100% risk-free.

And still the bank failed.

Which should scare the hell out of the Federal Reserve (and us too).

Here’s the problem in a bullet-point nutshell:

1. Silicon Valley Bank, SVB as it’s known, brought in billions of dollars in deposits over the last few years because of COVID cash that flooded the economy, and because it appealed to tech companies like online marketplace Etsy that were selling beaucoup products to pent-up consumers who had nothing to do during the pandemic shutdown other than mass consumerism.
2. That cash didn’t just sit in a bank vault until it was needed—it flowed into mortgages, loans, and Treasury paper (standard practice at all banks).
3. SVB was buying Treasury debt in 2020 and 2021, when yields were in the 1% to 2% range for 10-year notes. Today, new 10-year notes are in the 3.75% to 4% range. That means the value of SVB’s portfolio of 100% safe U.S. bonds plunged in value because the Federal Reserve pushed up interest rates at the fastest nominal pace in history—from 0.25% to 4.75% in exactly one year, an unprecedented 1,800% increase.
4. If the bank were able to hold that debt until maturity, all would be fine. It would recoup all of its initial investment plus interest. However, SVB did not have that option because…
5. Over the past year, the Fed’s belligerent interest-rate hikes battered the equity markets and venture capital investing. That, in turn, was unkind to startups, another of SVB’s primary client base. Without easy access to cash, those clients were drawing down their savings at SVB—at the exact same moment Fed rate hikes were killing the value of the bank’s reserves built around Treasury bonds.
6. The bank had to sell off Treasury debt at a loss to meet operational cash requirements.
7. Clients got wind of this and were worried that the bank might fail. That kind of worry sets off a bank run as clients pull their money out of the bank for peace of mind.
8. This malevolent cycle spins out of control quickly: As more clients demand their deposits back, the bank has to sell off more Treasury reserves at a loss, which just creates more worry… which sees more clients pull their cash… and soon the house of cards collapses.

Now, apply that How to Destroy a Bank in Eight Easy Steps to the national banking landscape.

America’s biggest banks are fine—JPMorgan Chase, Citi, Wells Fargo, Bank of America. The government has implicitly stated that as “systemically important banks,” those institutions have their full deposit base backed by Uncle Sam in a banking crisis.

America’s biggest regional banks are probably OK, too. Here, I mean PNC Financial, Capital One, M&T Bank, Regions Financial. Then again, Charles Schwab, the big brokerage firm, is also America’s #8 bank, and Schwab’s shares over just three trading days lost 38% of their value as fears about the bank’s future emerged. (That’s not saying Schwab is in trouble, just that even big banks are not immune to this moment).

However, the problem primarily lies with smaller banks and community banks.

They are not systemically important. And they manage their reserves just as SVB did—by investing in U.S. Treasury debt.

Question is: How many of those banks might be struggling with the same set of problems that killed SVB?

The New York Times noted last week that smaller banks all over the country “found themselves battling market turmoil as customers rushed to withdraw their deposits.” That’s hugely problematic because it means other bank runs—thus, potentially, other bank failures—will likely materialize.

And headlines over the weekend noted that nearly 200 U.S. banks are vulnerable to an SVB-like collapse.

This could lead to a full-blown crisis of confidence across the U.S. banking industry.

And, here at the bottom, that is exactly the point of this dispatch.

The Fed has to approach this week’s rate announcement with extreme caution.

Higher interest rates—even if just 0.25% higher—would inflict yet more pain on banks as the value of their otherwise 100% safe reserve assets decrease even more.

Wall Street and the bond market are clearly signaling that the Fed’s rate-hiking days should be kaput.

However, the Fed is headstrong and doesn’t necessarily listen to Wall Street or the bond market. It goes rogue at times.

If it goes rogue this time and announces tomorrow that it’s hiking interest rates… stocks and bonds will crater, bank stocks will be gunned down in a 1930s-style gangland drive-by, and the economy will likely slip-slide toward a deeper recession.

We will also see a mad rush by consumers to move their deposits to big, safe banks, thereby exacerbating the problem that smaller banks already face.

If, however, the Fed keeps its gun holstered and announces it’s pausing, stopping, maybe even cutting rates by 0.25% to help reduce some of the pain that banks are feeling… then stocks and bonds rally, and crypto rallies. Gold and energy probably rally too because it says the Fed has given up on the inflation fight in order to save the banking industry.

The Fed is a difficult beast to predict at the best of times. But my bet: The Fed will… pause. That is the only course of action that makes sense in the face of a potentially catastrophic banking crisis. (Unless, of course, the Fed has ulterior motives and is actively trying to bring the U.S. economy and consumer to its knees.)

Whatever tomorrow brings, it will very likely bring significant change to the trajectory of the economy and the markets. Whether that’s good or bad… we’re about to find out.