Strategic Income Outlook: And We Thought 2022 Was a Crazy Year
2023 has already been an eventful year, featuring a banking crisis and more Fed rate hikes. In our view, this is not a “set it and forget it” type of market – investors need to stay vigilant.
And We Thought 2022 Was a Crazy Year
Wow! What a start to the year this has been. We began with a full-blown risk-on rally, with lower quality and longer duration assets leading the charge. With no Federal Open Market Committee (FOMC) meeting scheduled in January, there was no rein on the exuberance. Pundits predicted a lower terminal fed funds rate and quick 2023 pivot to an easier monetary stance by the Fed, but we were skeptical. Sure enough, on February 1st, the FOMC spoiled the rally by raising the federal funds rate and announcing that “ongoing increases would be appropriate.” The soft-landing sentiment quickly hardened, leading to a risk selloff. Instead of arguing for a pivot and lower rates, as had been the case previously, investors reversed course and began calling for much higher rates – recency bias hard at work. To be fair, the sudden change of heart makes some sense, as the economic data have truly been a mixed bag so far this year. Weekly releases show either hot economic growth or slowing inflation, giving investors agita as they try to decipher which way the economy is going and what the Fed’s next move will be. Additionally, seasonal adjustments in January were much larger than usual, adding to the uncertainty. More on that later.
There have been no shortage of strategists, commentators, and armchair economists that have been saying that the FOMC was going to raise rates until they broke something. As is typically the case in tightening cycles, they finally did. For varied reasons, we saw the collapse of three banks (Silicon Valley Bank “SVB," Silvergate Bank, and Signature Bank), the forced takeover of a fourth (Credit Suisse), and two more that the market has soured on (First Republic and Deutsche Bank). Many wonder if this is 2008 all over again (hint: we don’t think so).
Perhaps a review of fractional banking would help explain why banks seem to falter with regularity. In fractional banking, banks take your deposit for safekeeping and hold only a fraction of it in readily accessible liquid reserves. They then lend out the rest in the form of mortgages, real estate, and personal/home equity loans. If there are not enough opportunities to make loans, they can lend to the government by buying Treasury securities. The difference in what the bank pays depositors and what they charge on their loans is the net interest margin, which is how the bank makes money. Think of those reserves as a cushion against losses on loans due to delinquencies, etc. If a bank keeps 10% of deposits, they have a 10% cushion.