The Federal Reserve acted today to increase the Fed Funds rate to a target of 4.75% to 5.00%, and said that additional policy firming may be appropriate.

Many observers wanted the Fed to suspend raising rates, in light of the collapse two weeks ago of Silicon Valley Bank and Signature Bank and resulting banking turmoil. Chairman Powell and the committee decided that today’s action was consistent with its dual mandate of controlling inflation and maintaining maximum employment.

The Fed observed that these recent banking developments were likely to result in tighter credit conditions weighing on the economy, including business fixed investment and housing. The impact is unknown, and possibly deflationary over time and, therefore, the Fed may not need to move as high as Chairman Powell had predicted just weeks ago.

The Fed is still targeting an end of year Fed funds rate of 5.10%, implying one more 25 basis point hike and then a pause. In his news conference, Powell indicated at least twice that market expectations about cuts in the Fed funds rate before the end of 2023 are unlikely. He stated they would not be consistent with the Fed’s resolve to maintain rates at an elevated level until it has seen meaningful progress in its fight to get inflation back to a 2% target, measured by the Consumer Price Index (CPI) and core CPI. These indicators remain in the 5.50% to 6% range.

During his conference, Powell noted that distress in the market has been felt by only a small handful of banks and the FDIC has created ample liquidity to address this condition. The banking system overall is strong and resilient. But when queried, Powell did not give much comfort to depositors looking for more certainty above FDIC limits, or to bank shareholders. And, regional banks came off quickly and sharply after the conference ended.

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There has been a lot of inaccurate information circulating in the media about what precipitated the failures at Silicon Valley Bank and Signature Bank, and what happens now.

Let’s try and clear up at least six things that have been said in the media over the last several days that are incorrect.

1.

Common perception in the media: Management at both Silicon Valley Bank and Signature Bank were completely incompetent, and they certainly committed a crime. They were borrowing at the short end of the yield curve and lending at the long end.

Reality: Banks make their money by borrowing at the short end of he yield curve and lending at the long end. This is what they do. This is one of the reasons why an inverted yield curve is dangerous, especially one that becomes grossly inverted, as the US yield curve has become. Management at Silicon Valley Bank and Signature Bank may have been incompetent, or at least made devastating errors in judgment and left themselves vulerable to a bank run with so many uninsured deposits, but they did not commit some sort of prima facie violation of law or even necessarily exercise bad judgment by borrowing at the short end and lending at the long end of the yield curve.

2.

Common perception in the media: Management at both Silicon Valley Bank and Signature Bank failed to properly gauge the direction of interest rates and then they tried to cover up their mistakes.

Reality: Very few people in the financial world took all of their actions over the last years in expectation of yields over 5% in 2023. Rates had been low for a generation and it seemed like the new normal. Even this time last year, both Jay Powell and Janet Yellen were still insisting that inflation was transitory. Yes, these banks got the direction of interest rates wrong. And, yes, they tried not to disclose the full damage of their misjudgment of the direction of interest rates, hoping that time would sort things out (presumably as their Treasuries got closer to maturity, they would not trade at huge discounts). Management’s delay in marking its longer term assets to market seems again does not necessarily violate account rules, violate the law or indicate bad oversight. The nature of business in America is that management sometimes makes decisions that don’t work out well and hopes that financial markets provide the time for them to work out. The nature of a bank run is that it denies a bank’s management the time that it needs.

3.

Common perception in the Rupert Murdoch-owned media: These failures never would have happened if Silicon Valley Bank and Signature Bank hadn’t been focused on diversity.

Reality: These banks would have failed much more quickly with the group-think of twelve people with identical backgrounds exercising the same judgment.

4.

Common perception in the media: The depositors had no idea they were taking risks by depositing over FDIC limits and what FDIC limits were. It is good that they were bailed out by the government.

Reality: Every time you walk into a bank or log onto a bank, you’ll see the FDIC notice (and NCUA notice at credit unions). Ignoring this is basically like driving and not paying attention the traffic signals. Bad things are not guaranteed to happen, but they can. Banks can fail and they can fail quickly. It is unclear that it is positive for government to protect depositors from moral hazard and create a precedent that it may not be able to stand by, especially for large corporate and ultra high net worth depositors who have the resources to do due some level of due diligence. For the moment, and unless and until there is an act of Congress expanding coverage, depositors should continue to abide by FDIC and NCUA limits regardless of what some anonymous Treasury official is reported to have said about your money being safe above those levels.

5.

Common perception in the media: The Fed needs to stop raising interest rates and reverse course before they cause more damage.

Reality: The Federal Reserve needs to fight inflation. There is nothing in the inflation numbers that indicates that anything is under control right now. Pause maybe, but the Fed is going to need to continue to see out its current course of tightening or else inflation will become endemic to the US financial system. Just step outside your home. Prices did not come down over the last five days and nobody is planning on dropping their prices because Silicon Valley Bank and Signature Bank are gone.

6.

Common perception in the media: The fact that US Treasuries have fallen indicates that rates will be coming down.

Reality: US Treasury prices are the result of supply and demand and they have fallen because of a rush to quality. That doesn’t mean that they will stay low. Online savings rates are firming, even at banks that do not need capital, indicating that rates may still be going up. Depositors seeking to lock in rates right now are much better served by looking at online CDs. As of today, online CDs currently offer rates that are far superior to comparable-duration US Treasuries even to those who benefit from the state and local tax advantages of Treasuries.

The FDIC’s and Federal Reserve’s decision to cover fully deposits at both Silicon Valley Bank (SVB) Bank and Signature Bank leaves some uncertainty about whether banks’ deposits are fully insured above $250,000 per depositor per class of deposit. President Biden did not clarify the issue when he spoke this morning to allay depositors’ concerns, even though he explicitly promised that deposits are protected.

There is an issue of moral hazard here. FDIC insurance limits are well established. Should depositors who ignore these well-established limits, and keep deposits above those limits to curry favor with senior bank executives and get certain privileges – as was the case with SVB - get their own rules?

But, still more important than the moral hazard issue here at the moment, is what happens when and if there is another 5 or 10 or 100 bank failures. With SVB Bank and Signature Bank, the FDIC invoked the banks as “systemically important” in order to provide the unlimited depositor protection that it is providing.

Can depositors assume that every bank going forward is going to be systemically important and that they’ll be made whole? Is there a number of banks that is hit when the “systemically important” designation can no longer work or a size of a bank? And, then what is the rule for credit unions and the NCUA?

Since this can only be changed by an act of Congress, and until such act occurs, we continue to recommend that depositors stay within applicable FDIC and NCUA limits.

A great primer on FDIC insurance can be found here.

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