There were two events that mattered this week. First was the regular Fed meeting on interest rates, where the Fed ended up raising rates by the expected 25 bps. Even as it did, though, Chair Powell led the press conference with unexpectedly dovish commentary. He explicitly said that the Fed was aware of the stress in the financial system, that it would have negative effects on the economy, and that it would affect future Fed decisions. All told, this was about as dovish a rate increase as you can get. On the whole, that seemed to leave markets feeling if not good, then at least not bad.
Although markets were okay with the Fed, it was the second thing—the ongoing turmoil in the banking system—that mattered even more. On Wednesday, for example, even as Chair Powell was saying (without promising) in his press conference that deposits were safe, Treasury Secretary Yellen was saying, not the opposite, but that the government was not planning to expand existing deposit insurance—and markets tanked. Her partial reversal the next day stabilized markets, which just underlined how worried they are about the financial system.
These two events mattered, but we covered them earlier. What I want to focus on today is something related but a bit different: how banks are dealing with their issues and why that matters going forward.
Good News on Banks?
Ultimately, the industry will have to sort itself out. How hard that is to do will determine, to a large extent, how much damage the rest of the economy takes. And here we have some good news, although it is admittedly pretty well-disguised as bad news.
The good news/bad news is simply this: banks are now going to the Fed for help. The bad news take on it, which is prevalent in the headlines, is that this move proves just how bad the situation is and that it is another reason to worry (more bad news). My own take is that we knew the situation was pretty bad, but now we know that banks have the resources to start solving the problem and are using them (that is good news). More to the point, we are seeing evidence that the program specifically created to help banks with asset valuation problems was the right answer to the problem.
We can see this in the demand for federal assistance by the industry. The initial source of support for banks was the Fed’s discount window, where banks can borrow. Demand spiked two weeks ago to around $150B, only to pull back sharply to around $110B the following week. That pullback was supported by a significant expansion of borrowing from the Fed’s Bank Term Funding Program (BTFP), the newly created program designed to support banks with impaired asset valuations, from just over $10B in its first week two weeks ago to about $55B in the second week.
The Right Solution and Real Progress
Obviously, that is a lot of money and signifies the extent of the problem in the banking system. But equally, it signals that the government got it right in putting that program in place. We had the problem before, but now we have verified we have a good part of the solution in place. Overall, in both cases, total funding needs were $160B–$170B. But the shift from the discount window (which is for general funding issues) to the BTFP indicates that banks are now using the BTFP as designed, which suggests there was and is a real need. This is the right solution to the problem. This is real progress, and it suggests that we will not be moving on to a full-blown financial crisis, which is what matters.
Not Out of the Woods
It does not, however, mean we are out of the woods on this. The size of the support suggests banks have a big hole in their finances. They now must fill that hole, which will mean fewer and more expensive loans across the economy. Those tighter financial conditions mean we are looking at a recession that will be sooner and deeper than looked likely even two weeks ago. More, we will almost certainly see more banks fail before this is done. Not all of them will be able to solve their problems, even with the extra time and support. Expect more bad headlines over the next couple of months.
The real takeaway from this week is that we now have some evidence that the problems have been diagnosed correctly and that the proper policies are in place to prevent something worse. That is good news. Lots of things that mattered happened this week, but that is what will matter the most going forward.
Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, at Commonwealth Financial Network®.
© Axial Financial Group. All Rights reserved. 5 Burlington Woods, Suite 102 Burlington, Massachusetts
Disclosures: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The Dow Jones Industrial Average is computed by summing the prices of the stocks of 30 large companies and then dividing that total by an adjusted value, one which has been adjusted over the years to account for the effects of stock splits on the prices of the 30 companies. Dividends are reinvested to reflect the actual performance of the underlying securities. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index. The Bloomberg US Aggregate Bond Index is an unmanaged market value-weighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities with maturities of at least one year. The U.S. Treasury Index is based on the auctions of U.S. Treasury bills, or on the U.S. Treasury’s daily yield curve. The Bloomberg US Mortgage Backed Securities (MBS) Index is an unmanaged market value-weighted index of 15- and 30-year fixed-rate securities backed by mortgage pools of the Government National Mortgage Association (GNMA), Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC), and balloon mortgages with fixed-rate coupons. The Bloomberg US Municipal Index includes investment-grade, tax-exempt, and fixed-rate bonds with long-term maturities (greater than 2 years) selected from issues larger than $50 million. Basis points (bps) is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1 percent, or 0.01 percent.