The Fed Finally Broke Something

John P. Calamos, Sr.
Founder, Chairman and Global Chief Investment Officer of Calamos Investments

Michael Grant
Co-CIO, Head of Long/Short Strategies, and Senior Co-Portfolio Manager of Calamos Investments

Markets have lately become unsettled over the fallout from the Silicon Valley Bank (SVB) receivership announcement and the subsequent response of policymakers. Many view this failure as the first sign of systemic risk arising from the Fed’s monetary tightening. Of course this interpretation is correct. In the absence of “free money,” speculation is no longer the easy road to riches. This lesson has been relearned: first by investors in crypto and the favored concept names, and more recently by the shareholders of SVB.

Borrowing short term to invest in longer-term assets, colloquially described as “carry trades” is the inevitable consequence of the cheap financing of the post-2008 decade. And this was the entire point. Central bankers starting with Bernanke depressed short-term interest rates to encourage everyone to invest in longer-duration assets. We see the footprint of this in commercial real estate, private equity and venture capital, and levered loans to name a few areas. The less obvious casualties include banks like SVB and Signature Bank.

This commitment to holding longer-term assets financed by debt generates attractive returns while funding is plentiful, but these investments turn upside down when short-term money becomes expensive. SVB became unsettled when its long-term assets declined in value (rising interest rates lead to lower bond values) while the short-term cost of funding for those investments (customer deposits) rose. When depositors begin to flee a bank, either because they seek a higher return on their deposits elsewhere or simply fear for the recovery of their deposits, a bank run ensues.

Before this week many had been surprised by the lack of financial stress arising from this tightening cycle, given its speed and size. However, there are good reasons why the current blowup took so long to appear relative to past cycles and why we believe this is not a repeat of the 2008 experience of systemic economic failure.

First, central banks have absorbed a material portion of the losses that have historically occurred during a rate-hiking cycle. For perspective, the combined balance sheets of the Federal Reserve, the European Central Bank and the Bank of Japan total around $22 trillion. If the value of these balance sheets has declined by 10% on a mark-to-market basis, or similar to the declines at SVB, we can conclude that more than $2 trillion of losses have been ‘socialized’ by central banks. Prior to the era of unconventional monetary policy, those losses would have been distributed to the private sector—often in concentrated hands.

The last time the Fed tightened as aggressively as the past year was 1994—the worst year for fixed income on record prior to 2022. The fallout included the financial blowups of Mexico and Orange County as well as prop desks and hedge funds. In 1994, the Fed’s balance sheet was only a few percentage points of GDP and was comprised entirely of Treasuries. Today the Fed’s balance sheet is ~40% of GDP and includes the same sort of interest-rate exposures that upended the private sector in the 1990s. Over in Europe and Japan, central bank balance sheets are much larger relative to GDP, with even larger holdings of risky assets.

Of course, there are still widespread unrealized losses in the private sector with an estimated $600 billion in securities losses for FDIC-insured banks. But the world would appear far worse without the central bank balance sheet vestiges of QE. The new Bank Term Funding Program announced over the weekend and the easing of terms for discount window borrowing are a windfall to the banking system and a lifeline to smaller and medium-sized banks.*

Central banks have absorbed a nontrivial portion of the duration losses that would have normally been allocated to the private sector in a non-QE world. But there is a second consideration that highlights the very different circumstances today versus 2008.

For every investor or balance sheet that accumulated long-term bonds at overvalued prices through the years of excessively low interest rates, there is a counterparty with the equivalent liability. In other words, someone decided to take on (i.e., borrow) that liability at an excellent long-term price, and whose balance sheet is solid as a consequence. Who is that person you ask? Typically it is the US homeowner with a 30-year fixed-rate mortgage at 2%. Many large corporations that fixed their interest rates at wonderfully low levels also stand to benefit. Both are now laughing all the way to the proverbial bank.

Our intention is not to minimize the financial disruption that is unfolding in unexpected places like SVB. In the coming weeks and months, every prudent consumer will seek to minimize their exposure to uninsured deposits in the banking system. After all, it is easy to avoid an SVB debacle by clicking a button on one’s phone and transferring monies away from the vulnerable and mismanaged balance sheets. In this sense the uninsured deposit story is far from over.

But there is another important message: this week’s events are not a systemic risk to the economy. In sorting through the unnerving reactions of markets, it is premature to assume an economic calamity is around the corner. Financial storms like the one that engulfed UK pension schemes in October are frightening when they appear. But except for the dramatic exit of former Prime Minister Liz Truss, there has been little fallout for the broader UK economy.

Where do we go from here?

The investment community is fearful, perhaps recalling the trauma of 2008 and its banking crises. Some political fallout seems inevitable and the case for owning bank stocks is problematic. However, the US consumer is underpinned by some very considerable momentum. His or her income prospects and balance sheets are in the best shape of a generation. This should not be ignored for it implies these financial shocks can be weathered.

Next week’s FOMC meeting could be a decisive moment. The Federal Reserve has done a boatload of tightening—one of the most aggressive moves on record. After the events of the past week, Chairman Powell has the ideal cover to not raise the Fed funds rate. Imagine the political ramifications if the Fed raises rates further and the bank runs continue. Few will question the rationale of pausing to assess how policy actions will impact the economy given the proverbial lag effects.

We will have better answers after next week’s FOMC decision. For now, the outlook for equities is largely unaltered. Equity returns will be muted, characterized by a new set of winners and losers as the era of “free money” is not returning anytime soon. Yes, the earning cycle is mature, but economic resilience will be the surprise. This implies no imminent recession and no collapse of US profitability. The world is simply not ending in 2023.