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Yesterday, the Fed completed its regular meeting and announced that it would increase interest rates by 25 bps, or a quarter percentage point. This move was in line with expectations, and markets shrugged. Even at the press conference, when some awkward questions were asked (which Chair Powell ducked), markets bounced around but remained calm. But then something else happened. After Powell had gone to some trouble to assure people that their deposits were safe (without actually committing to anything), Treasury Secretary Janet Yellen was asked whether there were plans to dial up deposit insurance across the board. She said no, and then the market started to sell off.
No Longer About the Fed
So, what can we take away from what happened yesterday? My own take is that this is no longer really about the Fed. It raised rates but signaled there would be one more hike and no more. Markets were fine with that because they expect a recession and consequent rate cuts by the end of the year. Although Powell was quite clear that inflation remains the priority, his comments in the press conference started out with a recognition of the risks from the current bank turmoil. The Fed is no longer what markets are worried about and neither, really, is a recession. What markets are now worried about is a financial crisis.
This shift is interesting because what we are seeing is that while there are problems—First Republic comes to mind immediately—overall the system is still working as it should. The FDIC continues to work on resolving Silicon Valley Bank (SVB). Rescue operations from the private sector are underway at First Republic. FDIC examiners are all over other banks at risk. There may be more bank failures, but they will be normal ones, under FDIC observation and control. Unless, of course, something else happens. What could that be?
We have some hints. While the last crisis was all about bad assets and lack of transparency there, this crisis is about bad liabilities: deposits. SVB had a big asset problem. What pulled the plug was the technology-mediated sudden flight of deposits. Credit Suisse had the same problem, along with a bunch of others. The market’s reaction to Yellen’s comment yesterday supports that idea. If deposit insurance is the problem, it is because the lack thereof can cause deposit flight from many banks. QED.
A Solvable Problem?
As usual, the useful question is whether this is a solvable problem. And it is. If the deposit insurance program is revamped and expanded—and I more than suspect that is in the planning process as we speak—the risk of deposit flight, slow or fast, will lessen. Details (how much, who will pay, and so forth) will have to be worked out. But the mere announcement will take much of the risk away.
Even without that, we are already seeing the problem start to be resolved by the private sector. The big banks dropping deposits into First Republic could be a template for the future. Smaller banks could push up their interest rates on deposits to help offset any risk. This will change their business model and make them less profitable, but it will solve the problem for some. There are lots of ways the problem can be attacked because, again, it is solvable. But, of course, it will take time, and there will be damage. The turmoil we are seeing in stock prices is a reflection of just this resolution. Expect some more bank failures and more headlines.
What the Markets Are Telling Us
The real thing to keep in mind, though, is that with all the turmoil and headlines, the system is working as it should to contain the damage. Since the foundation is solid, as banks on the whole are well capitalized and as the government has the tools and will to solve problems, the bottom line is that we will get through this. If you look through the daily volatility, that is what markets are telling us as well.
Keep calm and carry on.
