By Matt Tourville, Investment Adviser

Buckle Up!  It’s a Bumpy Ride…

Since the calendar turned to 2023, the market’s gaze has been fixated on largely one thing: inflation and the Federal Reserve’s actions to conquer it. When Fed Chair Jerome Powell appeared before the Senate Banking Committee on Tuesday, March 7th, he was clear about the direction of Fed policy. “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”  He added, “the process of getting inflation back down to 2% has a long way to go and is likely to be bumpy.”  His words were prescient. The ride became very bumpy within days of his comments to Congress.

Over the course of a week, news about Silicon Valley Bank (SVB) based in Santa Clara, CA, quickly evolved from ugly to catastrophic. Early during the week of March 6th, SVB was considering a share offering to raise capital, recognizing it needed cash to shore up its balance sheet. By the end of the week, regulators issued an order to cease operations followed quickly by the Federal Deposit Insurance Corporation (FDIC) seizing the bank’s assets, which resulted in the second largest bank failure in our nation’s history. Over the weekend, the FDIC established a receivership entity and began marketing SVB’s assets to potential buyers.

As is typically the case during shocks to the financial system, a “flight to quality” ensued, with traders snapping up U.S. Treasuries at a frenzied pace from Thursday, March 9th through Monday, March 13th. In fact, the decline in the yield of the benchmark 2-year U.S. Treasury note from Friday to Monday – over 55 basis points – was the largest one-day drop since 1987. Remarkably, the 2-year yield fell nearly 100 basis points over the course of a week, from roughly 5.00% to just over 4.00% on Monday. Expectedly, the 2-year rate snapped back on Tuesday to just under 4.30% based on reassurances by various government agencies that the damage to the banking system would be contained. The entire maturity spectrum of the interest rate curve followed suit, but not quite to the same degree. The 10-year yield declined to around 3.60%, down from a recent high of 4.08% at the beginning of this month, and the 30-year fell to 3.70% from its recent early-March high of around 4.00%.

Wait, where were we? Oh yes, inflation and future Federal Reserve actions…The Federal Reserve’s monetary policy-setting body, the Federal Open Market Committee (FOMC) meets next week and will announce its policy actions on Wednesday, March 22nd. Early last week, the market placed a roughly 70% probability of a 50-basis point increase to the fed funds rate and 30% for a 25-basis point spike. These expectations aligned with Chair Powell’s remarks to Congress mentioned above. Fast forward one week, and expectations have shifted materially. The probability of a 50-basis point increase is 0% (yes, zero) and a 25-basis point increase at 83%. This comes on the heels of the February Consumer Price Index (CPI) report being released, showing an as-expected 6.0% year-over-year increase, far greater than the Fed’s stated objective of 2.0%. Striking a balance between battling inflation and reducing risk to the financial system will now be difficult, to say the least. In fact, where markets were once pricing in a predicted peak fed funds rate of roughly 5.70% by September, now the expectation has shifted downward to an apex of just 4.75% in May. Additionally, expectations now show the potential for a series of cuts that may result in a 3.90% fed funds rate by September. This is a dramatic change in sentiment over an incredibly short period of time!

Issuers and investors should anticipate further rate volatility, as the markets digest the fallout from the SVB collapse and any potential shifts in Federal Reserve policy that may ensue. There were already plenty of unknowns and this latest wrinkle drastically complicates things. Our Investments Team can certainly speak to this dynamic. On Monday, we were reviewing potential opportunities for clients to capture increased prices on various securities in their portfolios, seeking to swap into higher-yielding alternatives of similar maturity. By Tuesday, that opportunity had greatly diminished, if not almost vanished. Catching lower rates is great for issuers, but volatility in the capital markets means pricing generally suffers as dealers and investors take a breath until better price discovery presents itself.

When Powell spoke of a “bumpy” ride just one week ago, the debate in markets focused on whether the Fed would be able to steer the economy towards a much desired “soft landing.”  The hope was that inflation could be tamed without significant economic pain. In just a few short days, market observers had to change their entire framework. The debate today seems less focused on whether the Fed will be able to land the plane with minimal shifting of our carry-on baggage. Today, we are collectively worried about the plane holding together while we are buffeted by stomach-churning turbulence. Just know all of us at Ehlers stand ready to help should you have trouble fastening your seatbelt!

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