You should expect consequences when unwinding one of the greatest distortions in history.
Nearly a decade of quantitative easing and zero interest rate policy by the Federal Reserve distorted financial markets and the economy.
And Inside Wall Street editor Nomi Prins has warned about the risks that’s creating for investors along the way.
Now, as the Fed attempts to reverse course by shrinking its $8 trillion balance sheet and raising interest rates to the highest level in two decades, the outcome is the worst financial crisis in 15 years.
So far in 2023, several banks have gone under including Silicon Valley Bank (SVB) and First Republic.
The failed banks collectively held $548 billion in assets, making it the worst wave of bank failures since 2008’s financial crisis.
Here’s what Nomi had to say about it in the March 23 Inside Wall Street:
The Fed’s steady rate hikes caused the value of banks’ reserves – their balance sheets – to plummet.
In fact, banks are currently saddled with $600 billion in unrealized paper losses on their portfolios of government securities.
You don’t have to be a finance wiz to see why this is a problem.
It’s like banks are sitting on a financial time bomb. You never know when the next bank run will happen. But as we’ve seen, when they do, those “paper” losses become very real.
The crisis even went global, with Credit Suisse acquired by UBS to prevent further collapse in the global financial system.
But just as quickly as the bank crisis arrived, it seems to have vanished.
A relative sense of calm has returned to the markets, and news headlines quickly turned to things like artificial intelligence and the U.S. credit rating downgrade.
But you shouldn’t be lulled into complacency. The issues plaguing banks are lurking, and recent developments show that it’s worse than ever.
An Ongoing Crisis
The Fed is unwinding a distortion of its own making, which is hurting banks in two ways.
First, banks park some of their excess cash in U.S. Treasuries. When interest rates rise, bond prices fall which creates losses on those Treasuries. If a bank is forced to sell the bond before it matures, then it realizes that loss.
Second, banks in general have been slow to boost the interest rate they pay on deposits. That’s because paying a higher interest rate to depositors eats into bank profit margins since it’s a higher cost.
Depositors are finally catching on that higher rates for their savings can be found elsewhere, so they’re pulling funds from banks.
Here’s where things come full circle…
If enough deposits leave a bank, then the bank could be forced to unload Treasuries at a loss to meet demand for cash. This is ultimately what led to SVB’s demise.
Here’s how Nomi put it back in March:
With rates going up quickly, banks had to compete with government-issued Treasuries. They were late to the rate-hiking party, and they failed to raise interest rates on their deposits fast enough.
So when people chose to put their money in Treasuries instead of bank deposits, the banking sector was in trouble. It lost over a trillion dollars in the first three quarters of 2022 alone.
But that’s not the only problem banks are facing…
When rates went from zero at the start of 2022 to over 4% by the end of that year, bond prices fell fast on the open market.
This meant that any bank that bought these bonds before the rates went up saw a big paper loss.
And there are signs that the bank industry isn’t out of the woods yet.
Deposits fell again last quarter, dropping by another $98 billion and falling for the fifth consecutive quarter… bringing total deposit outflows over that period to nearly $1.3 trillion.
You can see that in the chart below…
And in order to help banks manage losses on their bond portfolios, the Fed set up a special program where banks could exchange their bond holdings for cash.
Bank borrowing from that program spiked in the weeks after its launch to $79 billion, and it’s kept growing since. Just last week, borrowing from the program hit a record level at $107.8 billion.
That means the problems plaguing the bank sector haven’t been resolved – they’re only getting worse.
As losses pile up and deposits leave, banks are forced to take extreme measures to maintain an adequate supply of capital.
And it’s a crisis that could eventually spill over into the broader economy.
Pullback in Lending Activity
In order to conserve precious capital as deposits flee, banks are restricting loan activity at the fastest rate since the economic lockdowns during the pandemic.
A quarterly survey done by the Fed shows that 50% of banks are tightening lending standards for firms of all sizes.
Access to loans is the lifeblood of the economy.
Everything from houses, cars, and factories is financed using borrowed money. That’s why when banks decide to restrict lending, it eventually catches up to the broader economy.
That doesn’t mean the economy will be in a recession tomorrow, as the impact from slower lending takes time to play out.
But if deposits keep leaving banks while the Fed holds interest rates high, it will continue reinforcing the negative feedback loop.
For now, the best thing you can do as an investor is to avoid small- and mid-sized regional bank stocks.
It might be tempting to buy beaten down bank shares. But until signs emerge that deposit outflows are over, you never know where the next bank panic could happen.
Regards,
Clint Brewer
Analyst, Inside Wall Street with Nomi Prins
P.S. As we said above, the banking crisis is a problem of the Fed’s creation. But it’s not the only threat to our financial system…
In these pages, editor Nomi Prins has been warning about a major overhaul happening to our money. And she recently recorded an emergency briefing, Countdown to Chaos, to explain what it is… and her playbook for profiting from it.
History shows that folks who position themselves right now – before this overhaul is a done deal – could make as much as 10 times… 20 times… even 50 times their money, even as most Americans are blindsided. Click here to learn more from Nomi.