Fed May Pause Rate Hikes As Bank Stocks Keep Sliding, Despite New Rescue Fund

The Federal Reserve may not hike next week as the failure of SVB and two other banks shows the risk of moving too fast.

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May 14, 2023 • 3 min read

Wall Street is now convinced that the Federal Reserve may pause their rate-hiking campaign next week, as the failures of three banks have sparked concerns about the financial sector's stress. The Fed and other regulators made a series of moves over the weekend to boost confidence in mid-sized and small banks. However, the stock market on Monday was dominated by sellers who slashed bank stocks despite the Fed's and others' efforts.

The near-overnight collapse of Silicon Valley lender SVB Financial Group, caused in part by losses resulting from bond market investments, has at least made it clear that the Fed must change course to tighten policy with a deliberate pace. The Fed is no longer considering half-point rate increases, just one week after Fed Chair Jerome Powell said policymakers would be ready to accelerate the pace of rate hikes from February's quarter point pace at their next meeting.

A sharp drop in Treasury yields signals a sudden doubt about the strength and stability of the economy. Markets are betting on rate cuts even if the Fed does not pause next Monday.

On Monday, the odds of a no-hike at next week’s Fed meeting jumped from 0% to 50%, before settling down to 21% by mid-afternoon. The odds of a half point hike have now dropped to zero, after rising above 80% following Powell's Senate testimonies last Tuesday.

Powell appeared to be ready to accelerate the rate hikes, as the Fed is still uncomfortable with the inflation and jobs data. The sudden fragility of the financial sector is a roadblock to the Fed's ability more forcefully control inflation.

Goldman Sachs economists, however, said that they expected the Fed to remain steadfast. Goldman Sachs still predicts three quarter-point increases in May, July and June.

Markets are also indicating that expectations about Fed policy will change dramatically in the second half of this year. Wall Street now expects that the Fed's main rate will end the year at between 4% to 4.25%. This is down from 5.5% to 5.25% one week ago.

The yield on the 1-year Treasury fell 50 basis points, to 4.37%. This is a continuation of its decline from 5.2%, last Tuesday. The 10-year Treasury rate fell 17 basis points to 3.53 percent.

The failure of SVB as well as Signature Banks and Silvergate Banks has revealed several ways in which the Fed's most aggressive tightening policy in the last four decades puts pressure on the banking industry.

SVB's troubles arose from its heavy exposure to startups. Their deposits surged in the year 2021, amid healthy venture capital funding, but they have been spending their cash rapidly since then. SVB invested a large portion of these deposits in government-backed mortgage-backed securities prior to the rate spike. The value of these low-risk bonds plummeted as market yields soared.

SVB's financial statements were able to be treated as if certain bonds had not lost value. This is because the regulators assume that a bank will hold these bonds to maturity. SVB, however, did not have this luxury. SVB had to sell part of its bond portfolio at a loss in order to raise money due a sudden outflow of depositors.

The banking sector has also been affected by short-term Treasuries, which have offered risk-free returns of 5% or more on cash up until the last couple of days. This led to a withdrawal of deposits. The banks are increasing their lending rates but the higher rates make borrowing difficult, especially as the Fed attempts to slow down the economy.

Depositors may want to consider moving their money now that the health of small and midsize banks is under scrutiny.

Fed, FDIC, and Treasury Department acted to bolster confidence by announcing SVB and Signature Bank deposits that are not covered by FDIC coverage above $250,000 would be made whole. Analysts said this sets a precedent that the government will guarantee deposits that are not covered by FDIC.

The Fed announced a bank term funding program for one year to help small and midsize lenders solve a major problem that plagued SVB.

SVB could have tapped a Fed loan if the new Fed program was in place by using its falling bonds as collateral. This would have avoided the need to sell the bonds at a loss.

The confidence in small banks, and even those not so small, still seemed shaken. First Republic Bank (FRC), a small bank, fell 52%. Charles Schwab (SCHW), which fell 9% but recovered from even greater losses, also battled to recover. Even the biggest banks were affected, with Wells Fargo down 5% (WFC), Bank of America (BAC), 3.75% (and Citigroup up more than 5%).

Most of the time, selling is more likely to be a reflection of concerns about profitability than solvency. Federal officials have said that the depositors of SVB Signature Bank will be reimbursed by banks covered with higher deposit insurance fees. It's also feared that banks may have to improve deposit terms in order to reduce outflows.

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