Broker Check

Rates, Bonds and Banks

April 05, 2023

PIM Email Communications

From time to time, PIM desires to communicate with all our clients via email, at the same time.  Years ago, this was easily accomplished using a list culled from our client relationship management system.  Then, Microsoft instituted strict rules limiting the number of emails that could be sent from a single source.  Their rationale was that the new rules would limit spam email.

We then switched to mass email distribution using our website provider.  This worked, until it didn’t.  Last month, the email announcing the availability of our monthly written communication was delayed by several days because the website provider had a technology glitch.  We immediately went in search of a solution, which we have found.

We will now be using the technology of a new company, specifically dedicated to email distribution and management.  The primary difference that PIM clients will see is that emails will come from each PIM advisor to his/ her clients, as the email announcing the availability of this document has.  We only bring this to your attention because as the format of emails changes, it would be understandable for PIM clients to pause and wonder if what you have received is legitimate.  As always, if anything about a message you receive from PIM doesn’t look right, please call our office and speak with Jennifer LaDuca, or call your financial advisor directly. 

Banking Sector Issues

Bank Operations Generally

Banks must be profitable, but society requires them to be safe and boring enterprises.  The middle ground is hard to find.  The core activity of a bank is converting short-term customer deposits into long-term investments.  Your available-on-demand bank deposit could be funding an investment in a 30-year mortgage, a ten-year Treasury bond or five-year business loan.  Banks want to invest your deposit into long term investments because they generate more income.  But the longer the investment horizon of a bank portfolio, the greater the risk that it will receive customer deposit withdrawal requests that it cannot satisfy.  If banks become too conservative then there is plenty of liquidity to satisfy withdrawal requests, which is good, but to maintain profit, lending will be restrictive and more expensive, which is bad.

Banking Sector: Recent History

The COVID lockdown and gradual reopening of the economy was an interesting time for banks.  They were flooded with deposits due to increased savings rates and government stimulus checks.  Banks had what seems like a good problem; lots of deposits to invest.  However, they had few sound investment options.  Companies were either in severe distress, and therefore not credit-worthy, or they did not need loans because they had PPP checks.  Individuals did not need loans because they were stuck at home, comfortable with high rates of savings and/ or had government stimulus checks.  Mortgages were certainly in-demand, but those are primarily funded by government agencies, not banks.  Banks were forced, by regulation, to invest customer deposits into safe securities such as US Treasuries and government-backed mortgages.

U.S. Treasuries are considered to have no credit risk.  However, they certainly have interest rate risk.  We have discussed this in prior communications.  The value of bonds goes down when prevailing interest rates go up.  The longer the maturity of the bond, the greater the decline in current value.  Ideally banks would have invested their excess deposits into short-term Treasuries.  Unfortunately, they yielded almost nothing in 2020 and 2021.  A two-year Treasury yielded about 0.3% from April of 2020 to September of 2021.  As a result, some banks bought long-term Treasuries to earn higher yields.

Recent Bank Failure

Interest rates have indeed moved much higher, so those old ten-year Treasury bonds issued in 2020 are now worth 15-20% less than when they were initially sold.  This is a problem for the bank when the customer wants his/her money back.  It was a fatal issue for Silicon Valley Bank.  They invested heavily in long-term government debt during the pandemic.

To be clear, the rest of the banking industry is not even remotely close to Silicon Valley Bank.  They were a very big outlier.  In aggregate, US banks have been reducing their exposure to Treasuries since the second quarter of 2022.  Large banks turned away deposits from big commercial clients in 2020/2021 to avoid this problem as much as possible.  Smaller banks, such as Silicon Valley Bank, were not as selective.

The Federal Reserve has aggressively responded to the issue by offering loans to banks.  The Fed is giving banks the cash they need to meet withdrawal requests using long-term Treasuries as collateral.  For the purposes of this loan, the Fed is using the maturity value of Treasuries, not their current depressed market value.  Using central bank magic, they’re turning 85 cents of securities into a dollar of loanable funds for banks.  As a result, you’re hard pressed to find signs of stress in the bank funding market today.

Charles Schwab & Co. / Schwab Bank

The market went in search of banks that may have similar, long-dated bonds in their portfolio.  Schwab Bank was identified, resulting in a few concerning headlines and a sudden fall in the price of Schwab stock.  It is true that Schwab bank has a large portfolio of longer-dated Treasury securities.  And it is true that in hindsight, they probably wish they didn’t; like some others, they did not anticipate the extent to which the Fed would raise rates, nor how quickly.  But this is where the similarities end.  Schwab’s balance sheet is very conservative.  They have about half the leverage and 60% more core capital than the industry average.  And their bank model is not traditional.  For a complete explanation of Schwab’s position on this issue, see the following link:

Economic Considerations

Flight to Money Market

The Fed’s aggressive rate-hiking program, designed to break the back of inflation, has driven down the price of all bonds; the longer the maturity, the greater the decline in value.  This obviously created problems for banks that used customer deposits to fund a portfolio of longer-dated Treasury securities.  But bond value depreciation is not the only implication of higher short-term rates.  For the first time in a very long time, short-term, relatively secure investments, such as money market funds, are paying a noteworthy rate of return.  Quite naturally, there has been a mass exodus of capital from savings accounts paying 0.5% into money market funds that are paying 4.5%.  As such, banks must maintain an abundance of cash on hand to meet withdrawal requests.  With less cash on hand to make loans, and the need to maintain profits ever-present, we can expect loans to be hard to obtain and more expensive.

The Importance of Small Banks

Since the 2008 financial crisis, small banks have grown, in asset terms, much faster than their larger counterparts due to a lighter regulatory burden.  Small banks hold $7 trillion in assets and provide 30% of all U.S. credit, up from 22% since around 2009.  The types of loans these banks offer is important.

Banks with less than $250 billion in assets, roughly the size of Silicon Valley Bank, account for nearly 50% of domestic commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending, according to Goldman Sachs.  Small banks punch above their weight if you’re a consumer wanting a loan, or if you’re a developer wanting to buy or build commercial real estate.

The current environment, higher interest rates on short-term safe investments such as money market funds, higher borrow costs and depreciated bank investment portfolios should make loans from banks harder to obtain and more expensive.  Reduced lending activity means reduced consumer spending and reduced business capital investments.  Combined, it would be logical to see slower economic growth overall.  The exact timing and impact of tighter credit on the economy is dependent upon the need for credit.  Consumers, in aggregate, remain healthy, probably delaying any immediate impact.  However, pandemic-era personal savings balances are diminishing.  With the availability and cost of credit moving in the wrong direction, consumers will need to decide if they want to stretch their finances to maintain a growing level of consumption.  The alternative is to increase personal savings rates, which will, likewise, contribute to a slowing economy.  

Is there a silver lining?  Maybe.  The initial cause of all this turmoil is inflation.  Tighter credit conditions and increasing consumer savings should contribute to lowering inflation.

Capital Markets

The S&P 500 has been almost sanguine throughout the recent banking sector drama and was up 3.67% for the month of March (up +7.48% for the year).  However, this relative calm belies turbulence under the surface.  The S&P 500 is a “cap-weighted” index, meaning that companies are represented in the index proportionate to their size relative to the index overall.  This means that what happens to Apple, Microsoft, Amazon, Tesla, Google and Nvidia (20% of the overall cap weighted index) has an outside impact on index performance.  Unlike 2022 investors seem to have decided that these companies will be largely impervious to any economic slowdown.  By contrast, if we look at all S&P 500 index companies on an equal-weight basis, meaning each firm has the same impact on performance, the story is decidedly different.  Configured this way, the index was up 2.89% in the first quarter, but down 0.86% in March.  (All figures presented on a total return basis.)

Against the backdrop of tighter financial conditions, one would expect some level of pain for unprofitable, leveraged, volatile equities.  These are the types of companies that led the market lower in 2022, and to which we have de minimis exposure.

The Goldman Sachs index of unprofitable tech firms tells the story.  The index declined by 62% during 2022.  However, these are the exact companies that are leading the broad market higher so far this year.  Although the index remains 73% below its peak in 2021, it is up 18.06% year-to-date.  Are investors playing with fire, or has a durable bottom formed that will spread to other areas?  For reference, here’s a chart of the index in question over a five-year period:


Another interesting approach is to view the overall quality ratings of U.S. large cap growth mutual funds.  As of March 20th, there were 96 large cap growth funds with performance in the top decile of the Morningstar rankings for this category.  Of these, 56 are 1-Star funds, 8 are 2-Star funds and 5 are not even rated.  Morningstar star ratings are certainly not the only criteria one should consider when selecting an investment, but the rating is a reasonable indicator, most of the time, of the general level of quality of a fund, based upon risk and return history, parent company, process, and people.  Sixty-nine of 96 funds, more than 70%, are rated so low that unless we knew something about the fund that piqued our interest, we would never even look at them.  We can’t recall a time when such a large percentage of high performing funds were so poorly rated.

What explains the outperformance of risky assets and relative underperformance of higher quality investments?  The quantitative modelling tools to which we subscribe suggest that the debt market expects (hopes, perhaps) easing financial conditions and lower interest rates later this year...that the Fed can get inflation under control without significant adverse effects on economic growth.  This was certainly the story in January, during which most of this outperformance occurred.  But the case for easier monetary policy without a slowdown may be at odds with the facts.

Supporting the idea of easing monetary policy within the foreseeable future, headline inflation dropped from 9.1 in June of 2022 to 6.0 in February of 2023.  Core inflation (which does not include food or energy), dropped from 6.6 in September of 2022 to 5.5 in February of 2023.  While there may be short-term reversals, the trends are positive. Unfortunately, even with the improvement in inflation data, it remains significantly above the Fed’s 2% target.

Data from March showed that a narrower measure, called “supercore inflation”, has been accelerating for the past three months.  This measure, which excludes food, energy, and housing, has become of great interest to the Fed.  Energy and food prices are heavily influenced by weather and politics, while housing data lags by six to nine months.  What remains in the gauge is considered a good measure of the current inflationary pressures in the economy.  If this narrow, but vital, definition of inflation is rising, the Fed is in a tough spot.  The market is clearly confused, unsure of what the future path of interest rates will be.

One way to measure this uncertainty is the “MOVE” index, a volatility gauge for the bond market.  This index hit 200 this month, the highest level since the 2008 financial crisis.  Traders don’t know what to make of the current scenario, so the result is extreme volatility in the bond market.

Will the Fed lower interest rates to ease overall financial conditions and specifically to relieve stress on the banking system?  Or will it be forced to hold rates higher for longer to fight inflation?  During his recent news conference, Fed Chairman Powell indicated a slight easing of policy and explained the current view that higher rates combined with more restrictive credit conditions may combine to eventually achieve the desired outcome.

PIM Portfolios

Entering March, PIM portfolios were performing in line with our internal blended benchmark portfolios.  By the end of the month, we were underperforming. 

PIM portfolios are exposed to quality stock-based investments, (companies with more defensive characteristics, stronger balance sheets, and cash balances).  These companies have underperformed recently.  On the fixed income side, we underperformed as well, due to low exposure to interest rate risk (also called “duration”).  Although we added duration overall in December and February, we did not anticipate the largest decline in the benchmark ten-year Treasury yield since COVID.  Ignoring the pandemic, the only other time in the past decade that the ten-year Treasury yield declined this dramatically was the surprising Brexit vote in June of 2016.  The fixed income holding in PIM portfolios that did produce meaningful returns in March was long-term Treasuries, a modest holding first purchased in December of 2022.  Long-dated Treasuries can exhibit volatility similar to stocks, which is why our exposure is relatively low.  Ironically, it is this type of investment that has caused so much stress in the banking sector. 

Looking forward, we remain skeptical of the equity market in general; the risks appear to be to the downside.  This is especially true for technology stocks, which now trade at similar valuations to the highs seen during the Pandemic.  For fixed income, adding to higher volatility, long-duration bonds would not be prudent with supercore inflation proving to be more stubborn than expected.

That leaves us with portfolios that are light on equities (and quality focused), high on cash, and light on interest rate risk.  In summary, PIM portfolios remain quite conservative.

Closing Comments

One of the more important data points in the preceding commentary is the introduction to our readership of the “MOVE” index.  Many PIM clients may be generally familiar with the “VIX”, which is a volatility measure for the stock market.  But we are guessing that few know of the MOVE.  For this index to recently have hit its highest level since the great financial crisis provides insight into just how extraordinarily difficult it is right now to project the status of the US economy with any confidence.  The bond market is completely confused. 

Indeed, the case that the US economy is headed for recession is stronger than the case for a soft-landing.  But that doesn’t mean recession will occur.  Nobody knows.

Studies show that the emotional impact of losing a dollar is far stronger than the emotional impact of making a dollar.  If this is true, then hopefully our reluctance to add risk to portfolios, even if that means underperforming modestly during short-term garbage rallies, is generally understood, and accepted. 

As we make our way through spring, we hope you are enjoying the longer days and more frequent blue skies.  If you have any questions or comments, please let us know.

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