There is a saying on Wall Street that the Federal Reserve will hike rates until something breaks. Well, we finally heard the sound of shattering glass last week. On Friday morning the FDIC shut down Silicon Valley Bank (SVB). The storied financial institution was founded in 1983 and had grown to be the 18th largest bank by total assets in the United States. They are the largest lender by market share to venture capital and private equity. Their downfall was swift. On Wednesday afternoon the bank had over $200 billion in assets. This is the second largest bank failure in the history of the country after Washington Mutual, which had just over $300 billion in assets when they failed in 2008. The collapse was caused by a combination of rising interest rates and an old-fashioned run on bank deposits. Last night a government consortium stepped in to backstop all deposits in the banking system.
Rising interest rates continue to put strains on the economic system. We are experiencing the worst bout of inflation and subsequent rate hikes since the 1980s. During the fourth quarter of 2021, the Federal Reserve thought they might need to raise rates from 0.25% to 1% over the course of 2022. It is clear in retrospect that their estimates were widely off the mark. The Fed Funds rate now stands at 4.75%. Until this week, markets anticipated a 0.5% hike at the March meeting, with a terminal rate around 5.5%. It is too early to know whether a large bank failure will alter the Fed’s current plan.
We have long viewed the normalization of interest rates as a two-step process. First, the Fed would need to get rates up to a restrictive level. Second, we would most likely see some economic fallout. While last year was a bad one for financial markets, we did not view it as sufficient to reverse the decade long period of zero interest rates. It always seemed unlikely to us that the economy could smoothly transition away from over a decade of zero interest rate policy. So where does this leave us?
Currently, GDP is still positive. The economy has remained surprisingly resilient, and it is possible that it remains so. At the same time, the Fed’s primary tool is blunt. It operates with a lag that has been anywhere from 3-18 months. We simply don’t know – and won’t for some time – what interest rate is appropriate for a measure of stability (modest unemployment / 2% inflation). The next Fed meeting is now a big question mark. While they will undoubtedly take current events into account, they are committed to avoiding the stop and go mistakes of the 1970s that led to inflation becoming unanchored.
We don’t believe anyone can make consistently accurate predictions about short-term movements in the stock market. Our energy continues to be spent on locating companies with strong balance sheets and staying power. We will be here, looking for attractive opportunities, and doing our best to avoid bad outcomes.