The Madness of March
March was one of the most eventful and volatile months in the fixed income market in some time. The sudden demise of Silicon Valley Bank along with two smaller U.S. banks and one European (Credit Suisse, which was rescued by UBS) had a profound impact on financial conditions (bond spreads, lending conditions) and bond yields. Yields on Treasuries fell across the entire yield curve — the two year by 79 basis points — even as the Fed raised rates for the ninth consecutive time to 4.75%-5%. All of this led to strong gains for the broad market: total return for the Bloomberg Barclays U.S. Intermediate Aggregate Index was 2.15%. The municipal sector also performed quite well: total return for the Bloomberg Barclays Municipal Index was 2.22%.
Any time a major financial institution fails with little warning (Silicon Valley Bank was the 2nd largest bank failure in U.S. history), the market implications will be significant. This is the first financial crisis-type event since the Great Financial Crisis and it comes after the substantial increase in interest rates last year. One implication will almost certainly be tighter lending standards for businesses and consumers alike, which is often a precursor to recessions due to the critical role played by credit in our debt-dependent economy. Another could be new regulations aimed at small-to-midsize banks, and still another could be the changes to the FDIC insured deposit framework. All of this bears close watching for potential impacts on companies and industries that may not yet be apparent.
Due to the complex nature of the financial system, its role in facilitating credit creation and economic activity, and the myriad regulatory bodies involved in oversight of the industry, one failure quickly leads to heightened concern — what are the consequences, who is next, what other dominoes will fall. This immediate reaction in the market is a vivid reminder that trust and confidence are essential to the proper functioning of a financial system. When confidence is lacking, the market quickly reverts to a “risk-off” posture which means bond yield spreads widen — causing bonds to underperform like-duration Treasuries — and a cautious tone develops until enough evidence of stabilization emerges.
There were some aspects of Silicon Valley Bank (as well as Signature Bank and Silvergate) that were somewhat unique: the bank was founded in the 1980s to cater to venture capital technology companies. The bank took in massive deposits in the last three years, the vast majority of which were greater than $250,000 and therefore uninsured, and invested too heavily in longer-dated government bonds with little or no interest rate hedging. When depositors began fleeing for better returns over the last several months, the bank could not meet the demand for cash without incurring significant losses. This was poor risk management and a classic liquidity problem as opposed to a credit quality problem.
However, there are also certain endemic aspects to the banking industry that are cause for increasing concern and scrutiny. For example, many bank portfolios hold bonds with unrealized losses on their books due to the rise in interest rates over the last year. In addition, the spread between yields on bank deposits and money market instruments has widened which has resulted in declining deposits across the system. Finally, most banks have commercial real estate loans on their books and the office segment has been struggling since the pandemic altered the demand for office space. Banks with more exposure to office-related commercial mortgages may be exposed to higher default risk in the coming months as the economy slows.
Tighter lending standards increase the chance of a recession developing later this year. Still, the Fed took action in the midst of the turmoil by raising the Fed funds rate yet again to 4.75-5.0% which demonstrates their resolve in ending the inflation problem. This decision displayed how the macroprudential* actions taken by the Fed, the FDIC, and the Treasury Department were deemed sufficient to handle the banking crisis, leaving monetary policy free to continue fighting inflation. The rate hike came after favorable economic data in early March: another strong jobs report with 311,000 new jobs created in February along with solid housing starts and permits.
The sudden onset of a crisis means the economic data has taken a backseat for now. There’s little debate that economic resilience has been amply demonstrated in the first quarter. Now that something has “broken”, however, the broader implications may finally be enough to slow the pace of hiring and growth such that a recession develops in the latter half of the year. Some of the implications from the banking turmoil may also prove to be deflationary which could be helpful in the Fed’s battle to bring down inflation.
Bond market performance during the month was led by the big move lower in Treasury yields. Risk spreads on corporate bonds moved wider, particularly for banks, which means corporate bond performance did not keep pace with like-duration Treasuries. The same was true for Agency mortgage-backed securities. In comparison, municipal bonds were the star performers, lagging Treasury returns but still posting very respectable results.
Looking ahead, the Fed is clearly closer to the end of its hiking cycle and the macroeconomic picture is much more cloudy thanks to the banking industry uncertainty. The consequences from recent developments could be considerable and will almost certainly make the Fed’s job more challenging. Prevailing Treasury yields are already reflecting not only an end to Fed rate hikes but the first rate cuts, but we continue to believe rate cuts are unlikely in 2023. The resilience of the U.S. economy will surely be tested in the coming months, but entering any downturn from a position of strength could result in a less pronounced recession and perhaps a more rapid return to growth.
*Macroprudential policies are financial policies aimed at ensuring the stability of the financial system as a whole to prevent substantial disruptions in credit and other vital financial services necessary for stable economic growth.
Maple Capital Management, Inc. (MCM) is an independent SEC Registered Investment Advisor with offices in Montpelier, Vermont and Atlanta, Georgia.
This commentary reflects the views of MCM and should not be considered to be investment or financial advice. MCM does not warranty these views and will not update this communication after the date of publication. Any mention of specific securities is done for illustrative purposes and the securities mentioned may or may not be held in client accounts. No assumption or assurance should be taken that securities mentioned will be safe or profitable investments. Past performance is not indicative of future results
For further information, please contact Steven Killoran at 1-802-229-2838 or at [email protected]. For further information about Maple Capital, including a copy of our informational brochure, please visit our website at www.maplecapital.com.
The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
The Bloomberg Intermediate US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market with less than 10 years to maturity. The securitized sector is wholly inluded. The index includes Treasuries, government-related and corporate securities, MBS, ABS and CMBS..
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.
The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg US Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.
The Bloomberg U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.