Ep.104: Silicon Valley Bank (SVB) Contagion Fears Spark A Global Banking Sell-Off

Okay, hello and welcome to the Market Maker Podcast. This is episode 104, and today I've got two topics to talk about with Piers Curran, who is the co-founder of AmplifyMe. And we're going to talk about Jerome Powell's testimony to Congress, arguably the biggest by far macro event, because his moves have triggered a cross-asset class response. And that meaning in simple terms Stocks are down and quite aggressively so in the US. So we'll talk about why and what's happened and obviously what this means for interest rates, because the event from the FOMC is looming in just about 2 weeks' time or so. And then the other headline story capturing attention end of the week, SVB Financial, holding company for Silicon Valley Bank. Some of you might have heard of them, I'm guessing most of you haven't. Um, But what happened was a collapse in their share price, and that sparked a degree of contagion among financial stocks. Yesterday we did see the big four US banks— Bank of America, Wells Fargo, JP Morgan— they were down ranging from 4% to 6.5% and actually saw around $50 billion worth of market value wiped off their share price. It just yesterday alone on the back of SVB. So how does that happen? We'll explain. But let's dive in with Jerome Powell. So to set the scene, the, the way that this operates— so the Fed have 8 meetings per year, just to set the scene. This is where they'll officially set monetary policy. In between this, they have the semi-annual testimonies. This is where Jerome Powell will basically report back to politicians. Now, just to be clear, the central bank and the government operate independently, or should do, in the best intention to do so, in the Western world at least. Um, but the— what makes this slightly convoluted is that although there's independent thinking at the central bank, in the end the central bank has to report back to Congress. And this is one of these events, and it's always been a platform whereby historically, if so required, the central bank head or the chair in this case Jerome Powell, can use it as a staging post to sort of set out his latest forward guidance. And so the Federal Reserve, he said, would likely need to raise interest rates more than expected in response to recent strong data and is prepared to move in larger steps if the totality of incoming information suggests tougher measures are needed to control inflation. Does that summarize all anyone needs to know, or is there more that people should be aware of?

Uh, that summarizes it. I think that what you've just said, that's it. I mean, basically this— so Powell, you know, in these, um, semi-annual testimonies, you know, I mean, how long does it last? What was it, like an hour and a half or something?

Did you— pretty lengthy generally.

Yeah, it's a pretty lengthy thing, right? And what he does is he delivers a statement, a pre-prepared statement at the start, then all the senators start grilling him. And if you've ever watched one of these things, which unfortunately I have, my Lord, it's— you get these— I mean, all right, some of the senators are quite savvy, they understand the world of economics, and they understand the world of markets, and therefore they understand interest rates from a sort of markets and economics perspective. Others have just got no idea, which is fair enough, they're not from an economic background. So you get these senators, these like 70-year-old senators just banging on about something entirely irrelevant, and they just use it as a bit of a platform for themselves to basically say stuff that their, their electorate will like, and it's such a dull event. Anyway, it was about an hour and a half yesterday. All you needed to know was in the first 5 minutes, and that was in his pre-prepared statement. And I don't know, I'm— I was quite surprised that the market— well, I don't know, I would say that without the SVB bank situation this week. I, I would say yes, markets sold off on Tuesday, but then they were, they were kind of stabilizing before. Now we've got this latest story on SVB, which has taken things another leg lower. So I think there was a negative fallout in stocks to what Powell said, but it wasn't a huge one. And that's because what he said wasn't particularly surprising. We've known all of this. That's why we've been selling off for the whole month of February. You know, we know that data out of the US has shown that the US economy is way more resilient than we thought, therefore inflation is going to stay higher, therefore the Fed are going to hike rates more. And I, I guess the only thing about it yesterday was just how explicit he was about the fact that there's a rate hike acceleration is back on the table. So to quote him exactly, he said, if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes. Now, I mean, that is very, very, very clear language, which is very unusual for a central banker.

It's funny though, because actually step out of the, of the situation and just think about what he's just said. If data comes in strong, we're going to have to tighten faster. It's like, well, yeah, it's funny how markets are so behavioral. It's just this, yeah, this, this uttering of like, we could go faster, bang, everyone just starts selling at that point. And then it's like, well, it is— there is a condition to this, and there is major data coming down the pipe, right? There's literally non-farm payrolls, which is super key, is later today from when we're recording this. And then you've got US CPI on Tuesday next week.

Yeah, so I would say those two pieces of information will entirely determine what the Fed does on the 22nd of March, which is when their meeting is.

Yeah.

And if these two pieces of information come in strong, they're going to hike 50 basis points. Powell just told us, um, now the probability of a 50 hike at the March meeting went from a 30% chance to a 70% chance off the back of his comments. So yeah, there's been a pretty major shift in near-term rate expectations.

Yeah, federal funds rate futures now have actually leveled off. It's 50/50 price now. Okay, it swung from 30 on Monday up to 70 plus, it's dropped back to about 54 now. So yeah, but, but actually the other thing to contemplate here is Um, I think he's done, he's done a good job. He's done the right thing because there's the blackout period. This was actually one of his last, right, moments to communicate, and he's communicated that, look, there's data coming, everyone knows that, and there's no point us, I don't think, speculating because the question would be, what do you think, 25, 50? It's like, I don't need to guess, let's just wait and the data will tell me 25 or 50, basically.

And I I think the reason that probability dropped back down a bit was because of data we had yesterday, where we had initial jobless claims from the US, which just tracks the number of new applicants for jobless support each week. And it came in at 211,000. Why is that important? Well, it's the first time that number has been above 200,000 since mid-December. So well above what was expected. So that's kind of— maybe the first chink in the armor of this super strong labor market. Maybe that jobless claims kind of just points to, well, a turning point and perhaps now that labor market's going to start to weaken. Maybe. I mean, we're going to get the nonfarm payrolls data today. And I think the big argument is that the one kind of last bit of hope, if you're wedged in massively long stocks and you've taken a big hit in the last month as we've pivoted on our rate hike expectations, then your last ray of hope is the argument that the January jobs data was only strong because the weather in the Northeast of the US was much milder than normal in that month. And the Northeast of the US makes up 20% of the whole US economy. So was it the milder weather that led to the strong jobs number? We're going to find out today because we're going to get the February reading, and the weather definitely— I mean, I was in New York a couple of weeks ago and it definitely was not mild. So you're going to see that weather argument finally get put to rest today one way or the other.

Yeah, so the headlines expected at 200, got a range 78 to 325 at the high. ADP came out, which is often seen as the precursor for this, is private payrolls. That beat expectations, came in at 242,000 earlier this week against market estimates of 200. I did see one stat, and I was just looking at the— a chart, but to average out the numbers, basically ADP has dramatically underforecast the BLS's official job gains for months.

It's the best reverse indicator you can possibly get. Yeah, like, to put, to put that into context, the— so the ADP, they're trying to measure just private job creation, right, in the private sector. Nonfarm payrolls is private and public sectors, right? The ADP number in January was 119,000, the lowest reading for well over 12 months. In that same month, the nonfarm payrolls came in double expectation and was like the highest reading in many months, right? So yeah, I wouldn't be looking at that ADP report and drawing any conclusions whatsoever, and if any, using it as a reverse indicator.

Okay, we'll see. That's for educational purposes, not for investment advice, I must stress. Um, but look, let's jump on to the other story. So SVB Financial, and let's kick it off with who exactly is Silicon Valley Bank.

Yeah, well, as the name probably suggests, they're— well, probably the best way to describe it, they're the bank for tech startups in Silicon Valley. Um, and yeah, their share price tanked, cratered, whatever word you want to roll out, dropped 60% yesterday.

Okay, like, why would, would a company basically have such a meteoric decline like that?

Yeah, well, I think there's two— the big question, we'll go into why. The big question is, I mean, I was going to say they're quite a small bank and they are when you put them alongside the giants like JP Morgan and Bank of America and the rest, but they are the 16th biggest bank in the US. So we're not messing about here. So the question is, well, what happened to Silicon Valley Bank? Could that happen? To the other banks, the big boys? And that right there is the critical question. But what happened here specifically to SVB? I think on the one hand they are a bit unique, which is why we perhaps shouldn't get too alarmed yet about this being a contagion thing that leads to, you know, big issues across the financial sector. But So the thing about their bank is they've got an unusually high proportion of business depositors. So look, go back to the basics here. A bank takes in deposits, right? And normally a bank would have consumers, individuals that is, depositing money. You know, where do you put your paycheck every month? In your bank account, right? So all this money, all these deposits are coming in all the time. So you either have consumers or you have businesses Okay, so you have a business bank account, of course, and so in there you're depositing your money, right? Now, SVB have a very unusually high proportion of business depositors compared to individual consumer depositors. That's number one really important differentiator from the big guns like JP Morgan, for example. We'll come back to why that's important in a second. What happened in the financial— sorry, what happened in COVID In 2021, particularly, investors went crazy pumping money into tech startups. And it was one of the biggest years— well, no, sorry, not one of— it was the biggest year ever for investors funding tech startups, right? Where do these startups put the money? So when the investment comes in, right, great, we've done a capital raise, perfect, right? Now we're going to execute our growth strategy. But of course, you don't spend all that money bang in one go. You put it in the bank and then you spend that money in the months ahead as you're deploying your growth strategy, right? So what happened to Silicon Valley Bank is their deposits went through the roof in 2021, okay? Now normally what a bank does, their model, they take in deposits and then they take that money and then they lend it, okay? And we talked about net interest income, that's the, their profit margin basically. So how much are they paying their depositor versus how much are they generating in income from lending that money out. Okay, now the problem that Silicon Valley Bank had was that they— that the rate at which deposits was increasing was so rapid, they just didn't have the capacity, and actually there wasn't even the demand to lend that money out the other side. Okay, so what did they do? They instead invested that money into government bonds and mortgage-backed securities because they wanted to generate a return from that money that was higher than the deposit interest they're paying to their customer. Okay, and the only way to do that, they had to buy safe assets. Okay, because they couldn't lend it, they had too much money, right? So that, that's the premise, right? This is in 2021. The issue they had is they bought super long-term and they bought— they put it in their hold-to-maturity portfolio. Okay, they're kind of wedged in on a fixed rate return. Okay, now the issue was that then interest rates started to ramp higher in 2022. Now if you're holding bonds, then what happens if interest rates go up? Well, bond yields go up. Okay, but that means bond prices go down. So they got locked in at a relatively very low yield in 2021, and so then their securities portfolio is suffering as prices drop in 2022 as the Fed hikes rates. Okay, so now suddenly they're losing money on their securities book, um, so What's now happened to compound this is investors have stopped investing in tech startups, number one, so there's less new deposits coming in. Number two, businesses are very conscious of the rate of return they're getting on their deposits, and if your bank account isn't providing you with anything particularly meaningful, then the CFOs in these businesses will take the money out of the bank and they'll buy government bonds to generate a higher return on their cash. Okay, but this now means deposit withdrawals. So SVB Bank has seen deposit withdrawals just as their offsetting kind of securities book has declined in value. And so what they've had to do is sell some of these securities that they they bought. Now the problem is these were marked to market on their book at the prices they bought at in 2021. Prices have gone south, so they've had to sell their position at a quite a big loss. Okay, and this was all revealed yesterday, and they've had to issue new shares to cover this kind of shortfall, and all of a sudden everything's gone a bit panicky. And so their stock dumped 60%.

So the contagion effect then, is that appropriate or is that an overreaction in what we saw yesterday with the big boys?

I think it's a very hard question to answer. The initial reaction is contagion, and you've seen, as you were saying at the start, you've seen all the big banks, you know, come off really sharply yesterday. In fact, to put that into context, excuse me, the sell-off in JP Morgan shares wiped— what was it? I did have the stat. I don't know where it is now. Oh, yeah, here we go. So JP Morgan's valuation declined $22 billion yesterday because its share price dropped 5.4%. So $22 billion. That $22 billion loss from JP Morgan's valuation, that's more than double the entire valuation of the whole of SVB. Yeah, um, so you definitely— you've definitely had a big move across the sector because, you know, obviously other banks are also invested in these. They've done the same thing, right? In 2021, deposits went up and maybe they couldn't lend that money out, so they bought securities. But what I would say is a couple of differences which hopefully will mean this contagion thing is temporary and then things stabilize and go back to normal. That's what should happen. We'll talk about why it might not happen in a minute, but it should happen because, for a start, SVB is unusual in having a very large proportion of business depositors. Most other banks don't. Mostly their deposit base is consumers. Consumers historically are just way less savvy and can't be asked, to be honest, to change their bank, right? So they don't go around going, oh, I'm only getting 1.05% interest on my bank account here, right? I can get— if I bought 2-year US government bonds, I could get 5%, right? I'm going to take all my money out and I'm going to buy bonds. They just don't do it because they don't know about it or they just don't have time, right? So normally— so these bank— these other big banks are not seeing deposit with withdrawals like you're seeing SVB take on. Secondly, these banks have not invested as much to the proportion of the bank's book on the asset side is much smaller in terms of their investments into these, you know, locked-in long-term securities. But that doesn't mean to say they haven't invested in those at all. They have. And this has shown that the value of those assets that they've got on their book are possibly lower. If they were forced to sell like SVB were, then maybe those assets aren't worth as much, which is probably what you saw in yesterday's share prices. You know, investors just adjusting the value of those assets, right? Now, it shouldn't go any further than this, but You were around in 2008, and, you know, panic is irrational, and, you know, this is where logical sense goes out of the window. So the question is, are we at a 2008 moment? If I'm a betting man, I'd say no. But that doesn't mean to say the risk of that is zero, because it's definitely not, right?

So how I would have done my job in my previous life before Amplify— because right now this would be like the hot focus, and I guess the market to me is quite— is going to be in today's session specifically, although there's payrolls which might absorb a lot of the attention, as it naturally does, and it's important, as we discussed. But today specifically, just given the aftermath of what happened with the bank stocks, I would be super conscious of a rumor doing the rounds where a big bulge bracket bank might get named. Yeah, I would be actively now talking to my contacts to try and get ahead of that for any feelings on who this could be and some of the— just getting under the bonnet a little bit that you can't find through a Bloomberg terminal. And that would be me doing my job then to try and arm you, the trader, with the intel to answer that question. Is there going to be another? Um, and the important point there is, as you rightly said, psychologically or behaviorally, it doesn't need to be another. There just needs to be speculation. Yeah, that there's someone else at risk. That's all it would take is not 16th largest US bank But if we break into the top 10, top 5, then you've got some serious issues. Because for that session alone and that moment in time, you probably would get a repeat-type move in the market. Might— if it doesn't transpire to be anything, which is probably likely then to be the case, because as you said, they're generally a more diversified business, that doesn't mean that there's not short-term opportunity before then the dust settles. So I think today is really important from an information flow point of view.

I don't want to be too sensationalist, but I'm going to be. This next week, in fact, today and Tuesday— well, let's call it yesterday, today, and Tuesday— could be a phantom— the most important 5-day period of the whole of 2023. There you go.

I could never tell that you're a trader. You were about to say fantastic then, weren't you? I can see the dollar signs in your eyes.

The VIX is up 30% here, right? People have panicked a little bit. There's a little bit of a panic, not massive. If you layer on top a potential banking crisis, if you layer on top a really strong non-farm payrolls number and a higher than expected CPI reading on Tuesday, then our rate hike expectations continue to rise. The very thing that has put SVB, or one of the things that's put SVB in trouble. So if yields on bonds rise further off the payrolls reading and the inflation reading, SVB their problem gets worse, and then this panics people a bit more about the others. And so I'm just saying, it has the potential. Now, it could be that the payrolls number today is soft, much weaker than expected. It could be the CPI number drops quite sharply, in which case let's all take a breath and everything's fine. But yeah, this is, this is the moment if you're interested in markets. You need to be all over this data this afternoon and on Tuesday afternoon because it is— couldn't be more important.

Okay, and for anyone listening, that is Piers Curran getting mega excited. This is as far as he gets. All right, well look, on that note, I know that you're on client site today, so I'll let you go and let you crack on with the day. But, uh, thanks for giving up some time.

Always a pleasure. Enjoy the weekend.

All right, take care everyone.

Okay, see ya.