Battling Competing Problems, Fed Keeps Hike Small

MIKE TOWNSEND: Hi, everyone, and welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend. And on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

This week's episode is a little different because I've been battling a nasty virus that has left my voice kind of in tatters. So I'm going to try to talk as little as possible, an unusual trick for a podcast host, and, instead, leave the bulk of the talking to my fantastic guest this week, Liz Ann Sonders. Liz Ann is Schwab's chief investment strategist, and she's the perfect guest to talk about what has been a pretty crazy couple of weeks for the markets. Liz Ann, thanks so much for joining me.

LIZ ANN SONDERS: Oh, thanks for having me, Mike. And I'll do my best to fill the time. And, of course, I also hope you are on the mend.

MIKE: Thanks.

Well, Liz Ann, we have to start with the latest news, which is that the Federal Reserve announced a 25 basis point rate hike, but also indicated a lot of uncertainty about how things will play out going forward. Given the turmoil in the banking sector, which we're going to get into in just a minute, this was one of the most closely watched Fed decisions in years. So what are your big takeaways from today's decision and what do you think it means for interest rates though the rest of the year?

LIZ ANN: Mike, you're absolutely right that the up and down in terms of expectations heading into this is unlike anything we have ever seen from a much more aggressive assumption before Silicon Valley Bank failed to then some expectation that the Fed would pause. Although heading into the meeting, the market had an 83% likelihood of the 25 basis points, and it's generally the Fed's, you know, MO to not go against market expectation. So they did do the 25 basis points. Maybe somewhat surprising was that it was in a unanimous decision. I think there had been some expectation that there might be dissenters in favor of a pause.

You know, there was a lot of attention on some of the language that changed in the statement relative to the prior statement. It's kind of a funny change that people are still trying to figure out how to interpret it. The statement now says that 'The Fed anticipates that―and I'll put emphasis on the words―some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restricted to return inflation to 2% over time.' The 'some additional policy firming' is new. What used to be there was 'ongoing increases.' So Powell did get a question about it, but he didn't really share with any specificity what that meant. That maybe suggests that there's a little more flexibility by not saying 'ongoing increases,' but 'additional policy firming' doesn't suggest that they're ready to start cutting rates. And Powell certainly pushed back on the notion of near-term rate cuts during the press conference.

MIKE: Well, obviously, the Fed is in an extraordinarily tricky spot here. I mean, combating inflation and ensuring financial stability by dealing with the banking sector, those are sort of essentially opposite tasks. I mean, with one hand, the Fed's quantitative tightening is about pulling liquidity out of the system, and with the other hand, the banking rescue is about adding lots of liquidity. So how do you think the Fed might navigate this going forward, and what are the implications for the markets?

LIZ ANN: So Powell did get asked a couple of questions that sort of tie into that conundrum. And he did take some pains to distinguish what the Fed has done in terms of the additional funding facility that they announced the provision of lending through the discount window. And that is because banks have proactively stepped up to borrow in order to ease their own constraints. And he kind of pushed back on the notion that that would be considered a form of quantitative easing. So kind of reinforcing that the Fed still views its job as an inflation fighter, an important one, and didn't suggest there would be any change to the reducing of the balance sheet but left open the door that it's possible that we could have additional weeks where we see banks come to the borrowing window.

So maybe it's the semantics of whether we're calling it QE or something else, but I think it's important because quantitative easing, in terms of what the Fed has done historically, has been a proactive move to try to juice growth in the economy. That is clearly not what they're doing. So he wants to distinguish, to your point, that sort of on the one hand on the other and what the drivers are of what seems to be a bit of a clash.

MIKE: Liz Ann, let's take a step back here. A lot has happened in the past couple of weeks, and I want to make sure our listeners have your perspective on the events in the financial sector. So let's start with Silicon Valley Bank, which became the second-largest bank failure ever less than two weeks ago. But this was not a normal everyday bank. What were the unique circumstances at work here?

LIZ ANN: Sure, and I do think we, also, in answering that, have to step back a little bit in time and go back to the beginning part of the pandemic and the era, in particular, of the double-barreled massive stimulus that kicked in both on the monetary side of things and on the fiscal side of things. And that caused just a huge surge in liquidity, which, of course, helped bring the economy out of the COVID recession. It was also an environment where the venture capital world and tech and startups were big recipients of that liquidity and were also doing well as an industry. And that led to a massive surge in deposits at Silicon Valley Bank. Those cohorts were, for lack of a better word, very chummy with the bank. It was a very well-known bank, and so many deposits coming in from that community, in order to boost yields on those deposits, Silicon Valley Bank loaded up on longer-term government agency-type bonds. And the bank reacted to rising rates and losses on the securities that it had bought in early 2021 by designating them as held to maturity, HTM for short. And that was in the interest of the mark-to-market losses, sometimes thought of as the on-paper losses, not flowing through the bank's income statement. And as a result, per existing accounting rules, SVB could not hedge the risk. In addition, given the 2018 rollback of some of the Dodd-Frank regulations, one of which was upping the size of banks that were subject to stress tests from 50 billion to 250 billion. As a result, Silicon Valley Bank was not subject to those stress tests, including tests in the event of a sharp increase in interest rates.

Now, at the same time, the tech sector has been under lot of pressure, given the bear market and layoffs that we have seen. And the bank's industry concentration meant that their exposure and downfall was really two-fold. More than 95% of the bank's deposit base were not FDIC insured. They were big, huge deposits from that community―they weren't smaller deposits used to pay payroll, and that ranked Silicon Valley Bank 99th out of the top 100 banks in terms of percentage of non-insured deposits. More than 55% of their assets were invested in long-term bonds, and that ranked them number one out of the top 100 banks. So kind of the worst end of the ranking spectrum that you would want to be in both of those circumstances. So they had these unrealized losses on their portfolio, but they also had the concentrated industry exposure problem.

So Wednesday, March 8, the big day, SVB, Silicon Valley Bank, made a surprise announcement that it would need to raise more than $2 billion that they were hoping from equity holders. They had just sold their entire portfolio of available-for-sale securities, separate from the held-to-maturity securities, to meet liquidity needs. They took a $1.8 billion loss on the sale, and they were hoping that the equity holders would bail them out. That was not the case. And then due to things like social media and Twitter and suggestions that maybe depositors should pull their money out, a run on Silicon Valley Bank began, and they were forced to then realize those portfolio losses. And the lack of new deposits and/or lending opportunities coming in basically highlighted the fragility of their very, very unique model. And by March 10, no buyers of SVB had stepped in, and that's when we started to see what we've seen with the backstop facilities and everything the Fed and regulators and the FDIC has done. But really unique circumstances of Silicon Valley Bank, and to a lesser degree, Signature Bank, which is kind of the East Coast brother of Silicon Valley Bank.

MIKE: Yeah, really important takeaway for me there is the incredible percentage of deposits that were not insured. So above the FDIC limit was one of the key factors there.

The other major news that followed that was the buyout of Credit Suisse by UBS. Credit Suisse had a different set of unique circumstances, and the Swiss National Bank is backing that deal to the tune of $9.7 billion and waived the requirement for shareholder approval, a move that has a lot of shareholders concerned. So what are the implications for the global financial system of the Credit Suisse situation?

LIZ ANN: The short answer is we don't yet know, where we're just starting to get all the information. But it's important to remind listeners that Credit Suisse's backdrop was entirely different than Silicon Valley Bank. All you have to do is pull up a chart of the Credit Suisse stock and see that problems manifesting itself in the stock price date back a couple of years. And they've been just plagued with scandals of every variety, and losses, questionable business strategies. So that's been kind of a problem long in the making.

But because of the turmoil in the global financial system, it sort of brought that to light. And over the weekend, UBS stepped in to buy Credit Suisse in what many have jokingly called kind of a shotgun wedding. It's probably pretty apt. They paid 3 billion francs, which is $3.3 billion, in an effort to stem the crisis. The price per share for Credit Suisse represented a 99% decline from what was the peak in 2007.

What is important is it's the first combination of two large and systemically important global banks since the global financial crisis. And you had the Swiss National Bank backing the deal with a liquidity backstop, as you mentioned, Mike. It guaranteed a cover up to 9 billion francs or the $9.7 billion of UBS's losses, and also by waiving the requirement to get shareholder approval. This really, really made waves. The elimination of the need for shareholder approval is creating tremors, and, you know, how can they unilaterally do that?

What also happened is the equity holders, they certainly didn't get bailed out, but they got a few cents on the dollar. But contingent convertible bond holders, shortened nickname is CoCo bonds, they're getting wiped out. And this is making waves because unsecured bond holders have historically ranked above equity holders in the capital structure. So now that was sort of turned on its head. And it's important because many European banks in the aftermath of both the global financial crisis and the Eurozone crisis a few years later, issued a lot of CoCo bonds to strengthen their balance sheets. And I think at a minimum, given what we know now, uncertainty just about the global regulatory backdrop for large global banks will remain elevated.

So there's still a lot of questions that don't have answers specific to that capital structure and who got bailed out and who didn't.

MIKE: Well, Liz Ann, here in Washington, the main policy response to all this has come from the banking regulators, of course, and, in particular, the Fed. Here are some numbers that really surprised me. Data shows that banks borrowed more than $152 billion from the Fed's discount window for the week ending March 15. And that's an all-time record, smashing the previous record that was set during the 2008 financial crisis. To put that in perspective, the previous week, the total borrowing amount was about $4.5 billion. So it's nice to think that the SVB, Silicon Valley Bank, situation is an outlier, but lots of banks are holding long-term bonds that have dropped in value as interest rates have risen. The FDIC says that banks have more than $620 billion in unrealized losses, plus many of these banks have portfolios of mortgages that were extended when rates were really low. So I guess the question is how worried are you that there are more problems lurking in the banking sector, particularly if we see depositors keep taking their money out of mid-sized banks and moving it to the large banks, the ones that are deemed too big to fail? This situation could continue to expand no matter how much liquidity the Fed provides. So how concerned are you?

LIZ ANN: All of this is still an evolving story here in terms of what authorities have done, what remain possibilities to be done to stem any contagion that we continue to see. At least as we're taping this, Mike, there seems to be at least some relative calm that the facilities that have been implemented so far are, for now, anyway, doing the trick, and the equity market behavior would suggest that things are fairly calm.

But what the Fed in conjunction with the FDIC has done so far is … I'll use the term double-barreled, they stepped in to cover all the deposits, specifically, of Silicon Valley Bank and Signature Bank, but also established a new short-term lending facility called the Bank Term Funding Program. And that program allows banks, any banks, not just the two banks that now the FDIC controls, allows banks to borrow at par value government bonds for up to a year, regardless of what their present mark to market, meaning on paper, price. And those terms were also applied to the traditional discount window. And as I said, it did help to, at least for now, provide some confidence. And given that several regional banks faced increased deposit withdrawals over the past week in the aftermath of the SVB failure, and as a result, for the most recent data that we have, the weekly data out last week showed that borrowing at the Fed's discount window has spiked. And you mentioned a portion of that, but it might be confusing to people who have seen a number of 300 billion-plus. The differential is that 300 billion-plus is inclusive of the money provided to rescue the depositors of Silicon Valley Bank and Signature Bank. So I think, given that I've seen different numbers float around, I think that that's a helpful descriptor.

And the expansion, the related expansion of the Fed's balance sheet, which is now basically reversed about 25% of the quantitative tightening, the shrinking of the balance sheet that the Fed initiated a year ago or so, that's important. Now, a lot of people have been saying does that, in essence, mean that the Fed has relaunched quantitative easing? Not really The quantitative easing in terms of something being done proactively by the Fed has been done in the past to try to juice economic growth in really trying economic times. They're still fighting inflation and probably will continue behind the scenes in that quantitative tightening. This just is because banks had to step up to the borrowing window.

And, Mike, it's funny, you know, I've heard the term "whack-a-mole" these days, as every day we wake up and wonder, you know, what's the next institution that's going to be in the spotlight, First Republic Bank being an example of that? But I also think, indirectly, that could be applied to the type of economic data and information. You know, we've all been so obsessed with inflation readings on a month-to-month basis. That's what's gotten the market's attention. It captures the headlines. I got to say, I don't think it's a stretch to predict that this weekly announcement of the take-up of how many, you know, banks and financial institutions are coming to the Fed's discount window to borrow, I think that's going to be the hot piece of news on a weekly basis, at least in the near term.

MIKE: There's been a lot of focus, rightly so, I think, on depositors at these banks. But from an investing standpoint, what's striking is the sudden lack of investor confidence in the banking sector. It feels like a lot of investors are asking themselves, "How can I be confident that this financial institution in which I am an investor is able to manage its risk if at some of these places we've been talking about the banks themselves didn't understand their own risk, or at least they made no effort to hedge that risk?" Certainly, leaders like Treasury Secretary Yellen and Fed Chair Powell, they've been all over the media talking about the strength and stability of the banking sector. Do you think investors believe what they're saying? What's it going to take to rebuild investor trust and confidence in banks?

LIZ ANN: So I think it has to be a continuation of sort of soothing words and actions from the combination of the Treasury Department, the Federal Reserve, other central banks, to the extent this starts to be an issue outside the United States. But just as importantly, hearing from leaders within these banks, as well, looking at the individual bank level, regional or small banks, and hearing from their C-suite in terms of how they're managing through this turmoil so that there's actually specificity versus just the broad blanket, "Here's what we're doing from a regulatory, from a central bank perspective." And I do think you will see more of that, and that is probably the necessary additional ingredient to bring confidence back. We know confidence is a big part of this. Bank runs are about confidence. Sell-offs in equity market, even economic behavior is about confidence. But I think it has to come both from the top down and the bottom up.

MIKE: Well, from a policy perspective here in Washington, we're obviously hearing a lot of concern and a lot of ideas. Some have proposed increasing the FDIC deposit insurance amount. Some have said that while there are going to be a bunch of hearings over the next couple of weeks, and, in fact, there's one that is already scheduled for next week, it's going to be really difficult to reach any kind of policy consensus in this divided Congress. The Fed is undertaking an investigation. It expects to complete that by May. I think a lot of people on Capitol Hill want to see the results of that before making any decisions about next steps. But I think it's going to be tricky to find consensus on a policy route in a divided Congress.

Well, Liz Ann, I want to switch to inflation. The term of the moment seems to be "sticky." But what's the sticky part? Gas prices have been coming down. Rents have been coming down. There's more and more evidence that people's spending habits are changing, whether they're shopping in different places or buying cheaper versions of things that they shop for. Is the problem the slow pace of prices coming down? The Fed has said its goal is to get inflation down to its 2% target by 2025. That seems really slow and actually pretty doable. Has the concern for the financial system sparked by the Silicon Valley Bank failure and others made that goal less realistic?

LIZ ANN: Actually, Mike, it may make the goal more realistic and could mean that inflation comes down a bit more quickly than had this not unfolded. We've been talking quite a bit about what might have been defined as an asset crunch in the last year or so, separate from a credit crunch. In fact, a lot of folks that have been on the no-recession side of that debate had been citing the lack of a traditional credit crunch as a reason why the economy could avoid recession, given that that's typically a precursor to recession. Lending standards were already tightening heading into this. I think avoiding a credit crunch at this point is probably very difficult. But I bring that up because credit crunches and, in turn, attendant recessions tend to bring disinflation on much more quickly. So it is inherently disinflationary. I think the Fed knows that.

The question of how quickly will that filter into inflation, you've got, to your point in the first part of the question, the stickier components, which tend to be more on the services side of various inflation metrics, not so much on the goods side. But even on the goods side, you're still seeing a lot of volatility. Just the latest, you know, CPI report in February, you had energy services and electricity still up double-digit from a year ago. Some of the food categories up double-digit still from a year ago.

But really where there's been more steady stickiness, as opposed to volatile pops of heightened year-over-year or month-over-month changes, would be considered the shelter components. And in the case of the Consumer Price Index, it accounts for about 40% of core CPI. One component of that broad shelter category is rent of primary residence. That's pretty cut and dried. That's just if you rent where you live, what is the monthly increase? And then that's fed into the inflation calculation to get a year-over-year measure for that, as well. But then there's an imputed measure called owner's equivalent rent. It's a bit of a funky calculation. The creators get criticized for this, especially these days because there are quite a few well-watched what I would call real economy measures of rent inflation. Zillow has one. RealPage has one. Redfin has one. There are a number of others. Apartment List has one. All of those have come down markedly from the peak. It just hasn't fed into a commensurate decline in that owner's equivalent rent portion. And having those real economy gauges is a newer phenomenon. So we can't really go back and say, "Well how long in the past did it take for it to show up in those gauges before it showed up in owner's equivalent rent?"

So we're all somewhat flying blind here. Other than knowing it should eventually come down, the question is when. You know, myself included, thought it should have happened already. It hasn't. But that's what I keep a close eye on because that's where the stickiness has been most consistent.

MIKE: The other one that I know you watch really carefully are the jobs numbers, and those continue to be well above expectations. Yet at the same time, we continue to have these kind of headline-grabbing layoff numbers from the tech sector—another 9,000 at Amazon, another 10,000 at Meta. So what do you make of what you're seeing in the jobs sector?

LIZ ANN: To say this is a unique cycle because of the pandemic is the ultimate understatement. We all know that. We've been living through it for three years. But it's also kind of wreaked havoc with economic data, with inflation data. It's at the heart of why I've been saying we've been in this rolling recession where pockets of the economy have been hit at different times, pockets of inflation have been hit at different times.

And I think what's happening in the jobs market is a bit of a mirror image of what typically happens when you start to see deterioration. If you look at, call it a normal cycle, where the leading, leading indicators, things like layoff announcements, which, obviously, predate the classic leading indicator of unemployment claims … first, the company maybe stops hirings, you see announced hiring freezes, then there's layoff announcements, then there's the actual layoffs, then there's filing for unemployment claims.

Well, normally, the layoffs tend to be more bottom up, meaning it's lower-income, lower-wage folks that tend to be where the layoffs are concentrated at the early stage of a downturn. This has been turned on its head, and most of the layoffs, certainly the high-profile headline-grabbing layoffs, have been at these big, dominant headline-type companies and up the income and wage spectrum. So this is sort of a management, you know, somebody called it excess elite, that the weeding out is happening there first.

And it's part and parcel to what we already talked about. In the wake of Silicon Valley Bank, there's been so much focus on the bank part of the crisis. But the "Silicon Valley," as kind of a moniker, I think is also important because it's about where have the excesses been in terms of hiring? When you're in a 0% interest rate environment with liquidity as far as the eye can see, that gave support to startups who could fund their operations, who could bring a lot of employees on. Companies, you mentioned Amazon, that were big beneficiaries of the stay-at-home component of the pandemic. Now it's, "OK, we've got too much inventory" or "We've got too many people." But it's hitting up the wage and income spectrum, and that's why they're eye-popping to all of us because it's so many familiar companies. You're just not seeing it in things like payrolls or unemployment claims because that covers the entire swath of U.S. workers.

And the last thing I'd say, unemployment claims, people say, "But if people are getting laid off, you still would expect to see a pickup in unemployment claims." Well a lot of these workers, when they get laid off, they have either made enough money and have enough money that there isn't that immediate need to go to get unemployment insurance, to file for that, and/or they've received severance, which doesn't give them the ability to file for unemployment insurance.

MIKE: So that leads to the big question, recession. Given the turmoil in the banking sector, lack of clarity about what the Fed will or can do, all of the things happening in the economy, do you think recession is more likely now? We've been talking about the inverted yield curve for some time now and how that usually signals recession, but now the yield curve has steepened in a major way. So isn't that when recessions actually start?

LIZ ANN: You know, it's funny, I've gotten the question a different way, quite a bit, which is, "OK, we had a very large inversion for an extended period of time. Now that it's steepening, does that suggest we're out of the woods, that recessions come sort of at the point of maximum inversion?" The reality is that, yes, inversions in the yield curve have been very consistent precursors of recessions, with variability around kind of the lag. However, recessions, when they are ultimately declared as having started, which is always after the fact, it's often after the steepening has already occurred. And in many cases the recession has begun when the yield curve is no longer inverted. So I think that just because we've started to see this steepening, in and of itself, doesn't suggest, "Oh, no more recession risk." It was an inversion that already happened that is likely a precursor.

As I said, Mike, we've been saying it's been a rolling recession. Housing, housing-related, a lot of consumer-goods-oriented areas. Even the soft economic data, like consumer confidence, consumer sentiment, CEO confidence, all point in the direction of recession. We've had 11 months in a row of declining Leading Economic Index put out monthly by the Conference Board. Anytime we've been where we are right now with this decline from the peak 11 months ago, we've already been in a recession, we already talked about the yield curve, and now we've got the likelihood of a credit crunch. I just don't see how this moves the needle away from recession.

I just think this means that what has been a rolling recession more likely rolls into being a formal recession with what has been healthy, the job market, the services side of the economy, probably the next area to get hit. Especially because a lot of smaller businesses that are the biggest net employers, they use the small and regional banks to fund their operations, to borrow, to invest, to hire. So that's what I'd keep an eye on to get a sense of how much worse the economy is going to be from here as a result of what's going on in the banking system.

MIKE: Well, that brings us to the kicker, Liz Ann. You talk to investors all the time. I'm sure you're hearing from skittish investors who are looking for safety, and you're hearing from investors who are looking for opportunities and see opportunities right now. What are you telling people?

LIZ ANN: If you go back to the beginning of this year, which, obviously, predated the banking crisis we're in right now, there had been a quick kind of several week shift on the basis of the Fed maybe being close to a pause, to lower-quality, higher-beta sort of economically leveraged, even speculation-driven areas of the market, you know, meme stocks and non-profitable and heavily shorted. And we were saying at that time, again, even before what we're dealing with in the banking system, it didn't make sense to lean into those types of stocks, but instead stay focused on quality. And I think that still holds, but maybe what the added component to what to look for, to how to navigate through this environment that the banking crisis brings about is you want to look for companies, not just within the financial sector, but everywhere, that have strong balance sheets, that have high cash, low debt, that are what can be thought of as self-funding companies. They can fund their operations based on their cash flow. They don't have to go to the credit markets, which are getting tighter in terms of spreads. They don't have to go to the traditional banking system where credit is being constrained. They can fund their operations. Companies that are dividend … not just dividend-payers, but dividend growers. And I think that's an important distinction.

We're in a challenged forward-earnings environment, especially if economic growth expectations deteriorate. So you want to look for companies that have positive earnings revisions, positive earnings surprises. So that's kind of the basket. It's sort of a quality, but also has growth components, too. And it really represents focusing on factors that relate to things that are dear from a bigger picture perspective. And that's in addition to things like make sure you're diversified across and within asset classes. Take advantage of volatility to rebalance periodically so that you're adding low and trimming high, which we know we're always supposed to do. So it's sort of a general diversification, disciplined approach, but then that factor-based approach that we've been emphasizing, as well.

MIKE: Liz Ann, it's been a wild couple of weeks, no indication that things will be quiet anytime soon. I just want to thank you for making the time to talk to me, and I expect we'll be talking again soon.

LIZ ANN: I expect so, too. And be better. Get better. I hope your voice is back to normal, although it's kind of a cool sound. I like it, Mike.

MIKE: Well, thanks very much. That's Liz Ann Sonders, Schwab's chief investment strategist. You can follow her on Twitter @LizAnnSonders.

That's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. Take a moment now to follow the show in your listening app so you won't miss an episode. And if you like what you've heard, leave us a rating or a review. That really helps new listeners discover the show. For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.