Last year’s market selloff was almost entirely driven by the change in monetary policy by the Federal Reserve. Last year saw an unprecedented 7 rate increases totaling 4.25%. Those increases comprised the bulk of what the Fed needed to do to get inflation under control. This year the Fed raised rates two more times but only for a total of half a point. From here it’s unclear how much more, if any, the Fed needs to do.
What is becoming clear are the effects of the speed and magnitude of these increases. Most notable is the impact on the banking sector. The first quarter of this year saw two major bank failures and concerns over the entire small and regional banking sector, all driven by losses in their bond portfolios. These losses were the direct result of 2022 rate increases and the impact those had on their treasury holdings. The ensuing loss of capital and run on deposits left SVB Financial Group and Signature Bank insolvent and had to be taken over by the FDIC. SVB Financial Group and Signature Bank were the second and third largest bank failures in U.S. history. Having losses on treasury bonds large enough to sink banks of these sizes isn’t something the regulators had anticipated or modeled in their stress tests. These failures in turn sent panic into the markets as investors worried we’d see another bank led financial crisis.
It’s important to understand that, due to the sheer size of the federal government, whenever it makes a significant policy shift there are likely to be unintended consequences. This is especially true when it comes to things related to the economy (taxes, spending, interest rates, etc.). Long-term bond prices declined roughly 16% in 2022 due to the Fed’s policy changes. Because banks keep a significant portion of their capital reserves invested in these securities, they were left vulnerable to large customer withdrawals.
Prior to the banking crisis, the stock market had started the year off strongly. By early February, the S&P 500 had retraced roughly half the 2022 losses. However, most of the year’s gains evaporated by mid-March. Since then, the banking sector has seemed to stabilize with the help of yet another government program (it’s getting hard to tell if we actually live in a capitalist system anymore) and stock prices are back to their February levels.
Longer dated interest rates have backed off substantially this year. The yield on the benchmark 10-year treasury bill is now well under 4%. This can be attributed to a flight to safety during the banking concerns as well as a moderating inflation outlook. Inflation has dropped in response to tighter credit costs. While inflation is still high at 4.98% as of March 31st, that is much lower than the 9% peak back in June.
As income investors, we celebrated the higher rates for our retired clients, even at the short-term expense of the stock market. Our strategy has been to lock in attractive yields for a number of years now and wait for stocks to recover over the coming months. If an investor’s income is being met via interest and dividends, then the volatility in stocks is really a nonevent if you don’t have to sell into that market.
During 2022 we added approximately $25m to our client bond portfolios with yields between 5 and 6%. Now that rates have backed off, it has become increasingly difficult to find those sorts of returns in bonds. That being said, one positive aspect of the banking meltdown is that many are now issuing CD’s with just as attractive yields as they try to raise capital. So, we’ve begun to add these FDIC insured instruments to our client accounts as well.
We’ve even found that traded money market funds have become a good short-term holding place for cash. For the past dozen years, investors were penalized for holding any cash at all. But with each fed funds rate increase, institutional money funds have moved higher in lock step. The primary fund we use in this area is the Value Advantage Fund which is now yielding over 4.7%. In all, our client’s interest income is up over $1m from a year ago.
The Fed is probably at the end of the road for these rate increases. They say they’re going to follow the data and that data seems to point to inflation nearing a range they’re comfortable with. We’ve still not seen the full fallout of this cycle but are hoping to see less volatility in stocks this year as Fed policy become more predictable.