The failures of Silicon Valley, Silvergate, and Signature Banks were due to multiple factors but chief among them was the Fed’s aggressive interest rate hikes. Debt securities lose value when interest rise—if a bank bought a 2.0%, 10-year bond last year but could now get a 4.0% yield if they purchased the same bond, their current bond is worth @ 40% less. Yet if held until maturity, the bank would be paid back in full while receiving 50% less interest over the nine remaining years. The mismatch of demand deposits to long term collateral, raises liquidity issues and questions about credit quality of loans made. The banks above had both a deterioration of collateral and credit quality of loans made. Silicon Valley lent to start-up tech companies and had a bank run by Depositors. The other two banks were over-extended with loans to crypto companies. Silvergate is voluntarily liquidating, and Signature bank was put in receivership by the FDIC to protect depositors. Banks will now have to pay higher insurance premiums to shore up the FDIC fund assets.

These events have the Fed in the “Catch 22” dilemma we discussed in our 2020 commentary—raise rates and slow the economy and you get stagflation or stay the course with easy money and get hyper- inflation. The Fed has $9 trillion of debt securities on their balance sheet from purchasing corporate and mortgage bonds while operating under their Quantitative Easing program. These debt securities now have a market value less than par. The Fed has yet to get inflation under control and raising interest rates aggressively has had the adverse consequences of harming collateral, causing defaults, slowing the economy, and may potentially cause a stock market correction. So, the question now is what’s the Fed’s next move?

According to the Treasury’s announcement last night, all bank depositor’s money is guaranteed above the $250,000 level for 1 year. Ordinarily Depositors are first in line for being paid back ahead of everyone else including secured bond holders. With inflation still making Real yields negative (yields minus inflation must be positive), the Fed has more work to do but doing so exacerbates the Fed’s dilemma as the markets are telling the Fed they are breaking things now.

Consensus following the Fed’s speech last week was to expect another .50% rate hike March 22 and 3 more rate hikes with interest rates held there for some time. After the bank failures economists expect a .25% rate hike and a less aggressive Fed thereafter. We interpreted Fed Chairman Powell’s speech last week to mean the de-dollarization underway is of concern and higher interest rates are needed. Now the Fed’s job is a bit more tenuous as they face what might be termed a “Catch 33”—they must combat inflation by raising rates, not wreck the financial system by doing so, and yet defend “King Dollar” without destabilizing the markets and making things break.

Backwards, forward. Up and Down. Defense is the order of the day. We are partially hedged and under- weighted in stocks. We believe we have built quality portfolios with the liquidity and flexibility to maneuver whatever unfolds. We remain disciplined and we are watching for opportunities amidst the gyrations. Stay tuned. We are carefully monitoring every development and are being pro-active to protect your money and find opportunities at bargain prices.