In the midst of a wave of bank failures, government agencies took swift action to prevent a potential banking crisis. The FDIC, the Treasury, and the Fed collaborated to create a Bank Term Lending Program, providing a $25 billion loan backstop to safeguard uninsured depositors against the Silicon Valley Bank’s collapse. As a result of the program’s implementation, eleven major banks deposited $30 billion of uninsured funds into First Republic Bank, likely due to assurances provided by the Federal Reserve and Treasury.
The program was in high demand, as evidenced by the substantial $152 billion increase in borrowing from the Federal Reserve within one week. This represents the most substantial borrowing in a single week since the Financial Crisis. As of now, the amount has surged to almost $300 billion.
Following recent events, UBS has entered into what has been described as a “shotgun marriage” with Credit Suisse, and the Federal Reserve reopened its dollar swap lines to provide liquidity to foreign banks.
In addition, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank announced a coordinated effort on March 19 to improve the provision of liquidity to foreign banks via the standing U.S. dollar liquidity swap line arrangements.
To enhance the effectiveness of the swap lines in providing U.S. dollar funding, the central banks involved have agreed to increase the frequency of 7-day maturity operations from weekly to daily. These daily operations started on March 20 and are set to continue until the end of April, at the very least.
Historically, opening dollar swap lines is often followed by further monetary accommodations, such as rate cuts, quantitative easing, and other liquidity operations. However, such actions are typically in response to a banking crisis, credit-related event, recession, or a combination of factors.
Banking Crisis Cause Recessions
It is well-established that banking crises can cause recessions. When a banking crisis occurs, one of the most apparent consequences is a tightening of lending standards. Since credit is the lifeblood of the economy, both for businesses and consumers, tighter lending standards can severely impede the flow of credit in the economy.
As banks tighten lending standards on loans to firms of all sizes, it can ultimately lead to liquidity constriction, which can drag down the economy into a recession. A significant number of businesses depend on lines of credit or other financial facilities to bridge the gap between manufacturing products or providing services and collecting revenue. When these funding sources are restricted, businesses struggle to operate and meet their financial obligations, leading to negative consequences for the broader economy.
To illustrate this point, let’s consider an example of an investment advisory business that provides services to clients for a fee, collected quarterly. However, to operate the business, the firm must meet daily or weekly expenses, such as rent and payroll. In case of unexpected expenses, the business may need to rely on a line of credit until the next billing cycle. This is a common situation for many businesses that face a delay between the sale of a product or service and the billing and collection of revenue.
If lines of credit are suddenly withdrawn, businesses may have to lay off workers, cut expenses, and take other measures to stay afloat. As a result, consumers may cut their spending, leading to reduced demand for goods and services and further intensifying the economic drag. This cycle can continue, leading to a recession.
Currently, we are witnessing a withdrawal of liquidity across all forms of credit, from mortgages to auto loans to consumer credit. This banking crisis is likely a warning sign of a deteriorating economic situation, and if left unaddressed, it could trigger a recession.
As previously mentioned, there is a bullish expectation that the Federal Reserve’s “policy pivot” will bring an end to the current bear market. However, this expectation may not be met as quickly as many believe. Historically, when the Fed cuts interest rates, it marks the beginning, not the end, of equity bear markets.
Recessions, which are often triggered by a banking crisis or other economic shocks, can cause a phenomenon known as “repricing risk.” This risk refers to the possibility that market participants will reassess the value of securities, leading to a downward repricing of assets. In a recession, investors may become more risk-averse, leading to a sell-off of equities and a flight to safer assets such as bonds.
As a result, equity markets can remain volatile for a prolonged period even after the Fed has lowered interest rates. It can take time for market participants to regain confidence in the economy, and the impact of the recession on corporate earnings may not be immediately clear. This means that the end of a bear market may not occur as quickly as bullish investors expect, and equity markets may continue to experience volatility for some time
Recessions Cause Repricing Risk
As noted, the bullish expectation is that when the Fed makes a “policy pivot,” such will end the bear market. While that expectation is not wrong, it may not occur as quickly as the bulls expect. When the Fed historically cuts interest rates, such is not the end of equity “bear markets,” but rather the beginning.
It is worth noting that most bear markets occur after the Federal Reserve’s “policy pivot.” This is because the policy pivot typically comes after an economic or financial event, such as a recession or credit event, has occurred.
When the Fed takes action in response to such an event, the market reprices to reflect lower economic and earnings growth rates. However, forward estimates for earnings often remain elevated well above the long-term growth trend. During a recession or other economic or financial event, earnings tend to revert below the long-term growth trend.
Therefore, even if the Fed makes a policy pivot, it may take time for equity markets to recover. Market participants may remain cautious and continue to reassess the value of securities, leading to continued volatility. It is important to keep in mind that the end of a bear market may not occur immediately after the Fed’s policy pivot, and that earnings growth may take time to return to long-term trends.
To understand this phenomenon better, it is helpful to examine the long-term exponential growth trend of earnings. Typically, earnings tend to grow at a rate of approximately 6% from one peak earnings cycle to the next. However, any deviations from this long-term trend are corrected during economic downturns.
The 6% peak-to-peak growth rate is derived from the roughly 6% annual economic growth rate. As recent data has shown, the yearly change in earnings is highly correlated with economic growth.
Therefore, during a recession or other financial or economic event, earnings are likely to revert back to their long-term exponential growth trend. Any temporary deviations from this trend, which may have been caused by factors such as tax cuts or other temporary stimuli, will likely be corrected during the downturn.
It is important to keep this in mind when evaluating market conditions and making investment decisions. While a policy pivot from the Fed may be seen as a positive development, it may take time for earnings growth to return to its long-term trend.
It is important to recognize that earnings growth is largely dependent on economic activity. As a result, the current earnings estimates for the rest of the year may not be sustainable if the economy contracts. The deviation from the long-term growth trend, which is currently above average, is unlikely to be sustainable in a recessionary environment.
There are two certainties facing investors.
- The Fed’s rate hikes started a banking crisis that will end in a recession as lending contracts.
- Such will force the Fed to eventually cut rates and restart the next “Quantitative Easing” program.