SVB Collapse Likely to Discourage Rate Hikes

PGIM fixed income experts see a 25 basis point hike next week, no others this year as inflation is less of a risk than larger economic headwinds due to bank concerns.

The collapse of Silicon Valley Bank last week had the most immediate impact on the tech startups that helped make it America’s 16th-largest bank. But the ripple from its collapse is likely to impact everyday Americans by way of the Federal Reserve’s interest rate decisions, previously driven by inflation, according to experts at PGIM Fixed Income.

The collapse of SVB on March 10 was not an outlier, but a sign that the bank’s lack of risk management practices—partly due to not adjusting for rising interest rates—were not unique in the market, Daleep Singh, chief global economist at PGIM Fixed Income, explained on a webinar Thursday.

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In fact, there were “well above” $600 billion in unrealized losses on securities holdings across the U.S. banking sector by the end of last year, as people took out funds to take advantage of better yields from risk-free securities, according to the Newark, New Jersey-based firm, which manages $1.2 trillion in assets.

By the end of 2022, only about half of the total deposits in the U.S. banking system were insured by the Federal Deposit Insurance Corp., leaving almost $10 trillion in uninsured deposits, according to PGIM. That understanding by the Federal Reserve, U.S. Treasury and FDIC made them act quickly to create a Treasury-backed emergency facility to keep banks from having to sell long-term bonds at a steep loss to meet withdrawal demands, Singh explained.

“Even if your neighbor is smoking in bed and puts their own house on fire, firefighters will still come to put out it out to make sure the whole neighborhood doesn’t burn down,” he said.

What the Federal Reserve did not do, Singh emphasized, was adjust its balance sheet policy or signal any change to its interest rate trajectory. Whether that situation changes will depend on whether banks properly use the credit facility to stymie any further issues. That is no guarantee, Singh said, considering that at-risk small banks make up 40% of all lending in the U.S.

“The net impact on credit could be negative,” he said.

Singh believes the Federal Reserve will slow interest rate hikes despite a continued risk of inflation and a relatively strong job market. “We’ll get the final 25 [basis points] hike from the fed next week … and that will be the last in the cycle,” he predicted.

Overall, the economist noted three reasons he sees a stop to rate hikes following the SVB and New York-based Signature Banks collapses. The first is that tighter credit conditions will substitute for tighter monetary policy. The second, he said, is the threat of having to rescue the banking sector yet again after doing so during the financial crisis more than a decade ago. Finally, he noted that the risk of tightening the economy too much has shifted to doing too little to avoid a widespread contagion.

“I think it’s certainly possible, definitely desirable, to separate interest rate policy from financial stability policy,” Singh said.

Overall, large banks should be safer from collapse, as any outflows they see will likely be replaced by people leaving smaller firms for their relatively safer option, David Del Vecchio, co-head of U.S. investment grade corporate bonds at PGIM Fixed Income, said on the webinar.

“The large-money bank will be on the receiving end of some deposits,” he said. “They will be more likely to receive funds from some of these other institutions.”

Economist Singh said the banking sector is definitely not out of the clear.

“It’s not yet clear we are only dealing with a liquidity issue in the banking sector,” he said. “Illiquidity can lead to insolvency, in which case the Fed cannot control that, and other measures will need to be taken.”