The present banking crisis has brought back memories of the 2008-2009 global financial crisis. So far, the financial contagion has been corralled, thanks to swift government action. The winners and losers, however, have changed.

 

Most readers are familiar with the term "too big to fail." It refers to the financial theory that asserts that certain corporations, particularly banks, and some other financial institutions, are so large and so interconnected that their failure would be disastrous to the greater economic system. As such, these entities must be supported by governments when they face potential failure.

 

Back in the day, when Britain ruled the world, the government had a hands-off attitude toward failing banks.  Over time, Parliament began to realize that the cost of bank failures in the Commonwealth was far greater than supporting them. Through the years (and many successive financial crises later), more and more governments worldwide began to get involved earlier and with more aggressiveness to avert bank failures.

 

Here in the U.S., we learned our own lessons during the Great Depression when 9,000 banks failed taking with them $7 billion in depositors' assets. In the 1930s, remember, there was no such thing as a Federal Deposit Insurance Corp. (FDIC). The life savings of millions of Americans were wiped out by these bank failures. Years later, the New Deal legislation reformed and bolstered the framework of the financial sector in America.

 

While we still pride ourselves in believing in free markets and private capitalism, the reality is that a great many industries in the U.S. are private-public partnerships. A case in point is the banking industry. In the U.S., the government needs banks to create money and foster economic growth. The banks need the government to prevent bank runs and act as a lender of last resort. It is a symbiotic relationship.

 

The Great Financial Crisis almost tipped us into a second, worldwide depression.  The government's actions, or should I say reactions, to the crisis were ad hoc at best. Lehman Brothers went through a chaotic bankruptcy. JP Morgan was arm-twisted into buying a rival for an amount that kept its bondholders intact. Other institutions were kept alive through huge capital injections that left both shareholders and bondholders intact. 

 

None of these public actions truly solved the problems that got the banks into hot water in the first place. It required many years, and cost billions of extra dollars, before those issues were solved. At the same time, there was an enormous backlash by the tax-paying public against the bank bailouts and the government's actions to protect shareholders and bondholders. Since then, both banks and governments have learned several lessons.

 

The intervention in Europe to save Credit Suisse, and the U.S. actions in the case of Silicon Valley Bank (SVB) and Signature Bank were aimed at strengthening the overall financial system rather than leaving it weaker. Signature Bank was shut down. At Credit Suisse and SVB, senior executives were fired, while both bondholders and shareholders lost money.

 

On the other hand, the banks that acquired these troubled banks are ending up with hefty gains on their balance sheets. Both banks were effectively sold at a negative sale price, which was the difference between the amount that the acquiring bank is paying for its new assets and the book value of those assets.

 

It seems clear that the lessons learned from the Financial Crisis are that in the event of a bank failure, bond and shareholders' risk capital can, and in this case, did go to zero. Protecting depositors and the financial system has now become the top priority of the government and the banking system. And that is as it should be.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

In the face of uncertainty over the fate of regional banks, the U.S. central bank hiked interest rates and said they would continue with their program of quantitative tightening.

 

Stocks fell and bonds rose after the FOMC meeting on Wednesday, however, the real drama was elsewhere. U.S. Treasury Secretary Janet Yellen was testifying before a Senate Appropriations subcommittee at the same time as the Fed meeting. She told lawmakers that she has not considered or discussed "blanket insurance" for U.S. banking deposits without approval by Congress.

 

Many traders in the markets had just assumed that since the government had made all depositors whole in both Silicon Valley Bank and Signature Bank, all depositors would be bailed out. Yellen made it clear that was not the case. That statement shook investors' confidence once again, given that there has been a continued outflow of deposits from smaller regional banks to the large money center banks.

 

Readers should know that the FDIC insures those with deposits of $250,000 or less, but that's the limit. To change that regulation, Congress would have to act. That would take time and in the hyper-partisan atmosphere of the present Congress, it is doubtful that the limit would be changed.  

 

Interestingly, those who listened to Fed Chairman Jerome Powell's answers in the Q&A after the FOMC meeting took away what they wanted to hear. Many in the bond market, for example, now believe that there will be no more interest rate hikes and that the Fed will begin to cut rates before the end of the year.

 

The financial issues that are plaguing the banks, they believe, will result in less loan growth across the entire financial sector. That will in turn slow the economy and put added pressure on the inflation rate. In other words, the regional bank crisis will do much of the work for the Fed going forward.

 

On the other hand, more and more economists are convinced that we are on the verge of an economic slowdown that will result in at least a mild recession. The Fed's continued tightening, which has already caused some breakage (regional banks) will go too far and risk a hard economic landing.  That in turn will cause corporate earnings to decline and with them the stock market.

 

My take is that nothing has changed after the FOMC meeting. Jerome Powell said he could pause further rate hikes, if necessary, but "rate cuts are not in our base case." He did not say we won't see further interest rate hikes in May and June. He did say that the issues in the banking sector were real, however, and triggered a credit crunch with significant implications for the economy and the markets.

 

To be clear, no one, not even the Fed, knows which scenarios will turn out to be correct, or maybe some of each will occur in some form or another. The point is that we are in an environment where every headline has the power to move markets up or down by more than one percent or more daily.

 

I said that will result in a choppy market, which will keep the major averages in a trading range. This week, the 200-day moving average (DMA) trendline of 3,934 on the S&P 500 Index was tested once again and bounced. Upside resistance is hovering around 4,012. That range will ultimately be broken when enough data points give the market a new direction.  

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

 

This week, gold briefly climbed above $2,000 per ounce. The precious metal is commonly thought of as an inflation hedge, but also serves a different function in times of financial stress. Gold can be a safety trade.

 

Gold is a highly speculative asset in the best of times. But, unlike bonds and stocks, it has one redeeming factor in times of economic slowdown, financial instability, and geopolitical tension. It does not carry the risk of an issuing entity collapsing, such as a bank or a government. There have been many examples of this throughout history.

 

The latest example was back in February 2022, during Russia's invasion of Ukraine. Gold spiked to $2,078 per ounce within the next month. Historically, gold has also functioned as an inflation hedge. In the aftermath of the Russian invasion, supply chain disruptions, especially in energy, food, and materials, pushed prices and the inflation rate higher. That aided and abetted the precious metals safety trade for a brief time.  

 

But gold's shine was diminished quickly when central banks around the world announced a tightening of monetary policy to combat rising inflation. Higher interest rates have always been kryptonite to the price of gold bullion. Gold bullion is stored for a fee, and that fee is based on the going rate of interest. Gold prices fell to $1,618 by November 2022. Higher interest rates ultimately trumped the safety trade.

 

As interest rate fears rose in 2023, gold continued to fall. It was largely dead money since the start of this year, trading at $1,832 per ounce just a month ago. The collapse of Silicon Valley Bank and Signature Bank in the U.S., and Credit Suisse's forced demise in Switzerland last week suddenly changed the calculus in gold investing.

 

As investors worried that money deposited in banks was suddenly at risk, they rushed into gold. The largest exchange-traded physical gold fund, for example, added 20 tons of gold to its ETF in a week. That was the largest single inflow of demand for gold since the Russian invasion. At the same time, yields on interest rates plummeted, as bond prices also jumped. The combination of lower rates and elevated risk provided a double boost to the gold price.

 

Investors need to realize, however, that in any safety trade, there is an implied risk premium that is embedded in the asset, in this case, the value of gold. The greater the risk, the higher the premium. Market Risk Advisory, a Japanese-based research firm, figures that based on historical interest rates, the price of gold should currently be trading around $880 per ounce in a riskless world. That would mean that the present risk premium, plus the impact of the decline in yields, is more than $1,000 per ounce of gold.

 

This week, due to the actions of the Federal Reserve Bank, the U.S. Treasury, the FDIC, as well as similar institutions in Europe, the fear of the investing public had been somewhat reduced. As a result, stocks went up and yields on most government and corporate bonds fell. As that happened, the price of gold fell more than $42 per ounce or 2.12 percent in just one day.

 

Does that mean that if the perceived risk of additional problems in the banking sector diminishes, the price of gold will fall further? It should--all else being equal — but all else is never equal.

 

Many believe that it will take some time before the banking sector returns to normal. U.S. Treasury Secretary Janet Yellen has said that she has not considered or discussed "blanket insurance" to U.S. banking deposits without approval by Congress. As such, some risk premium will likely remain in the price of gold going forward.

 

There is also the question of interest rates. The fear of financial contagion could deter further interest rises by the Fed in the months ahead. In addition, if the Fed feels they have tightened enough to slow the economy and reduce inflation, that would relieve the rate pressure on the price of gold. The direction of the U.S. dollar is also important to watch since gold has an inverse relationship with the greenback. The bottom line, there are more than enough reasons that could keep gold in play in the months ahead.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

The global banking sector took center stage as three U.S. banks bit the dust and a fourth large bank in Europe floundered. This puts the Fed between a rock and a hard place.

 

The Federal Open Market Committee meets this coming Wednesday and, before the collapse of the Silicon Valley Bank, was expected to raise interest rates by 25 to 50 basis points. Today, expectations are split between no rate hikes at all, and maybe one more hike of 25 basis points and then a pause.

 

Investors large and small held their breath last weekend in the wake of three bank failures. Fears of financial contagion swept the country throughout the week. Regulators acted on several fronts to contain the potential fallout. The FDIC announced that they would fully protect all depositors, while President Biden assured the nation that U.S. banks were solid.

 

The Federal Reserve bank also announced a new $25 billion bank term funding program that offers one-year loans to banks under easier terms than it typically provides.

 

Investors on Monday responded positively to the news, but the near collapse of yet another bank later in the week, this one a large European bank, Credit Suisse, had traders once again running for the hills. Banking stocks tumbled again.

 

Most Wall Street pundits blamed the Fed's rapid rate hikes over the last year for the banking fallout. As such, a rising chorus of alarmists is insisting that the Fed, needs to back off from any more rate hikes immediately. Over in the bond market, the vigilantes are betting that the new scenario is a "one and done" 25 basis point hike in March and then a pause. Some strategists are even expecting the Fed to begin easing its tight money policies by the middle of the year if not sooner.

 

The easing argument is that regulators (because of the bank failures) will soon be increasing the number of banking regulations in the financial sector, which will reduce their ability to lend money. If so, that would slow the economy, reduce inflation, and therefore do the Fed's job for them. In that environment, there would be no need to raise interest rates further.

 

As it stands, both the Consumer Price Index (CPI) and the Producer Price Index (PPI) for last month indicated some small progress toward slowing inflation. However, the data is not enough to dissuade the Fed from backing off its program. The economy is still growing, and employment is still much stronger than the Fed would like to see.

 

The question on many investors' minds is whether the Fed will back off at next week's meeting or risk further financial contagion and continue its interest rate hikes.

 

One indication that they will continue their program was the actions of the European Central bank (ECB) on Thursday. Beleaguered Credit Suisse was given a $54 billion liquidity lifeline by the Swiss National Bank. It may not solve the Swiss bank's problems, but for now, it appears sufficient.  investors still expected that the ECB's planned interest rate hike of 50 basis points would be delayed or even canceled.

 

Instead, the ECB hiked rates a half point and assured investors that the eurozone banking sector was resilient, adding that they stood ready to supply liquidity to banks if needed.

 

It was no accident, in my opinion, that U.S. Treasury Secretary Janet Yellen told members of the Senate Finance Committee almost the same thing assuring them that the U.S. banking system remains sound.

 

I am sure the Fed and the Treasury discussed the ECB's intended actions. In times of turmoil in the global banking system, central bankers confer with each other regularly, as do their counterparts in the Treasury. It seems to me that the odds favor Chairman Jerome Powell and the Fed following the ECB's lead and continuing with their tightening program.

 

Stocks have had a mountain of bad news this week and tested the 3,800 level on the S&P 500 Index, which was my downside target. From there, we bounced more than 160 points before falling back again. I expect markets will continue to trade in these wide swings until the Fed meeting in the middle of next week. From there, the market’s direction will be Powell-dependent. I am betting it is up.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

The recent calamity in the banking sector is complicated, but one issue stands out. Even the safest of investments have risk.

 

Understanding the relationship between bond prices and interest rates is extremely important. Bonds, overall, are considered safer investments than stocks and history indicates that bonds have been less volatile than stocks most of the time. However, when interest rates rise, bonds can get hurt for a variety of reasons, and credit risk is at the top of the list.

 

Credit risk refers to the possibility that a corporation (or a government entity) could default on a bond they have issued. That happens when the issuer fails to pay back the principal or cannot make interest payments. Normally, U.S. government bonds, called Treasuries, have lower credit risk. Presently, however, even Treasuries have some credit risk. If Congress refuses to increase the debt limit by this summer and allows the country to default, the consequences for our government debt could be grave.

 

However, all bonds have interest rate and duration risk. Bond prices and interest rates move in opposite directions. As interest rates fall (as they have for much of the past decade), the value of fixed-income investments rise. Since last year, interest rates have risen substantially due to the Federal Reserve Bank's efforts to combat inflation.

 

This is where duration risk comes in. Let's say you have long-dated U.S. Treasury bonds that do not come to maturity for 10, 20 or even 30 years from now. If you hold them to maturity, you will receive your principal investment back plus whatever interest rate coupon was promised. However, if rates rise (as they are doing now), and for whatever reason, you sell your bonds before their maturity date, you could end up receiving less than what you paid for your bond.

 

In general, duration is expressed in terms of years and generally bonds with long maturities and low coupons have the longest duration. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing interest rate environment. Over the last year, the Fed has increased interest rates at its fastest pace in recent history, which has caused the price of bond holdings to decline substantially.

 

Enter the Silicon Valley Bank (SVB) stage left. SVB, like most banks, relies on a mixture of short-term and long-term financing. The short-term side largely consists of customer deposits. A bank's assets typically consist of long-term loans that get paid back with interest over time as well as bonds the bank purchases that pay out over the term of the bond.

 

More than half of SVB's assets at the end of last year were "safe" bonds issued by the U.S. government or federal mortgage institutions, which they had purchased before the Fed's tightening policies began. Safe from default risk, maybe, but not from the climbing interest rates. And most, if not all, of those bonds, were low coupon, and long-term in nature — a classic case of duration risk.

 

The nightmare that all banks fear is a bank run. Think of "It's a Wonderful Life" and George Bailey's Building and Loan, a small community bank in Bedford Falls. Depression-era depositors, fearing for their financial lives, rushed to take their money out of Bailey's bank. Few depositors understood how credit and loans work. They thought their money was simply sitting in the safe. George tried to explain the concept but ended up making good for his customers by giving them his honeymoon money.

 

In the case of SVB, the same thing occurred, although, unlike George Bailey, the management of the bank could not make their depositors whole. For most depositors, there was no need to stand in line. A simple electronic transfer via computer transferred millions out of the bank in seconds. As a result, SVB was forced to sell bonds at a loss to satisfy depositor demands until it couldn't. The rest is history.

 

What may some readers have in common with SVB? In today's market, there has been a mad rush to capture higher interest returns after years of an interest rate famine. The U.S. Treasury markets, especially on the short end, have seen yields of 5 percent or above for six-month, one-year, and two-year notes and bills.

 

Putting excess cash into these high-yielding instruments and intending to hold them to maturity is a reasonable financial strategy. However, if you need to sell them to raise cash for an emergency may leave you open to losses. Remember that a bond's yield is not the same as the interest rate coupon promised at maturity on that instrument.

 

A six-month note may have been issued with a fixed 1.75 percent coupon, however, because of the Fed's recent interest rate hikes, the price of the note has declined. As it does the yield has climbed. 

 

You are in effect, buying that note at a discount to the original purchase price. If you hold the instrument to maturity, you will receive the full-face value of the note when it was issued, plus the coupon. That is ideal. But remember, yields will go up and down over time in an inverse relationship with the instrument's price depending on market conditions. If things change and you need to sell early, you may face the same issues as SVB. That is the risk you are taking when you buy Treasuries.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.