While the February U.S. employment report, and its implications for U.S. Federal Reserve (Fed) policy, was supposed to be the major market event of last week, markets have been roiled by the collapse of Silicon Valley Bank (SVB), which fell victim to a classic deposit bank run to become the largest U.S. bank failure since Washington Mutual in 2008.  Countless headlines and opinion pieces have popped up since SVB’s failure, with varying views on just how wide-reaching the effects of the collapse may be, and the likely policy implications.

While the situation is likely to remain dynamic for some time, one clear impact is the dramatic repricing of interest rates and expectations for the fed funds rate.  In only four business days (March 7-10), yields on two-year U.S. Treasury notes have plunged, from 5.1% to 4.1%, while expectations for the fed funds rate by the end of 2023 have fallen from 5.45% on March 7 to 4.03% on March 13.  This move reflects a view among some investors that recent events are proof that the Fed has inflicted enough economic pain via its series of interest-rate hikes and will need to pivot aggressively to contain potential systemic risks.  However, the fact that the surprise closure of SVB occurred during the trading day on March 10, hours after the release of monthly payrolls data for February, underscores the fact that the Fed must still navigate a variety of potentially conflicting pressures.  While there is much we still cannot know yet about the extent to which depositor panic may impact other banks, and the extent of the response from the Federal government, we will also get a number of economically significant economic releases this week, including the latest CPI and PPI reports, as well as monthly retail sales activity.

Said differently, the Fed must balance the needs of the hour with the needs of the year.  Markets are understandably focused on the potential turmoil in the banking industry.  However, the central bank must balance policy response with both short-term and long-term needs, and we caution investors against conflating the two.

Silicon Valley Bank (SVB), a unit of publicly traded SVB Financial Group, was the go-to bank for the venture capital (VC) economy, where it had 50% market share and was growing rapidly. Nearly all its deposits were from these VCs and tech-related firms, which is an unusual level of depositor concentration. Because so many depositors were commercial enterprises, nearly 90% of these deposits were uninsured (above the $250,000 limit from the Federal Deposit Insurance Corp.). SVB’s deposits increased at an extraordinary rate over the last few years because of high levels of start-up tech funding and money flooding into private equity. The bank deployed 70% of that cash into fixed-rate, low yielding bonds (mostly Treasuries and mortgage-backed securities).

However, that dynamic reversed abruptly in the past year, as the bank’s clientele burned through cash at a higher-than-expected rate, quickly reversing the deposit growth.  SVB opted to sell some of their bonds to raise cash, then raise capital, and reinvest the cash at higher rates. However, SVB’s situation worsened because of the optics of selling the bonds at a loss before raising capital.  When the stock fell 30% in response, some VC firms began advising clients to pull deposits, which created a classic bank run. An additional $42 billion in deposits was pulled out Friday and the FDIC stepped in to put the bank into receivership and did the same for Signature Bank on March 12.

While the SVB failure is notable, it is not large enough on its own to create these extraordinary market dynamics.  Rather, markets are concerned about a contagion effect, where panicked investors pull money out of other banks, creating a larger systemic issue.  In part because of this difficult-to-quantify risk, the Treasury, Fed, and the FDIC announced on the evening of Sunday, March 12 that depositors in SVB would remain whole and have access to their funds on Monday, March 13, funded by the FDIC.

The SVB news comes against the backdrop of data showing a still-strong U.S. economy. The February jobs report showed an increase in the jobless rate and moderating labor-cost growth, but also displayed stronger-than-expected aggregate job growth. The segment of the jobs release that surveys U.S. households reported that the unemployment rate rose from 3.4% to 3.6%, a rise that would normally only take place in a sharply slowing economy. However, the 3.6% jobless rate is still extremely low, indicating that the economy is operating above full employment, and some of this increase is due to a welcome rise in labor force participation.

Meanwhile, the part of the report that surveys U.S. employers showed that nonfarm payrolls increased at a greater than expected 311,000 in February, a pace of employment gains well in excess of the 50,000-100,000 that is consistent with normalized monthly labor force growth. That implies the economy continued growing rapidly during the month and was even farther above full employment than previously thought. That’s the exact opposite message from the one delivered by the household survey.

In addition, average hourly earnings only rose 0.2%, a sign of diminishing inflationary pressure despite a red-hot labor market. However, because earnings growth in February 2022 was even lower, year-over-year average hourly earnings gains increased from 4.4% to 4.6%.

On its own, the mixed jobs report would probably tilt the Fed towards a 25 bp increase in the fed funds rate at its March 20-21 meeting. However, given the short term uncertainty in the banking sector, we would not be surprised if the Fed adopts a “wait-and-see” approach at its March meeting that should not be viewed as a broader change to their longer-term focus. Data on U.S. consumer prices for February and other releases scheduled for the week of March 13 will still factor into the Fed’s future rate plans, though to a lesser degree given the need to address the continued fallout from the SVB failure.

Some analysts have suggested the abrupt collapse of SVB is proof that the Fed has already hiked too far and must cut rates soon to minimize the damage.  We disagree, as the inflationary pressures in the economy have not yet abated, nor are they likely to have done so by the time this bank scare has played itself out.  As we have discussed in the past, there are many implications associated with the abrupt shift away from the decade-long low-rate regime, and surprise discoveries of companies and sectors that were overly dependent on low rates is part of that process.

However, as painful as the events around SVB may prove to be, we do not view them as systemic, nor do we view them as fundamentally changing the Fed’s longer-term focus. While we can safely rule out a 50 bps Fed hike off during the March meeting and will not be at all surprised to see policymakers pause and assess conditions at that time, it is important to remember that the central bank has many policy levers for ensuring the health of the financial system, even as it retains its longer-term focus on longer-term issues.