The collapse of Silicon Valley Bank has led to a surge in signs that a recession is likely.
After SVB’s sudden Friday implosion and Sunday’s federal takeover of credit lender Signature Bank, investors appear to be betting that a recession is in store.
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Prior to the bad news about the banking sector, more economists had been suggesting that the Federal Reserve might be able to bring down inflation without plunging the economy into recession, but now economic indicators are making that scenario look less likely.
Markets
The markets are reacting to the Silicon Valley Bank fallout. While the Dow Jones Industrial Average, the Nasdaq, and the S&P 500 all opened down on Monday morning, they have since recovered.
Still, plunging individual stocks for some regional banks are causing fears that more bank failures might be in store for the economy as skittish investors weigh recession odds.
Shares of San Francisco-based First Republic Bank plunged by more than 73% after opening but have pared those losses a bit. Western Alliance Bancorp was down by some 65% at one point and PacWest Bancorp was off by 36%.
But even more cause for alarm is what is happening in bond markets.
The yields on U.S. Treasurys nosedived on Monday, continuing declines incurred late last week. At one point, the yield on the 10-year Treasury fell by 0.2% to 3.498%. The two-year Treasury yield was down a full percentage point since Wednesday — the worst three-day plunge since 1987 after the infamous crash known as “Black Monday.”
Those two yields are also inverted, meaning the shorter-term yields are higher than the longer-term ones. Yield curve inversions are a top warning of recessions, as they show investors expect growth to drop in the weeks ahead.
The yield curve is now deeply inverted for the first time since 2007 when it portended the recession that began in December of that year as the financial crisis took hold.
Mortgages
Mortgage rates, gauged by Mortgage News Daily, which tracks rates on a day-to-day basis, have dropped to 6.57% on Monday, down by nearly 0.2% in one day alone. That is nearly a 0.5 percentage point plunge in just the past week alone.
Mortgage rates move somewhat in tandem with interest rates, so the sign is an indication that the market is betting on the pace of rate hikes to slow. Many economists also see the housing market as already in a recession, one which will begin to ripple through the broader economy as construction demand and projects dry up.
Researchers at Goldman Sachs recently predicted that housing in several overheated cities in the western part of the U.S. will see massive price declines this year. The firm predicts that places such as Austin, San Jose, Phoenix, and San Diego will grapple with price declines of more than 25% from their most recent high over the next year or so, owing in part to the Fed’s rate hiking.
The Fed
At the heart of Silicon Valley Bank's demise are the Federal Reserve’s policy actions.
Desmond Lachman, a senior fellow at American Enterprise Institute, said the Fed created a “huge mess” by being too easy with its monetary policy in the wake of the pandemic. During that time, the Fed slashed interest rates to near-zero levels and kept them that low until the beginning of last year. Since then, rates have soared as Fed officials grew ever more concerned about inflation proving stubbornly high.
“When money was very easy, everybody thought that this was going to last forever so they did stupid things. Now what is going on is the Fed is having to raise interest rates because it’s got to fight the inflation,” Lachman told the Washington Examiner.
Before Silicon Valley Bank's collapse, many investors were predicting a rate hike next week that was even bigger than the last. Now that confidence in more aggressive increases has evaporated.
There is now about a 25% chance of no rate hike at all, according to CME Group’s FedWatch tool, which calculates the probability using futures contract prices for rates in the short-term market targeted by the Fed. There is also about a 75% chance of a mild hike of 0.25 of a percentage point.
In sum, if the Fed opts for a milder rate increase (or no rate hike) it would be an indication that the central bank thinks doing so might bring on a recession and a subsequent wave of unemployment. Lachman thinks it’s likely the Fed pauses its rate hiking this month.
What’s next?
Lachman said the Silicon Valley Bank collapse does raise the odds that the Fed will cause a hard landing, a scenario in which the central bank isn’t able to avoid a recession in its quest to tame inflation.
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“If you’ve got problems in the financial system and everybody is anxious about what is going to happen, sure, that raises the odds of a recession,” he said.
By raising interest rates quickly, the Fed is causing stress in the financial market. More banks are likely to fail before this is all over, Lachman noted. Although, he said that because the government is stepping in to keep depositors at Silicon Valley Bank whole, it is preventing contagion from spreading.