September 2023 Insights

In August, various markets experienced significant fluctuations driven by key events. Fitch Ratings downgraded the credit rating of U.S. debt (from AAA to AA+) during the month, coinciding with a notable increase in the yield on the 10-year U.S. Treasury Note, which reached 4.34 percent. This marked the highest yield since November 2007. As a result, the S&P 500 index declined 1.77 percent over the course of the month. Additionally, the price of a barrel of West Texas Intermediate (WTI) oil surged to its peak for the year, surpassing the $85 mark.

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July saw a continued rally in the equity markets, with the S&P 500 index gaining 3.11 percent. This impressive performance was fueled by cooling inflation and the resilience of the U.S. economy, despite the Federal Reserve raising interest rates by 25 basis points, reaching the highest level since January 2001, with a federal funds target range of 5.25 percent to 5.50 percent.

However, some of the positive factors that contributed to the rally may be shifting. Oil prices surged more than 15 percent in July after Saudi Arabia announced an extension of its one million barrel per day supply cut. Additionally, interest rates on the 10-year U.S. Treasury Note climbed above 4.0 percent, up from 3.32 percent in May. Furthermore, the U.S. dollar showed signs of strengthening, having declined by over 12 percent since last September. While a weaker dollar can benefit U.S. companies operating abroad by reducing product costs and potentially boosting profits, a stronger dollar may create headwinds.

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In the month of June, the U.S. markets rallied impressively as the overhanging concern of the debt ceiling was alleviated, providing a boost to market sentiment. Furthermore, a brief military coup in Russia emerged and dissipated almost as swiftly as it began, easing geopolitical tensions for now.

The Federal Reserve decided against raising interest rates in June. However, Federal Reserve Chairman Jerome Powell conveyed a clear indication that more interest rate hikes were on the horizon. During the month, the S&P 500 index rose 6.47 percent, the interest rates on the 10-year U.S. Treasury Note increased from 3.64 percent at the end of May to 3.81 percent, and the price of a barrel of oil dropped about $1 compared to the previous month, settling at around $70.50.

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May was a month of mixed performance in the markets.  The Dow Jones Industrial Average experienced a decline of 3.4 percent, while the S&P 500 index managed a modest gain of 0.2 percent.  In contrast, the NASDAQ Composite showed strength with a rise of 5.7 percent.  Additionally, the yield on the 3-month U.S. Treasury Bill increased from 5.10 percent at the end of April to 5.52 percent in May, reflecting concerns surrounding the U.S. debt ceiling negotiations.  Moreover, the yield on the 10-year Treasury Note rose by 20 basis points to 3.64 percent, and the price of oil dropped by more than 11 percent, settling just above $68 per barrel.

The market experienced significant volatility during May, largely due to ongoing debt ceiling negotiations in Washington D.C.  However, an agreement to raise the debt ceiling was ultimately reached, and it was expected to be signed by President Biden over the weekend.  This news provided relief to the markets, resulting in a rally on June 2nd, as the U.S. avoided the potential risk of default.

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In April, the S&P 500 index rallied 1.2 percent despite the Federal Deposit Insurance Corporation (FDIC) grappling with the third US bank failure in less than two months. First Republic Bank was the latest to fail, but the FDIC arranged for JP Morgan to acquire the majority of its assets under a “loss-sharing agreement,” with the FDIC providing $50 billion in financing to JP Morgan. This followed the failures of Silicon Valley Bank, Silvergate Bank, Signature Bank, and the Swiss National Bank’s orchestration of up to 100 billion Swiss francs in “liquidity assistance” to UBS for the takeover of Credit Suisse.

While the US Treasury Department’s spokesperson stated that “the banking system remains sound and resilient, and Americans should feel confident in the safety of their deposits and the ability of the banking system to fulfill its essential function of providing credit to businesses and families,” the reality is that the bank problem has not been entirely resolved. Many banks have invested heavily in bonds, which have depreciated in value due to the 20-fold increase in the federal funds rate within a year.

Consequently, many bank balance sheets are plagued with large unrealized losses, and as confidence erodes, insolvency becomes a real issue, with deposits leaving.

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In March, several banks failed or were in trouble, which prompted central banks to intervene with emergency liquidity injections to prevent further “bank runs.” As a result, interest rates on government bonds saw a significant decline, and some of the excess liquidity flowed into the stock market, which led to a 3.5 percent rally in the S&P 500 index for the month.

The yield on the 10-year Treasury note declined from over 4 percent in early March to 3.39 percent, and the 2-year Treasury yield fell from over 5 percent to 3.76 percent in eleven days.

In the previous report, it was noted that the surge in interest rates resulted in marked-to-market losses of nearly $1 trillion on the bonds held on the Federal Reserve’s balance sheet. However, given the Fed’s ability to create money, those losses were unlikely to have an immediate material impact. As regional banks lack the same capability, significant investment losses can create massive problems, as seen with Bear Stearns and Lehman Brothers in 2008.

Banks invest funds to generate interest to pay a small return on their deposit base, and they usually classify their bonds into two accounting categories: “available for sale” and “held to maturity.” Bonds in the “available for sale” category are marked-to-market, which means their value is based on current market prices. As interest rates increased, the prices of longer-dated bonds decreased in value, resulting in losses for banks holding such bonds.

Bonds categorized as “held to maturity” are not subject to the “marked-to-market” valuation requirements because they are not intended to be sold. However, a crucial exception to this is that if any of the “held to maturity” bonds are sold, the entire portfolio must then be valued at current market prices.

In early March, shares of Silicon Valley Bank (SVB) stock experienced a decline of over 60 percent in a single day following its announcement that it sold $21 billion in bonds and was in search of additional capital. This news indicated that the bank was either insolvent or close to it, which triggered a run on deposits.

According to reports, at year-end SVB had $91 billion in the “held to maturity” category that were worth just $76 billion. The $15 billion “unrealized loss” equated to almost all of SVB’s shareholders equity. This created stress on other banks such as First Republic Bank, PacWest, and Credit Suisse to name a few. Central banks flooded the markets with liquidity and other measures to stave off a panic.

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Following a 6.2 percent rally in January, the S&P 500 index fell 2.6 percent in February as the Federal Reserve raised interest rates for the eighth time since March 2022. By the end of the month, the yield on the 10-year Treasury Note increased to 3.92 percent from 3.52 percent, and crude oil prices (WTI) declined about $2 a barrel to just under $77, down from roughly $79 at the end of January.

As of February 28, 2023, the 3-month Treasury Bill yield was 4.88 percent while the 10-year Treasury yield was 3.92 percent. With short-term interest rates higher than long-term rates by 96 basis points (0.96%) – known as an inverted yield curve – the odds of an economic recession have increased materially as the “inversion” has persisted for the past 18 weeks.

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After a tumultuous year in the markets in 2022, when the Federal Reserve underwent an unprecedented interest rate hike cycle with an 18-fold increase in the federal funds rate over nine months and a war between Russia and Ukraine broke out, the S&P 500 index rebounded in January with a 6.2 percent rally. Interest rates on the 10-year Treasury Note fell from 3.88 percent at the end of 2022 to 3.52 percent on signs that inflation is decelerating.

In our last piece we highlighted the fact that despite the massive interest rate hikes in the second half of 2022, the S&P 500 index registered a 1.4 percent increase. While that was not something to cheer about, it was an indication that perhaps a good portion of the selling was behind us as stocks tend to bottom on bad news.

Another reason for the January rally is likely due to positioning. For example, net speculative S&P 500 futures contracts have been negative (net short positions) for 32 consecutive weeks, indicating a persistent bet that the S&P 500 index would decline. What’s more, a prominent Wall Street firm suggested that there was no reason for investors to take on risk, which is quite extreme. In addition, the fourth quarter saw equity fund allocations underweight by the most since 2005.

As a result, investor sentiment had gotten so negative, a small bit of good news had the potential to spark a rally.

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The financial markets had a challenging year in 2022 largely due to the Federal Reserve’s adoption and implementation of a radical, untested theory which allowed inflation to reach a 40-year high before the Fed changed course. As a result, the markets lost confidence in the Fed, which was reflected in lower stock, bond, and commodity prices, to name a few.

For the year, the S&P 500 index declined 19.4 percent and the yield on the 10-year U.S. Treasury Note more than doubled to 3.88 percent from 1.52 percent at the end of 2021. After dismissing inflation for more than a year, the Fed frantically tried to address the problem by increasing interest rates at a record pace.

At times, to be quite candid, the Jerome Powell-led Fed has been intellectually dishonest. In one instance, a former U.S. Treasury Secretary publicly called out Mr. Powell specifically for making statements that were “analytically indefensible.”

Another issue is that Chairman Powell often reads answers to questions at press conferences, which makes it look staged and gives the impression that he is not in command of the subject matter, followed by responses that seem to confirm it. As a result, the Fed’s credibility has taken a massive hit.

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