The certainty of policy uncertainty

By Atul Bhatia, CFA

In July 2012, the eurozone was in crisis. Large fiscal imbalances had led bond yields to rise, driving speculation that the currency union would fall apart. At the height of the crisis, Mario Draghi, then-chair of the European Central Bank, famously remarked, “Within our mandate, the ECB is ready do whatever it takes to preserve the euro. And believe me, it will be enough.” Draghi—in coordination with political leaders—backed up his words with concrete policies to stabilize markets. The measures worked, the euro stabilized, and the crisis passed.

In 2008, U.S. officials failed to produce a comparable soundbite, but they followed the same policy playbook: clear goals and decisive action designed to unambiguously draw an end to a crisis.

Unfortunately, we believe U.S. officials have forgotten those fundamental lessons. Instead, we see their recent actions as amplifying uncertainty and creating potential future risks. While we believe there is still ample time for policymakers to make fixes, we believe investors need to be cognizant of the long-term implications of what we believe are recent policy mistakes.

First, do no harm

Following the failure of Silicon Valley Bank (SVB) in early March, the Federal Reserve announced the creation of the Bank Term Funding Program, a way for banks to borrow against the face value of their government bond holdings and not their current market value. The difference between the market and redemption value of SVB’s bond holdings had been a major contributor to the bank’s rapid failure.

One interpretation of this move was that the Fed was repeating its actions of 2008—quietly using policy moves to communicate resolve to the market. In this case, the central bank would have been signaling to investors that it would not allow banks to fail if management had made sound credit decisions. After all, central banks were formed in part to prevent those types of failures by providing emergency liquidity against good assets.

An alternative interpretation was that the central bank was adrift and its move was driven only by expediency and the need to issue a press release, not a considered policy response.

Like many investors, we believed the former interpretation. But that was incorrect.

The collective misreading of the Fed’s actions was evident during the failure of First Republic Bank. First Republic, like SVB, held assets that deteriorated in value as interest rates rose. Instead of government bonds, however, its portfolio was heavily weighted in residential mortgages. Was there a difference in portfolio risk between SVB’s government bonds and First Republic’s over-collateralized mortgage loans made to high-net-worth households with outstanding credit scores? Absolutely. Is the difference so stark that it is readily apparent that SVB’s bond-style investments deserved a special Fed rescue program but that First Republic’s mortgage loan portfolio warranted the bank’s failure? That’s debatable, in our view.

The Fed’s failure to communicate any rationale for the apparent bait-and-switch to the market, sending a lifeline to certain sound credit decision-makers but abandoning others, puts its credibility at risk. We are concerned that in an inevitable future crisis, investors will look to the fine print of Fed programs instead of seeing a commitment to do “whatever it takes.”

Fed’s decision to limit term funding reduces uptake, broader consequences

Line chart showing the use of the Fed’s Bank Term Funding Program in both absolute and relative terms, as it grew from $11 billion on March 15, 2023, to $91 billion by May 24, 2023, which represented growing from 0.14% to 1.09% of all Fed assets. The chart compares that growth to the fall in First Republic’s share price from $122 on March 1, 2023, to $0.30 as of May 24, 2023.

• Federal Reserve Bank Term Funding Program, $ billion (LHS)
• First Republic USD/share (LHS)
• Term funding as % of all Fed assets (RHS)

Source – RBC Wealth Management, Bloomberg; data through 5/24/23

Change is in the air

An even graver mistake, we believe, was made by Treasury officials as they dealt with the fallout of SVB’s failure. Government officials took great pains to point out that investors would receive no assistance, even as depositors were retroactively protected on millions of uninsured assets.

To be clear, there are incredibly strong arguments in favor of the government’s stance. Investors, we believe, should reap the consequences of their decision-making, and bailouts create a moral hazard and often sow the seeds of the next crisis.

But we also believe the government’s stance is a change from investors’ existing reasonable expectations. During the 2008 financial crisis, investors in most banking institutions did not suffer permanent losses even as the government pumped in billions of dollars to support the financial system. Our concern is that policymakers have failed to consider the implications of their new stance.

With a potential total loss now on the table, investors may rationally demand higher yields for their non-deposit bank investments, and they will likely also look to exit their holdings faster if concerns rise. Banks can, of course, pay higher coupons on their bonds to attract investors, but will that level make economic sense? After all, banks will eventually need to make a loan at a higher rate to pay off bond holders. At some level, they will likely decide the additional funds can’t be justified and the banks will be forced to commensurately reduce their lending activities. Faster exits may be rational for an individual investor, but it can also lead minor problems to magnify and spread more quickly.

We are concerned the Department of Treasury—while reaching for the no bailouts sound bite—has created conditions that undercut the overarching policy goal of a stable and resilient banking system. We are confident that regulators and legislators will eventually put forward a coherent plan, but we are concerned that so little forethought goes into the implications of policy pronouncements.

Boringly predictable has benefits

Policy mistakes have not been confined to banking. The turmoil associated with raising the U.S. debt ceiling has not, in our view, been helpful to the economy or investors.

Whatever one’s political beliefs, our view is that the process of making fiscal policy has been weakened by recent events. Even if this round of negotiation leads to smart fiscal moves—and we take no position on that—the ability to fundamentally alter government budgets in a rapid, opaque, and difficult-to-predict process is not helpful to anyone.

Will future debt ceiling increases be accompanied by large increases in personal or corporate income taxes, for instance? Or will new waves of permit requirements be introduced at a future negotiation? Investors, individuals, and corporations order their financial lives based on reasonable expectations of the rules of the game. Stability and predictability have real value and that value has been tarnished, in our view.

Words matter

The most powerful tool policymakers have is their ability to drive investors and economies using words to signify intent, and the power of those words boils down to credibility. We are concerned that recent events have cast U.S. policymakers in a less-than-ideal light, leading to questions on their degree of commitment—and degree of forethought—as they engage in critical decision-making.