A major market move happened this week and no it was not Abercrombie’s (ahem) I mean Fitch’s downgrade of US debt. In regards to that, I would paraphrase Jamie Dimond, “If the US credit rating is downgraded below the other countries our military and economy supports, what does the rating even matter relative to them?”
Now getting back to the significant event…
Back in January I wrote how interest rates can affect a business plan and the challenges business owners have in a rising rate environment. Essentially when a small business begins raising funds, they have three options; (A.) they can offer to sell equity, (like on shark tank) or (B.) they can apply for a loan, or (C.) some combination of the two.
It is ideal for companies to raise money via equity sales when valuations are high, and markets are climbing. However, this usually happens in a declining interest rate environment, like 2020 and 2021. Conversely when markets are falling and interest rates are rising, businesses in need of funding are hit with both ends of the stick, because equity investments trend downward devaluing what they could get for their capital raise, and interest rates make the cost of borrowing even more expensive. Not only that, but banks are less inclined to make loans to riskier debt investments (such as a loan for a small business) because banks know if fed continues to raise rates, their debt investments will show unrealized losses on their balance sheets, which is not good for their investors. Much like what happened earlier this year, when banks reported $515 billion in unrealized losses for the first quarter of 2023.
So from a banks perspective using deposits to generate net interest income, you’ve got a few choices, invest in short term overnight funds (SOFR) rate and (historically) kick back a % of that to your depositors to keep their business. (B.) Invest in SOFR and don’t give depositors any kickbacks to maximize your own profit, which usually only works when investors are scared to move their money due to news of failing banks. (C.) Invest in treasuries to draw out the yields over a longer period of time. Or (D.) Make riskier business loans at a much higher interest rate.
If you are a bank and you think the Fed is going to keep raising rates, then it would not be prudent to invest in the long duration debt because in the case of a liquidity event like Silicon Valley Bank, you would end up losing money, so banks that have been more conservative with their investing have really increased option A activity.
However, this week we saw a spike in the longer duration treasuries that broke through the recent yield ceilings, indicating that something has changed. If you are not familiar with how that works let me explain. The yield on a bond is relative to the price. If the price of a bond goes up, the yield on a bond goes down. Imagine a bond pays $5 per year and it costs $100 the yield would be 5%. If there is a sudden surge in demand for that bond, (i.e., investors enter bidding wars to get it) causing the price of the bond to go up to $105, the yield would go down to 4.76%. Conversely investors might say, “I’m not pay a penny over 95 for that paper,” the yield would reflect 5.26%. So, any time we see a sharp increase in yields across the spectrum even to the point where short-term yields surpass long term yields, we can see that investors may be worried about a further decline in value or increase in Interest rates.
Now what happened this week that has been different than all the other weeks aside of from march of this year?
The 2-year treasury continuous futures prices revisited their June of 2007 lows.
Now everyone should ask, “Does that even matter?” Or is it “just another headline for equity markets to climb over?”
Whether you are worried about the markets or confident in their power to overcome obstacles, its important to know what your portfolio may be exposed to and whether that is what you are comfortable risking. That’s why Blacor offers a free tool for investors to gauge their comfort levels and identify what risks they are willing to make for their potential investment returns. Regardless of the economic weather, we not only search for the right investments for each investor, but also strive to sift out the investments that may not be fit for a client’s objectives.
Blacor Investments has provided Private Investment Advice since 1959. Our experience stems from three generations of investment professionals spanning 9 recessions and market growth cycles.
References:
FDIC: Speeches, Statements & Testimonies - 5/31/2023 - Remarks by FDIC Chairman Martin Gruenberg on the First Quarter 2023 Quarterly Banking Profile https://www.fdic.gov/news/speeches/2023/spmay3123.html
https://www.sofrrate.com/Secured Overnight Financing Rate (SOFR) (sofrrate.com)
Chart from Factset financial services.
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