Push Hard Enough and Something Will Break

I shake my head in wonder and disappointment at the actions of the central banks. The U.S. Federal Reserve, in particular, seems intent on breaking the back of the U.S. economy. Well, this week something broke.

The Silicon Valley Bank (SVB) collapsed into FDIC receivership. The unprecedented increase in interest rates (driven by central banks) forced the bank to sell its U.S. treasury bonds at significant losses. Nervous clients of the bank decided their funds were safer elsewhere and the run on the bank began. Unlike the classic film "It's a Wonderful Life", no Jimmy Stewart prevailed and the bank is shuttered. Why would central banks push so hard as to destroy a creditable bank?

I think it really started a decade ago. Central banks felt that if they maintained interest rates at close to zero both consumers and businesses would be encouraged to spend and invest. This proved to be the case but at incredible costs. Those of us that saved and did not utilize credit, paid the price. This policy of paying little on savings was nicknamed "Financial Repression". We were paid 0.25% on our savings with inflation running at +2%.

To no sensible person's surprise, these artificially low rates allowed inflation to come roaring back. The central banks, realizing their lagged response to inflation, jacked up interest rates at unprecedented speed. In doing so they rewarded the savers with bank accounts now yielding north of 4.5%.

Like a pendulum, the pressure swung from the consumer to the banks. When you deposit funds at the bank, a portion of deposits is held by the bank in government bonds (a prudent strategy). Trouble starts when the central banks force interest rates up causing government bond prices to go down. Bank clients get nervous, ask for their deposits back and the bank sells its bond portfolio (creating a realized loss on the bonds). The downward cycle continues until the bank is refinanced or defaults.

How might this situation be resolved? This situation occurred in the early 1990s and again more recently in 2018. The U.S. Federal Reserve in the fall of 2018 started to raise rates, spooking the bond and equity markets (equity markets experiencing a quick 20% fall). The Federal Reserve backed off in light of the financial fallout.

I suspect that political pressure will come to bear on the central banks. Why not be sensible, tone down the rhetoric and allow time to pass as inflation gradually falls to their desired 2% to 3% range? There is always a delayed reaction to changes in interest policy, jumping from tightening to easing in rapid succession helps no one. The Canadian central bank (sensibly) appears to have taken the position that rates have moved far enough and now is not the time to see if they can break the Canadian housing market.

For the individual investor, this situation is incredibly difficult. Cash and interest on bonds earned you next to nothing for 10 years. Now interest rates are attractive, but equity valuations have been damaged. There is no safe harbour!

In my view, investors should suppress a desire to alter their asset allocation based on current events. Do not zig when the central bank zags.

• Fixed income is more attractive than at any time in the last 10 years. Finally, bonds pay interest that is likely to have a positive return over inflation (if I look out to the next 5 years)

• Stock market valuations look reasonable. Equity markets had a terrible 2022. It is very unusual to experience two poor returning years in succession.

• Stay away from speculation. The crypto market lost $70 billion in valuation late last week.

Central banks "talk their book". Collectively trying to force changes in consumer behaviour. Reality and politics will intervene at some point to lessen their detrimental actions.

One can only hope that lessons have been learned. A more moderate, middle-of-the-road approach to interest rates benefits the great majority of us.

regards, Tim

Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your registered advisor for investment advice.