Aftershocks part 3: Ripples still widening. Technology borrowing costs now 63bp LOWER than banks and VIX closed below 20 1st time since SVB.

It has been nearly 3 weeks since the sudden failure of SVB and the aftershocks continue. The biggest impact from the banking crisis is the market’s expectations for Fed policy has legged lower — obvious from looking at Fed Funds futures (now sees >50bp cuts by YE) and intuitively makes sense (credit tightening which is a substitute for rate hikes) and that combined with general heightened caution by consumers means inflation is set to weaken materially in the next few months.

• Probably obvious, but the aftershocks of the SVB failure, in our view, are the most important on the margin for markets. These ripples are widening and as we noted early in this crisis, First Republic (FRC) is a battleground stock and already significant actions have been taken by a coalition of banks and by regulators. How the FRC situation is resolved is also important as the implications for bank equity and debt holders will become clear — there is little doubt that depositors will have protection, but the uncertainty is really around the size of haircuts for equity and debt tranches.
• And the ultimate size and scope and severity of the banking crisis will determine the path of equities. Because we are in the midst of this crisis, one cannot necessarily have high conviction in either direction. But our case remains that the outcome ultimately favors staying long equities into end of April.

• Let’s start with the bearish risks. With GFC (2008 financial crisis) still fresh on investor’s minds and experiences, and given the fragility of depositor confidence in a digital world (move money easily), a significant level of stress is priced into bank debt and equity:
  – CDS spreads for major banks are elevated including JPM 1.11%  C -0.14%  DB -1.28%  etc
  – Bloomberg reported that DB’s rout was caused by a relatively small $5mm CDS bet (article –> here)
  – Regional bank senior debt trade below par (see below) with several in the 50s (% par)
  – On other hand, Bank inv grade spread (OaS) is 190bp (BBG I09860US Index <>), while elevated, not near 600bp seen at GFC
• Just because markets (and many investors) believe this is 2008, doesn’t mean this is 2008 again — meaning, a full blown financial crisis is not inevitable. And that distinction is key. After all, there is a liquidity crisis. And the tightening of credit, particularly around commercial real estate, means more stress for banks. And even then, it is not inevitable this is a full blown crisis. This is an uncertainty and therefore a risk.
• On the flip side, there are signs that overall stresses are easing within credit, albeit from tight levels. The MOVE Index has edged back to 156 after surging to a 2009-like 200 post-SVB. A sub-125 reading would be best but this shows that implied volatility is easing in credit/rates markets, despite continued uncertainty around FRC/DB and other ripple effects.
• Senate/House hearings continue, this week focused on regulator’s response and Wed 10am ET is the House Financial Services Committee hearings (link–> here) and as CNBC outlined earlier on Tue on Closing Bell (link –> here), Fed regulators saw red flags for SIVB 0.00%  SIVBQ as early as end of 2021. The broader implication, in our view, is this will likely pressure Fed/regulators to step up their own measures to compensate for earlier inaction. As Dan Loeb, founder of Third Point, has been known to say “markets can stop panicking when regulators start to panic.” The current regional bank crisis has not yet reached that point, but developments could be pushing regulators in this direction towards need to “panic.”
• On the plus side, the VIX closed below 20 (Tue) for the first time since 3/10/2023 (see below). The VIX term structure is also back into normal contango with 4M less 1M spread positive at +2.3 vs negative between 3/10 to 3/15. This normalization of spread is often a sign investors see the worst of the crisis behind.
• That is generally a constructive sign and is certainly counter to the general gloom of investors post-SVB failure. This ultimately becomes an important point. If investors are gloomy and expect a financial crisis to follow, but this doesn’t happen, this means sentiment and positioning will be key. In many ways, this could be the setup now.
• The yield (to worst) of investment grade Technology (IG Tech) debt has fallen to 4.98% in the past week from 5.5% on 3/8. This is a sizable drop in cost of funding for IG Tech. And is -63bp lower than the 5.61% cost of debt for investment grade banks. Think about that. It is now far cheaper for Technology stocks to borrow in debt markets than it is for banks. This spread has widened dramatically since SVB crisis.

BOTTOM LINE: Equity markets moving higher for past 6 months (Oct low) and if stocks do not make a new low post this crisis, the bears could capitulate

There is a lot of uncertainty injected by the banking crisis. But this same crisis has arguably brought more certainty to the trend of inflation — the combined impacts of credit tightening and uncertainty plus impacts on start-ups means inflationary pressures are far lower today than compared to the start of the year.

• to us, this decline in inflationary pressures supersedes other factors, as it enables the Fed to become less singularly focused on inflation
• as such, this becomes the “bear dilemma” — if equity markets do not make a new low in coming months, what will be the catalyst for a new low?
• granted, bears are convinced EPS declines are the next leg lower as a “hard landing” is on the horizon
• but if equities continue to strengthen, and they are flat for the month of March despite this crisis, then creating new lows is harder to achieve
• and what is the counter-state to “bears expecting new lows?” It is bears becoming reluctant bulls.

VIX: Falling below 20 is positive progress

The VIX on Tue’s session closed below 20 for the first time since SVB failure. This is a positive as we noted above.

And the VIX term structure shows that the inversion of 4M less 1M VIX has righted itself.

• VIX TS was inverted from 3/10 to 3/15 as markets grappled with aftershocks of SVB failure.
• but the normalization is a good sign historically.

And similarly, bond volatility aka MOVE Index, has moved below 160 and now 156, after surging to >200

• this pullback is a good sign but it is still elevated
• falling below 125 and ideally 100 would be a sign the crisis is ebbing

TECHNOLOGY: Borrowing costs lower than Banks.

The cost of funding for investment grade Technology is now well below that of banks as shown below:

• after peaking at 5.5% cost of debt (yield to worst), Technology funding costs are now 4.98%
• this is 63bp less than the cost of financing for a bank
• this is peculiar and another reason why investors are buying Technology stocks.

Perhaps it is not surprising to see investors allocate into Technology stocks. The Bloomberg article below reports that Technology stocks saw the largest one week inflows in more than a year:

• with lower overall interest rates
• lower cost of borrowing (higher equity returns)
• shouldn’t this also be supportive of Technology equities?

And despite all the gloom around banks, the spread (options adjusted spread, or OaS) is at 184bp:

• this is elevated from ~60-80 before Fed tightening
• but is not at stress levels seen around GFC of 600bp or higher
• even during pandemic peak, it was 325bp
• so 184bp today is a far more modest level

CRISIS PROGRESS: Status of 4 key indicators to see first signs the crisis ebbing

As we have mentioned recently, we get the sense that investors are being patient. They want to see how markets react to these multiple actions and how the Fed responds to the market turmoil. This means stocks are buffetted by these aftershocks.

The natural question is what are the signs this crisis might be ebbing?

• First Republic (FRC) comes to a resolution
• MOVE Index (bond volatility) below 150 (156 now) and hopefully settles below 125
• VIX Index falls below 20
• Regional bank deposits stabilize (Tables 9 and 10 of Fed’s H8).

The congressional hearings continue on Wed (see below) with House Financial Services Committee hearings.

And as CNBC highlighted below, there are some red flags that regulators missed on SVB as early as end of 2021. The CNBC clip is here –> link

But this ties to the issue that FRC remains a festering issue

• since 3/10, despite several bold measures including a coalition of banks injecting $30 billion of deposits and regulators establishing the BTFP facility, FRC equity and bond prices have not recovered
• The distress around FRC remains festering as the stock is ~$12 from ~$150 pre-SVB and bank debt trades at ~55 (% par) vs ~77 pre-SVB.
• and as we noted previously (below), other regional banks are seeing similar pressures. How regulators/Fed handle FRC will be a template for how bank equity/ debt holders ultimately fare.

Similarly, would be good to see bank CDS rally further. Some progress but not enough.

ECONOMIC CALENDAR: U Mich next week most important in our view

There are some key inflation data points this week:

• most notably PCE deflation for Feb (its late)
• U Mich 1-yr inflation March final (more important)

Key incoming data starting March 19

• 3/7 10 am ET Powell testifies SenateHawkish
• 3/8 10am ET Powell testifies House Neutral
• 3/8 10am ET JOLTS Job Openings (Jan)Semi-strong
• 3/8 2pm ET Fed releases Beige Book Soft
• 3/10 8:30am ET Feb employment report Soft
• 3/13 Feb NY Fed survey inflation exp. Soft
• 3/14 6am ET NFIB Feb small biz survey Soft

• 3/14 8:30am ET CPI Feb Tame
• 3/15 8:30am ET PPI Feb Tame
• 3/17 10am ET U. Mich. March prelim 1-yr inflation BIG DROP
• 3/22 2pm ET March FOMC rate decision DOVISH
• 3/31 8:30am ET Core PCE deflator Feb
• 3/31 10am ET U Mich. March final 1-yr inflation

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