This article originally appeared in the National Post.
By Philip Cross, March 15, 2023
The events leading to Silicon Valley Bank (SVB) closing its doors look from the outside to be just another mysterious bank run. Its only apparent significance for many analysts was as the most dramatic example of how the fortunes of the once-booming technology sector have soured, following widespread layoffs at major corporations such as Meta and Amazon. However, students of the history of business cycles see SBV’s collapse as part of the inevitable blow up of investments made on the expectation that interest rates would stay low indefinitely. Financial markets are realizing rates will be higher for longer than expected.
SVB, like many banks, held many of its assets in long-term government bonds. As interest rates skyrocketed over the past year in response to accelerating inflation, the price of these bonds fell sharply (interest rates and bond prices move in opposite directions). With rumours circulating that the SVB balance sheet was weakening as bond prices fell, depositors began to withdraw funds rapidly. The bank could only raise funds in the short-term by selling more of its assets, putting more downward pressure on bond prices and depressing the value of the bank’s assets on its balance sheet until it was insolvent.
There are at least two lessons from the SVB fiasco. One is that during the period of low or even negative interest rates engineered by central banks during the pandemic, investors moved into a wide range of risky investments. The list of investments that briefly surged during the pandemic and have since receded include Special Purpose Accounting Companies (SPACs), cryptocurrencies, the real estate market and technology stocks. These investments have faltered as interest rates normalize, encouraging investors to return to the safe haven of money market funds and other short-term deposits.
Central banks encouraged the move into riskier assets through their policies of low interest rates and quantitative easing. They did so because such policies appeared to encourage more spending as investors earned higher yields from risky investments while discouraging saving. The problem always was how that increased risk would be managed if asset prices suddenly reversed, especially if interest rates escalated rapidly. This is what happened in 2022 in response to soaring inflation.
One can understand why investors bet on interest rates staying near zero. After all, central bankers gave their word on interest rates being lower for longer. For example, Bank of Canada Governor Tiff Macklem made the extraordinarily rash promise in the summer of 2021 that “interest rates are very low and they’re going to be there for a long time. If you’ve got a mortgage or if you’re considering making a major purchase, or you’re a business and you’re considering making an investment, you can be confident rates will be low for a long time.”
Macklem had to walk back his promise early in 2022 as he belatedly raised interest rates. However, investors and households could not restructure their finances as quickly as central bankers changed their economic outlook and interest rate policy. Bill Dudley, former head of the New York Fed, warned that one of the problems with central banks being slow to raise interest rates is that they then had to hike them rapidly, leaving less time to evaluate the impact of previous increases. This increased the risks of rates over-shooting and creating a deep recession or stressing the financial system.
Rather than taking their cue from fallible central bankers, investors would have been better off heeding the words of one of their own. The legendary investor Warren Buffett once wrote that “only when the tide goes out do you know who’s been swimming naked.” As interest rates return to more normal levels, they will expose other investors in vulnerable financial positions like the SVB’s.
It always was naïve of central banks and gullible investors to think that the only financial cost of normalizing interest rates after a decade of easy money policies would be a brief dip in the stock market, especially after the huge increase in debts incurred during the pandemic. There will be more casualties as markets realize that central banks have consistently erred about inflation, first by mistaking its initial rise in 2021 as temporary, then by delaying higher rates until 2022, and most recently by signalling a possible pause in their tightening. Central banks would have served the public and investors better if they had clearly signalled their intention to raise interest rates rapidly in their relentless determination to return inflation to its target rate and stabilize financial conditions.
Philip Cross is a Senior Fellow at the Macdonald-Laurier Institute and former Chief Economic Analyst at Statistics Canada.