A Tsunami Has Formed

The Next Phase of The Earthquake Effect

Investors,

Fundamental risks to the broader financial system are rising, which has severe implications for the underlying economy. News about Silvergate Capital and Silicon Valley Bank were thrust to the top of the headlines this week, following initial concerns after Jerome Powell’s remarks on Capitol Hill earlier in the week. The failure of Silicon Valley Bank (SVB or $SIVB) has dominated financial news headlines for the past 48 hours, igniting the next phase of the Earthquake Effect that I shared in November 2022. The tsunami phase of the analogy represents market failures that can produce structural damage to the infrastructure of our financial system and economy.

We’re witnessing a modern run on the bank after California regulators shut down Silicon Valley Bank on Friday and put the bank under receivership at the FDIC. However, this reaches far beyond the borders of California, as Lawrence Lepard shared on Twitter:

Lawrence Lepard, "fix the money, fix the world" @LawrenceLepard

Shades of 1930’s. This is my bank in Wellesley this morning. Boston Private Bank, recently acquired by Silicon Valley Bank. Ruh, roh.

The FDIC is now directly involved with the task of insuring depositors up to $250k, while attempting to sell off the Bank’s assets to make all depositors whole. It’s vital to understand the scale and magnitude here: SVB had approximately $209Bn in total assets and about $175.4Bn in total deposits. According to a recent piece by Marc Rubenstein, “The Demise of Silicon Valley Bank”, the Bank had 37,466 deposit accounts with a balance larger than $250k, having an average account balance of $4.2M and total deposits of $157Bn. This is huge.

The chart above highlights the severity of the SVB situation, the second largest bank failure since 2001. However, it’s also appropriate to say that it’s the second largest in U.S. history!

Could anyone have seen this coming a year ago? Most likely not, considering that SVB was trading at $750/share in January 2022. Shares settled at $109 on Thursday, but overnight concerns caused the stock to plummet to $37/share. With the early morning announcement of the closure of the bank, shares didn’t even have a chance to trade on Friday.

SIVB from January 2020 - March 9, 2023

The stock is dead. Worthless. Caput.

A month ago, when shares were trading at $320/share, Jim Cramer himself said that “the fears were not justified and it’s a very compelling situation”. He continued by saying that “the stock is still cheap”. At one point, this stock had gained +51% YTD in 2023! You literally can’t make this up.

Literally five days ago, SVB posted the following on Twitter after being named to the Forbes list for America’s Best Banks…

SVB @SVB_Financial

Proud to be on @Forbes' annual ranking of America's Best Banks for the 5th straight year and to have also been named to the publication's inaugural Financial All-Stars list. 👉 bit.svb.com/3ZFxwyp

The point is, people didn’t even see this happening a month ago, let alone a year ago! Anecdotally, one of my connections on LinkedIn shared last weekend that she was accepting a director-level position at SVB. If there were concerns about SVB, would she have quit her prior position and taken the job? Most likely not.

When the tide of liquidity recedes via rate hikes and the Fed’s balance sheet reduction, market dynamics can get flipped on their head in an instant. No one knows with certainty who the next subject will be, but there will surely be more casualties. This was the nature of my mid-November piece “The Earthquake Effect”, where I highlighted how and why these types of contagion events were occurring. In that report, I shared the why a coastal earthquake was analogous to the current macro environment:

• Earthquake = inflation

• Tectonic plate displacement = Federal Reserve rate hikes & balance sheet reduction

• Receding water = tighter financial conditions & declining liquidity

• Naked swimmers = leveraged investors, scams/frauds, malinvestments

• Tsunami = recession, financial crisis, market failures, bankruptcies

At the time, contagion events were contained within the crypto industry, with the notable failures of Terra Luna, Three Arrows Capital, Celsius, Voyager, BlockFi, and then FTX; however, I acknowledged that further monetary tightening would lead to more failures in the financial system:

“Even if the Federal Reserve reduces the pace of their rate hikes, they are still raising rates. In turn, this will reduce liquidity, force the “ocean water” to recede further, and potentially expose more naked swimmers. As the tide goes out, we don’t know who will be exposed or how severe of an impact it will have on the broader market.”

Since then, the Fed reduced the pace of their rate hikes from +0.75% to +0.5% and now +0.25%. Either way, liquidity tightened and another naked swimmers has been exposed who was previously unsuspected of swimming naked.

Unlike the failure of FTX, which was largely contained within crypto, the failure of Silicon Valley Bank will have a much larger impact on actual economic and financial conditions in the United States. California is the 4th largest economy in the world (yes, the world) because of the growth engines in Los Angeles and the Bay Area. Many startups and technology companies will be impacted by this shutdown & liquidation, which we will understand more clearly in the months ahead. On Friday afternoon, the CEO and founder of Y Combinator, the startup accelerator & venture capital company, announced that more than 1,000 of their VC-backed startups are directly affected by SVB’s failure. These are startups that are potentially working on the next multi-billion dollar company, likely poised to become collateral damage. Publicly traded companies like Roku Inc. had $487M in deposits with SVB, roughly 25% of the company's total cash on their balance sheet.

Who’s to blame for this situation? First and foremost, Silicon Valley Bank. Whether it was for a lack of risk controls, lending requirements, capital allocation decisions, management, or culture, they fucked up. Big time. However, the Fed is the other culprit for the failure of the bank, as they’ve been the cause of the Earthquake Effect outlined above. From my perspective the Fed’s monetary stimulus (and the Federal government’s fiscal stimulus) are the primary engine of the inflationary cycle that we’ve experienced over the past 24 months, and the current tightening cycle is just an attempt to fix their mistake of excessive stimulus. If there wasn’t inflation, the Fed wouldn’t need to be tightening at such a considerable pace & magnitude. If the Fed wasn’t tightening at the ongoing rate, these market failures wouldn’t have happened.

It’s all connected.

Unfortunately, the Fed still isn’t done tightening, preparing to raise rates again in just a few weeks. The market is unsure whether or not they will raise by +0.25% (again) or revert back to +0.5%, according to CME futures, however, it’s worth noting that the odds of a +0.25% rate hike have risen dramatically upon the failure of SVB. On Thursday, odds of a +0.25% rate hike were 31.7% vs. Friday’s odds of 62%.

As it pertains to the Earthquake Effect, it doesn’t matter whether or not they do +0.25% or +0.5%! All else being equal, raising rates will accomplish the following: a tightening of financial conditions and a reduction in liquidity, both of which will exacerbate the Earthquake Effect. This is the exact point that I reiterated in my 2023 Market Outlook, published on January 1, 2023!

“Even if the magnitude and pace of rate hikes decelerates, which appears likely, higher real rates will tighten financial conditions and reduce liquidity. The longer they remain elevated, the more liquidity will decline. The combined effect of real rates that are higher for longer and the simultaneous reduction of the Fed’s balance sheet will apply pressure on the financial system and the economy. On net, this means that liquidity will continue to recede, potentially exposing more naked swimmers and creating a tsunami of fundamental economic pressure.”

I believed in this dynamic so strongly that the analogy became the centerpiece that underpinned my entire market thesis for 2023. I placed a probable likelihood that the U.S. would experience a recession or crisis (of any given magnitude), explicitly because the Federal Reserve was (and is) embarking on the largest & fastest tightening cycle in modern financial history. When the entire system has been built upon a base of zero interest rates for 10 of the last 14 years, there are going to be severe repercussions as the cost of capital rises, particularly at the ongoing pace & magnitude! This is why rate of change is so important, and we’ve just undergone the fastest rate of change in interest rates ever.

While the SVB situation is yet another naked swimmer exposed by the ongoing tightening cycle, this is the first contagion event to symbolize the formation of a tsunami in the distance. The ripple effect from SVB could lead to a wave of company shutdowns (clients/depositors of SVB), unemployment, markdowns, and potentially more bank failures. Even if there aren’t any casualties directly caused by SVB (highly unlikely in my opinion), continued tightening by the Federal Reserve will assuredly apply more pressure on the financial system, and therefore the economy.

Investors and market participants are finally waking up to this fact, scared by the potential unknown dominos that are yet to fall. After a significant resurgence in Treasury yields across the maturity spectrum since early February, yields plummeted in the second half of the trading week as a result of heightened economic risks. The 2-year Treasury yield had it’s largest 2-day decline (-0.46 basis points) in nominal terms since September 2008, the month that Lehman Brothers collapsed.

It’s important to note that this historically significant decline is happening because of the fact that rates are so high, trading at their highest levels since 2007. If we measure the percent rate of change, rather than the nominal decline, the current 2-day decline of -9.5% isn’t out of the ordinary:

Nonetheless, the bond market is signaling a bleak outlook for its expectations of the future. Investors, desperate for safety amidst rising uncertainty & risk, are increasing their demand for Treasuries. In turn, the yield on said Treasuries declines as a result of rising demand. Because Treasuries are perceived as a nearly risk-free asset, investors are willing to lend their money to the U.S. government for the promise of a yield (aka future dollars). With the YoY inflation rate at +6.4% as measured by the headline CPI data, why would investors be willing to “only” generate a 4.6% rate of return on their 2-year Treasury yield? Because they are scared about the future, and a -1.8% real return is better than a -6.4% real return from inflation.

It’s vital for investors to understand that yields always plummet at the onset of a recession, with bonds appreciating in value as investors desperately seek safe assets that can generate a return. During times of heightened uncertainty and risk, investors sell their equities and liquid dollar-denominated assets for the following two assets:

• Dollars

• Treasuries, of various maturities

When shit hits the fan, or people think that shit is about to hit the fan, investors flock to the assets that they trust in order to avoid the chaos. As we look at the asset markets this week, the price action is perfectly aligned with the narrative above:

• Dow Jones $DJX: -4.43%

• S&P 500 $SPX: -4.55%

• Nasdaq-100 $NDX: -3.75%

• Ark Innovation ETF $ARKK: -10.97%

• Bitcoin $BTC: -9.7%

• Ethereum $ETH: -8.8%

• Total Crypto Market Cap (excluding BTC & ETH) $TOTAL.3: -6.5%

It’s noteworthy to point out that the riskiest segments of the market, like ARKK and crypto fell much more than the equity indexes; however, the Dow Jones performed worse than the Nasdaq-100! This is because the Dow has significantly higher exposure to financials, and the SVB situation is causing fear within the overall financial & banking industry.

For example, look at the weekly returns for the following financial ETF’s:

• iShares U.S. Financials ETF $IYF: -9.05%

• iShares U.S. Broker-Dealers ETF $IAI: -11.4%

• SPDR S&P Regional Banking ETF $KRE: -16.03%

Meanwhile, bonds launched higher:

• iShares 20+ Year U.S. Treasury ETF $TLT: +3.64%

• iShares 7-10 Year U.S. Treasury ETF $IEF: +2.27%

• U.S. Treasury 2-Year Note ETF $UTWO: +0.6%

• iShares Short-Term U.S. Treasury ETF $SHV: +0.1%

Whether or not a crisis materializes in the months ahead, this is the exact dynamic that occurs when crises do materialize. We are in the thick of it now, where the market environment is shifting on a dime and valuations can suddenly dissipate. Premium members will know that I’ve been highlighting weakening momentum & deteriorating market dynamics for the past month in my paid weekly research. I’ve continued to stress the need for patience, risk management, and prudence in the market environment, using the hot YTD start as an opportunity to reduce exposure to tech & semiconductor stocks, while shifting into a more defensive portfolio allocation and increasing my cash position.

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On January 12th, I took advantage of a money market fund offering a yield of 4.3% with no minimum investment, provided by Fidelity, which has been my second largest position aside from cash. To be quite frank, I’ll likely allocate more capital to this MMF in the coming week, in addition to 1-year Treasuries that are offering 4.88%.

Amazingly, the 1Y Treasury yield was just offering 5.25% on Wednesday, March 8th! If this situation with SVB worsens, or unrelated entities begin to crumble, expect yields to plummet even more. Investors who buy these Treasuries today, locking in a 4.88% yield, will potentially be able to waive their Treasury to other investors if/when the 1Y is trading below 4% and say: “Hey, do you want more yield than the market is currently offering? Come and buy my Treasury at 4.88% for more than I paid for it!”

These Notes shouldn’t appreciate in value by a significant degree, but they will unequivocally appreciate in an environment where there is more demand for a “risk-free”, yield-generating asset. Investors who buy Treasuries today and choose not to sell can idly sit back and collect the yield until the Treasury matures.

It’s not sexy and it’s not exciting, but prudent investing isn’t designed to be either of those things. It’s designed to produce results that optimize returns per unit of risk.

Investors who refuse to accept this truth are potentially subjecting themselves to excessive risk in an environment that is not conducive to risk. As liquidity continues to get drained from the financial system, I fully expect that the ocean water will recede further and expose more naked swimmers who were previously perceived to be clothed. The silhouette of a tsunami is appearing on the horizon for the first time, but it’s far too soon to know when it will arrive on our shores. It could be in weeks, months, or even in 2024. There is nothing that guarantees that it will happen this year, or that the magnitude of the impact will be cataclysmic. The mystery and uncertainty about these events is what makes it so unnerving.

The February 2023 CPI data will be released on Tuesday morning, set to provide more clarity on the trajectory of inflation. After headline CPI came in at +6.4% YoY in January, median estimates are currently projecting that the February data will reflect an increase of +6.1%. This would certainly be a step in the right direction after a hotter-than-expected result in January. I still firmly believe that disinflationary pressures will continue for the remainder of 2023, and market failures like SVB will only improve the likelihood that inflation continues to decelerate. Services and core CPI are likely to stay sticky for the next few months, with the Shelter component still set to accelerate until April-July 2023.

The nonfarm payroll results for February were very resilient once again, with +311k jobs created vs. expectations of +205k.

While the unemployment rate ticked slightly higher, 3.6% unemployment is historically strong and was likely the result of an increased labor force participation rate. As people officially re-enter the labor force and begin looking for work, they are officially considered unemployed. When they weren’t looking for work, they were considered “discouraged workers” who aren’t counted in the unemployment rate statistics. Therefore, there’s a positive relationship between the LFPR and the UR.

We’ve seen a resurgence in service sector activity via the ISM data in recent weeks and the Atlanta Fed’s GDPNow Forecast for Q2 2023 is projecting an annualized growth rate of +2.6%, per their latest update on March 8th. While these backward-looking indicators & metrics are still showing encouraging signs about the fundamental U.S. economy, the Earthquake Effect will likely become the dominant market force in the months ahead, particularly as the tsunami approaches the shores of our economy & financial system.

I hope that the analogy of the Earthquake Effect is useful in your own understanding of market dynamics. If so, please like this post and share it with people who you think are interested and would benefit from the information above.

If you have any questions, please comment below and I’ll be sure to get back to you!

Best,

Caleb Franzen

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DISCLAIMER:

This report expresses the views of the author as of the date it was published, and are subject to change without notice. The investment thesis, security analysis, risk appetite, and time frames expressed above are strictly those of the author and are not intended to be interpreted as financial advice. As such, market views covered in this publication are not to be considered investment advice and should be regarded as information only. Everyone is responsible to conduct their own due diligence, understand the risks associated with any information that is reviewed, and to recognize that the information contained herein does not constitute and should be construed as a solicitation of advisory services. Cubic Analytics believes that the information & sources from which information is being taken are accurate, but cannot guarantee the accuracy of such information.

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