Despite the recent stress in the regional banking industry, both the stock and bond markets performed well last month. As a result of the situation, hundreds of billions of dollars left banks and flowed into money market funds that invest in Treasury bills, which now offer close to a 5% yield. Furthermore, the ten-year government bond rate has dropped to around 3.3% from its peak of almost 4% in late February, and is now a full percentage point lower than it was last October. This drop in rates could potentially benefit banks, as the main problem they have faced so far is losses on their loans due to rising interest rates. Additionally, the lower rates may lead to increased activity in the real estate market.
Last month, the stocks that experienced the biggest gains were often those that had the most significant declines in 2022. Precious metals funds saw an increase of over 10% as investors speculated that the Federal Reserve would need to lower interest rates and take a more relaxed approach to combating inflation due to the recent bank panic. Additionally, many investors sought out supposedly safe assets during the crisis. However, it should be noted that gold has a questionable track record when it comes to protecting against financial crises.
In March, the main action in the stock market was in large-cap growth and technology stocks, which saw gains of 5 to 6% in most funds in these areas. Our recently re-added Vanguard Communication ETF (VOX) fund was our top performer, with a return of 6.87%. Additionally, our single country funds performed well and outperformed the S&P 500 as the US dollar weakened.
There's a growing myth that the US dollar is losing its reserve status. Firstly, given our large investments abroad, a drop in the dollar wouldn't be all that bad. Secondly, it's highly unlikely to happen in my lifetime. Other countries simply don't have what it takes — it requires a combination of a large economy, stable inflation (or at least more stable than others), the ability to create money at will (as we've just done to address issues in the banking system), and attractive property rights, taxes, and non-restrictive capital controls (sorry, China). So, don't hold your breath.
We were able to keep pace with the globally balanced Vanguard STAR fund, thanks to strong returns on our bond investments. As interest rates decreased, we saw a near 6% increase in Vanguard Extended Duration Treasury (EDV) and a close second with Vangaurd L/T Treasury (VGLT). Additionally, foreign bonds did well, with iShares JP Morgan Em. Bond (LEMB) seeing a 3.18% increase, outperforming the bond index. Our underperforming funds were mostly shorting, notably our inverse Bitcoin bet Proshares Short Bitcoin (BITI), which fell nearly 25% as crypto enthusiasts believe the banking crisis will only increase the likelihood of digital currencies taking over banking. Banks receive a Fed loan when they have trouble and all depositors receive a bailout. The fact that Roku received their $500 million back from Silicon Valley Bank while Mr. Roku watcher lost his $50,000 investment at FTX highlights why banks are safer than crypto – not the other way around.
Regarding the current state of the markets, the primary area of concern is the collapse of banks. Let's examine the situation.
The recent banking crisis was not caused by an economic downturn or loan defaults, as is typical in banking problems. Rather, it was the result of regional banks, which are subject to less stringent regulations put in place after the Great Recession, taking in a large amount of deposits, particularly in response to the trillions of dollars distributed by the government in response to the Covid pandemic. These banks paid very low interest rates on these deposits, while making loans at 3-6% and investing in US government bonds that yielded only 1-2%. Thanks to rapid rate increases to fight inflation, the value of these government bonds fell by 10-20%, as did the banks' loans (which are not marked to market), the banks found themselves sitting on trillions of dollars in paper losses, including nearly a trillion in government bonds.
This alone would not have been a major problem, except that when short-term interest rates rose to nearly 5%, the banks attempted to maintain their profits by continuing to pay almost nothing on deposits. Some banks that dealt primarily with uninsured depositors, who held more than $250,000 in the bank, took advantage of looser rules and invested aggressively, without maintaining sufficient cash to handle potential liquidations or making questionable loans. Some even opened their banks to "hot money" from the cryptocurrency industry. When some of their largest balance clients, with $50 million to $500 million in deposits, realized that the banks were making risky loans to themselves and their tech companies, and needed to raise capital, they began an old-fashioned bank run, only at internet speed.
This has resulted in over $20 billion in losses for the Federal Deposit Insurance Corporation (FDIC), as well as hundreds of billions of dollars in Federal Reserve loans to enable other regional banks to handle withdrawals. The best case scenario is that lending will be reduced for years and bank profits will suffer, not just from the shrinking spread between the rates banks lend and borrow at, but also due to the fact that the "good" banks will be paying for the FDIC bailouts for years with higher insurance fees. Additionally, there will likely be increased regulations on mid-size banks.
In some ways, this is exactly what the Federal Reserve wants: to remove excess money from the banking system and slow down the economy. Stocks have done well during this crisis because investors anticipate that the worst is behind us and that the Fed will need to lower interest rates to stimulate the economy in the coming months. However, this is an overly optimistic view. There is an equally likely scenario where investors can earn safe, relatively high bond yields now and then switch to stocks when the economy falters and interest rates fall. The "buy now" strategy assumes that such a sale will never happen, but this is risky because the market can be volatile, as was seen during the Covid pandemic when stocks initially fell by nearly 40%, only to be almost completely restored in just a few months of zero interest rate policy.
It might be wise to wait for a true panic before making the switch from bonds to stocks.
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Despite the recent stress in the regional banking industry, both the stock and bond markets performed well last month. As a result of the situation, hundreds of billions of dollars left banks and flowed into money market funds that invest in Treasury bills, which now offer close to a 5% yield. Furthermore, the ten-year government bond rate has dropped to around 3.3% from its peak of almost 4% in late February, and is now a full percentage point lower than it was last October. This drop in rates could potentially benefit banks, as the main problem they have faced so far is losses on their loans due to rising interest rates. Additionally, the lower rates may lead to increased activity in the real estate market.
In March 2023, our Conservative portfolio gained 2.52%, while our Aggressive portfolio gained 2.13%. Our benchmark Vanguard funds for the same period were Vanguard 500 Index Fund (VFINX) up 3.67%, Vanguard Total Bond Index (VBMFX) up 2.56%, Vanguard Developed Mkts Index (VTMGX) up 2.63%, Vanguard Emerging Mkts Index (VEIEX) up 2.54%, and Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 2.79%.
Last month, the stocks that experienced the biggest gains were often those that had the most significant declines in 2022. Precious metals funds saw an increase of over 10% as investors speculated that the Federal Reserve would need to lower interest rates and take a more relaxed approach to combating inflation due to the recent bank panic. Additionally, many investors sought out supposedly safe assets during the crisis. However, it should be noted that gold has a questionable track record when it comes to protecting against financial crises.
In March, the main action in the stock market was in large-cap growth and technology stocks, which saw gains of 5 to 6% in most funds in these areas. Our recently re-added Vanguard Communication ETF (VOX) fund was our top performer, with a return of 6.87%. Additionally, our single country funds performed well and outperformed the S&P 500 as the US dollar weakened.
There's a growing myth that the US dollar is losing its reserve status. Firstly, given our large investments abroad, a drop in the dollar wouldn't be all that bad. Secondly, it's highly unlikely to happen in my lifetime. Other countries simply don't have what it takes — it requires a combination of a large economy, stable inflation (or at least more stable than others), the ability to create money at will (as we've just done to address issues in the banking system), and attractive property rights, taxes, and non-restrictive capital controls (sorry, China). So, don't hold your breath.
We were able to keep pace with the globally balanced Vanguard STAR fund, thanks to strong returns on our bond investments. As interest rates decreased, we saw a near 6% increase in Vanguard Extended Duration Treasury (EDV) and a close second with Vangaurd L/T Treasury (VGLT). Additionally, foreign bonds did well, with iShares JP Morgan Em. Bond (LEMB) seeing a 3.18% increase, outperforming the bond index. Our underperforming funds were mostly shorting, notably our inverse Bitcoin bet Proshares Short Bitcoin (BITI), which fell nearly 25% as crypto enthusiasts believe the banking crisis will only increase the likelihood of digital currencies taking over banking. Banks receive a Fed loan when they have trouble and all depositors receive a bailout. The fact that Roku received their $500 million back from Silicon Valley Bank while Mr. Roku watcher lost his $50,000 investment at FTX highlights why banks are safer than crypto – not the other way around.
Regarding the current state of the markets, the primary area of concern is the collapse of banks. Let's examine the situation.
The recent banking crisis was not caused by an economic downturn or loan defaults, as is typical in banking problems. Rather, it was the result of regional banks, which are subject to less stringent regulations put in place after the Great Recession, taking in a large amount of deposits, particularly in response to the trillions of dollars distributed by the government in response to the Covid pandemic. These banks paid very low interest rates on these deposits, while making loans at 3-6% and investing in US government bonds that yielded only 1-2%. Thanks to rapid rate increases to fight inflation, the value of these government bonds fell by 10-20%, as did the banks' loans (which are not marked to market), the banks found themselves sitting on trillions of dollars in paper losses, including nearly a trillion in government bonds.
This alone would not have been a major problem, except that when short-term interest rates rose to nearly 5%, the banks attempted to maintain their profits by continuing to pay almost nothing on deposits. Some banks that dealt primarily with uninsured depositors, who held more than $250,000 in the bank, took advantage of looser rules and invested aggressively, without maintaining sufficient cash to handle potential liquidations or making questionable loans. Some even opened their banks to "hot money" from the cryptocurrency industry. When some of their largest balance clients, with $50 million to $500 million in deposits, realized that the banks were making risky loans to themselves and their tech companies, and needed to raise capital, they began an old-fashioned bank run, only at internet speed.
This has resulted in over $20 billion in losses for the Federal Deposit Insurance Corporation (FDIC), as well as hundreds of billions of dollars in Federal Reserve loans to enable other regional banks to handle withdrawals. The best case scenario is that lending will be reduced for years and bank profits will suffer, not just from the shrinking spread between the rates banks lend and borrow at, but also due to the fact that the "good" banks will be paying for the FDIC bailouts for years with higher insurance fees. Additionally, there will likely be increased regulations on mid-size banks.
In some ways, this is exactly what the Federal Reserve wants: to remove excess money from the banking system and slow down the economy. Stocks have done well during this crisis because investors anticipate that the worst is behind us and that the Fed will need to lower interest rates to stimulate the economy in the coming months. However, this is an overly optimistic view. There is an equally likely scenario where investors can earn safe, relatively high bond yields now and then switch to stocks when the economy falters and interest rates fall. The "buy now" strategy assumes that such a sale will never happen, but this is risky because the market can be volatile, as was seen during the Covid pandemic when stocks initially fell by nearly 40%, only to be almost completely restored in just a few months of zero interest rate policy.
It might be wise to wait for a true panic before making the switch from bonds to stocks.