In a recent CNBC interview, Larry McDonald, the author of “The Bear Traps Report,” believes that the current turmoil in the financial markets may prompt a sharp reversal from the Federal Reserve’s aggressive monetary tightening aimed at taming inflation.
Federal Reserve’s Hawkish Regime
With the collapse of Silicon Valley Bank, McDonald speculates that the Federal Reserve would slash interest rates by up to 100 basis points by December to prevent contagion in the financial system. This means interest rates could drop from the current 4.75% to 3.75% in the next nine months.
The Fed has gradually increased interest rates over the past few years to 4.75% as of March 2023. This monetary policy decision aims to curb inflation which has seen consumer prices rise 7% year-on-year since Dec. 2021. The impact of rate hikes has increased short-term interest rates, making Treasuries more attractive to citizens and leading to deposits being drained from regional banks like SVB.
On the other end, the hawkish regime of the Fed also makes it difficult and costly for citizens to borrow more, which reduces the supply of money circulating through the economy. Accordingly, investment in stocks and cryptocurrencies contracted as capital flew to safe havens like the USD and bonds, impacting coin prices like Bitcoin.
Higher interest rates also led to a $1.8 billion loss on SVB’s portfolio. This, in turn, stressed the bank, eventually triggering a dump of SVB shares when they failed to get a buyer. The situation got worse when several venture capital firms advised their portfolio companies to withdraw money from the bank.
Silicon Valley Bank Contagion Risk
While some analysts fear SVB’s troubles could spread to other financial institutions and trigger a systemic crisis, McDonald thinks the risks are limited.
He argues that big banks have the resources and risk management expertise to manage the current interest rate. Moreover, he believes regional banks like SVB are poorly equipped for this hawkish regime.
The CNBC contributor believes the Fed may need to bring out the “other firehose” and cut rates within six to nine months as the contagion across the ecosystem, affecting high-yield and leveraged loans.
The Fed’s decision to cut rates could mark a significant shift in its current policy of aggressive tightening. Subsequently, this could highlight the risks and uncertainties in the current economic environment.
Although massive banks can weather the turmoil, the impact on the technology industry and crypto startups should not be underestimated. Considering that many technology startups use SVB, these entrepreneurs are at risk of a liquidity crisis.