The Effects of Silicon Valley Bank Collapse On Credit Markets: Is the Tide Still Going Out?

As you may know, the following article is based on our recent weekly investment video, which was published on March 27, 2023, Weekly Update: Corporate Debt Issuing Slowing to a Crawl

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Due to the recent turmoil in the credit markets that was caused by the collapse of Silicon Valley Bank, Warren Buffett has a famous line that reminds us of his famous quote, "You'll only learn who has been swimming naked when the tide goes out." As investors try to determine if the tide continues to go out, if credit seizures in the economy and markets are getting worse, or if the situation is improving, they are asking whether the tide is still going out.

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According to Jerome Powell, during the recent Federal Reserve press conference, the Fed had considered a 50-basis point hike but decided to go with a 25-basis point hike as a result of the tightening that occurred due to the bank runs and its disruption of financial conditions.

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As the Fed has been hinting lately, they may be reaching the end of the rate hike cycle by the end of next year. However, the market is still pricing in approximately 100 basis points of rate cuts by the end of next year, creating a disconnect between the market and the Fed.

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This is a similar situation to the one in 2018, when the market expected rate cuts while the Fed planned rate hikes. When the junk bond market was completely seized in December 2018, the Fed changed course in January 2019 to stabilize the market using all the tools available to them at their disposal. In light of this, the Fed may once again be compelled to accept the market's position, and this raises questions about it.

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We must analyze various debt markets, including investment grade debt, junk bonds, and leveraged loans, in order to understand the impact of the Silicon Valley Bank collapse (the second largest bank failure in US history), as well as the long-term consequences of other recent banking crises.

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Debt of a high credit rating

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Using the comparison chart above, we can see that the pace at which investment grade debts were issued flatlined in March 2023, just before the bank collapsed in March 2023. As a consequence of this divergence, corporations may be unable to issue new debt to repay old debt, resulting in a credit seizure if they are unable to issue new debt to pay off old debt.

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According to the data above, the issuance of investment-grade debt in March 2023 reached a low point that was worse than the issuances in March 2020 and March 2018, even worse than the issuance in March 2018 (see image above). This indicates that the corporate debt market has froze and has not yet thawed.

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Bonds with low credit ratings

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A recent report from Trade Algo reveals that the junk bond market has also flattened in recent weeks. According to the report, when comparing March 2022 to March 2023, the number of deals and total volume of junk bonds issued is identical to March 2020 based on its low levels. This suggests a substantial effect on the riskier credit market.

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Loans with a high level of leverage

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It is also evident that the leveraged loan market, which is often used by private equity firms as a means of acquiring companies, is also experiencing a slowdown. The number of debt issuance is significantly lower in March 2023 compared to the first three months of 2022. The number of deals and the debt issuance for leveraged loans in March 2023 have been the lowest in the past ten years.

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The Stock Market vs. the Credit Market

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There is a notable difference between the stock market and credit markets as the stock market displays less stress. Credit default swap indices indicate that the S&P 500 should be about 5% lower than it is right now. Credit markets have historically proved to be much more accurate when it comes to predicting future trends than other economic markets.

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Tech in large caps and new lows

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According to the New Lows in the Stock Market, the rally has been driven by large cap technology companies, which were more prevalent in December and January than in March. According to the advance-decline line, the rally is being propped up by a select group of large cap tech companies, which means that fewer stocks are participating in the rally.

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The Federal Reserve and its role in the economy

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It will be vital to determine how the markets will progress in the future if the Federal Reserve responds effectively to the credit market turbulence and the collapse of Silicon Valley Bank. Despite the Fed's indication that it is nearing the end of its rate hike cycle, the market continues to price rate cuts into the future as the Fed indicates that it might soon complete its rate hike cycle.

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As in the past, the Fed had been able to restore confidence and stabilize market conditions when it changed course in response to market turmoil. Whether the Fed will again align its stance on policy with what the markets are expecting remains to be seen.

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As a conclusion

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A significant impact has been experienced by the credit markets as a result of the collapse of Silicon Valley Bank. All types of debts, including investment grade and junk bonds, have experienced a decline in issuances. Although the stock market has been relatively resilient thus far, the divergence within the S&P 500 and the negative advance-decline line suggest that the rally may not be sustained in the future.

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If the Federal Reserve adjusts its policy to align with market expectations, it may help stabilize the situation. If the Federal Reserve does not respond and the economy further deteriorates, the markets may face further stress. In the event, however, that the disconnect between the market and the Fed persists, further turbulence and stress could occur in the credit markets and broader economy.

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As the tide continues to go out and revealing more vulnerabilities in the financial system, buyers and sellers must pay close attention to what's happening in both credit markets and the Fed's stance on policy. Only time can tell whether the tide is going out, revealing even more vulnerabilities in the financial system, or whether things will begin to improve.