The beginnings of major recessions and periods of prolonged economic uncertainty have historically coincided with the collapse of one or more large, high profile financial institutions. Are Silicon Valley Bank, Signature Bank, and Credit Suisse the canaries in the coal mine, and what will it mean for commodity prices?
A popular reason to invest in commodities is that they have a low correlation to the stock market and other retail investments. This allows long-term commodity traders to concentrate on fundamentals and disregard many of the hotly debated financial news topics of the day. Those fleeting issues often have no impact on the one-year outlook for crude oil, coffee, or soybeans.
Other issues, even if they are not overtly related to commodities, are too big to ignore because they threaten to impact global trade and the economy as a whole.
Evaluating the health of individual banks is outside the scope of Cordier Commodity Report, but we are concerned with evaluating the potential for systemic failure and long-term consequences.
When the trouble with Silicon Valley Bank hit the news a few weeks ago, our first reaction was to consider the likelihood of widespread cascading bank runs. That concern was quickly diminished when the Federal Reserve backstopped all SVB and Signature deposits, including balances above and beyond the FDIC limit. The crisis at hand was averted, but a precedent was set which, as always, will have unintended consequences. What impact will these bank failures and the government response to them have on commodity prices in the upcoming year, or five to 10 years?
Bank Failure Involved Buying ‘Safe’ U.S. Government Bonds
The most interesting thing about Silicon Valley Bank is that they went bust by purchasing US Treasuries, typically considered the safest of investments. Let’s first understand how that could happen.
Following the financial crises of 2008, the public demanded banking reform and politicians obliged. The Dodd Frank Act was passed and the phrase “stress testing” was sold to the public, creating the impression that government oversight would protect investors and depositors. Dodd Frank created a score card to evaluate the health of financial institutions. Previously, banks could hold junk bonds, CDO’s, and other assets on their balance sheet and their values were subject to interpretation when it came to accounting standards. Dodd Frank changed this by weighing assets on the balance sheet differently and emphasized certain assets over others. For example, US Treasuries are classified as the soundest investment on a balance sheet versus other “riskier” assets like CDO’s and junk bonds. This sounds logical on the surface, but it ignores the most basic principle of bond trading- there is an inverse relationship between bond prices and interest rates!
As interest rates began to rise in 2022, suddenly the balance sheet showed huge losses. SVB might have been able to trade their way out of that position if not for the extreme outflow of customer deposits.
A Failure to Diversify Contributed to Bank Failures
We often discuss the importance of diversification in the context of investment portfolios, but it also applies to ordinary business practices. If all your customers come from the same industry, you are reliant on that industry continuing to thrive. Silicon Valley Bank was the bank of choice for large technology companies and venture capitalists who invested in tech startups. Some startups go on to trillion-dollar valuations while others end up practically worthless, but most will accept a buyout somewhere in between. There is a high degree of speculation when it comes to evaluating what those companies are currently worth. As a result, the assets on the books of SVB’s clients had valuations that were highly subjective and intangible compared to traditional banks.
Ignoring the cost of capital, a startup with a 1 in 1,000 chance of reaching a trillion-dollar market cap is currently worth $1 billion. Most of these so-called “unicorns” fail to reach mega-cap status, but profits from the few that do would make it all worthwhile. Venture Capitalists were happy to hold large portfolios of illiquid and intangible startups, hoping that one or two of them would hit it big. That strategy worked well for years in an environment of ultra-low interest rates, but VCs continued to ignore the cost of capital even after it became relevant.
When the tech sector ran into trouble, the big companies began layoffs and the unicorns had to be reevaluated. The resulting withdrawals and mark-downs were the catalyst for the ultimate collapse of Silicon Valley Bank. Signature, similarly, had a disproportionate number of clients in the cryptocurrency business.
It’s great to invest in new ideas and people and possibilities, that is how society moves forward and tremendous fortunes are made. However, it is unwise to be overly exposed to one sector. Silicon Valley Bank itself was not investing in startups, and Signature was not buying tremendous amounts of Bitcoin, they were holding 30-year treasuries. The true fatal flaw was that all their clients were from the same industry, and when that industry hit hard times, the bank couldn’t maintain adequate reserves.
The Potential for Bank Failure Contagion
Bank runs of old involved lines outside a bank and took days to process transactions. That time was typically spent by bank management building backstops to contain the run. Everyone understands that banking has changed since 1929 but may not realize how much it has changed in the fifteen years since the last banking crisis. In 2008, Washington Mutual (which was larger than SVB) collapsed after customers withdrew $16B over a ten-day period. Silicon Valley Bank’s customers, by comparison, attempted to withdraw $42B in a single day.
According to Treasury Secretary Yellen, “No matter how strong capital and liquidity supervision are, if a bank has an overwhelming run that’s spurred by social media so that it’s seeing deposits flee at that pace, a bank can be put in danger of failing.”
There will be plenty of questions about why the Bank Risk Officers didn’t raise the alarm sooner, but this situation was not caused by a few individuals acting irresponsibly. There are deep systemic problems with the regulatory framework, as implied by the presence of former Congressman Barney Frank, co-sponsor of the Dodd Frank Act, on Signature’s board of directors at the time of the collapse.
The Impact of Bank Failures on Commodities
Despite all the recent criticism of fractional reserve banking, there is no reasonable alternative that we could transition to without upending the whole economy, so it is here to stay. The inherent fragility within this system will show itself from time to time with liquidity crises, which lead to changes in risk management practices and regulations. We anticipate loan origination to slow down dramatically in the near term, but it is unclear how long that will persist.
Ultimately, we see this leading to consolidation in the industry, with JP Morgan, Citi, and Wells Fargo standing to gain the most. Depositors have already begun to move their funds to larger banks, with the expectation that, in the event of insolvency, they would be deemed too big to fail. That implies confidence in the banking system as a whole is very low. There will be calls for stricter regulation, which is costly to implement, creating yet another advantage for the mega banks over their smaller competitors. A few more medium sized banks will go under, and many others will agree to be purchased by large banks, but this should not result in a banking collapse like we saw in 2008. Nonetheless, the turmoil and change of landscape has created new risks and opportunities.
Short Term Impact
The primary concern for most people is that the likelihood of a major recession this year has increased, though it is still not a foregone conclusion. The mere hint of bank failures is enough to throw the Federal Reserve off its path of raising interest rates, resulting in either a pause or a course reversal. We don’t have much faith in the Fed intentionally orchestrating a soft landing (or “no landing” as we have recently been hearing about), but there is a small chance they will stumble into one accidentally. Fed Chairmen Powell’s motivation may be to prevent systemic bank failures, but the unintended consequence could be a brief period of economic growth along with another round of inflation.
The ensuing dollar weakness would inflate commodity prices across the board, with the most immediate impact being felt in precious metals. If the Fed does reverse course, the price of gold and silver could rise dramatically [Silver Outlook 2023]. High inflation, easing interest rates, a dysfunctional but growing economy, loss of confidence in the financial system, and tightening regulation over cryptocurrency would all be bullish for metals over the next six months.
While the bank scare was dominating headlines, the Biden administration took the opportunity to quietly approve the Willow Project, expanding domestic oil and gas drilling (a possibility put forth in our March Crude Oil update). The prospect of record-level energy production along with the uncertainty in the financial system caused Crude oil prices to peak a few months earlier than we anticipated.
If the economy does in fact benefit from a rate cut, we will see higher consumption of all goods, with crude oil and gasoline seeing significant upticks in demand. This would partially offset the bearish supply outlook, creating relative stability in those markets. We came into the year expecting WTI Crude to range between $60-$90 per barrel during 2023, and still do.
Long Term Impact
Speculating on the impact this event will have five or ten years down the road, assuming we do see major consolidation of the banking industry, it would influence the type of loans that are granted. With a less fragmented system of lending, access to loans will be largely determined by a few elite institutions. The financing of large-scale projects, which typically require multiple lenders, may become more efficient as a result. Such projects would include new sites and new technologies for oil and gas drilling, mining for industrial metals, or massive agricultural undertakings. Additionally, it could spur infrastructure like railways, tankers, container ships and ports, pipelines, and LNG terminals.
With all the string-pulling behind the scenes between big banks and government, we could also see an emphasis on lending to ESG (Environmental, Social, and corporate Governance) projects, including wind, solar, and electric vehicles. These potentialities do not have much impact on today’s trading decisions but are worth keeping an eye on as they unfold.
The Federal Reserve created the problem of inflation by printing over six trillion dollars in 2020/21, and were addressing it with aggressive rate hikes in 2022. Inflation is not simply going to disappear now because another crisis has arisen. The Fed will have to decide which threat is more perilous, and we can expect some short-term volatility across markets as they try to figure out the right approach.
At the moment the economy appears safe from cascading bank failures, but CCR will continue to follow this story and analyze its impact on commodity markets.