money downIn the past few days, Silicon Valley Bank has suffered a significant blow due to the technology industry's rough patch, compounded by the Federal Reserve's aggressive plan to increase interest rates to combat inflation. As with most banks, the bank held billions of dollars worth of safe investments, such as Treasuries and other bonds. However, the previously issued bonds' value began to decline because they paid lower interest rates than comparable bonds issued in today's higher interest rate environment.

Why did Silicon Valley fail?

In essence, banks receive short-term deposits from customers and then use these deposits to provide long-term loans. In recent years, there have been higher saving rates resulting in fewer loans, so many banks invest the money instead. These investments often involve longer-term treasuries that fluctuate in value day-to-day.

This strategy is generally sound if the investments are held until maturity, as day-to-day fluctuations become irrelevant if they are not sold. However, if customer withdrawals exceed the cash on hand for the bank, some securities must be sold before maturity to cover the withdrawals, potentially resulting in a loss.

This is precisely what happened in this case. Silicon Valley Bank needed to sell investments to cover withdrawals, but they had invested in securities that were too risky and unhedged, intentionally exposing the bank to unnecessary risk. As news of this spread, a self-perpetuating cycle of nervous customers withdrawing more money and the bank liquidating more investments at losses ensued, leading to a bank run.

What is the Expected Market Impact?

In the short term, we expect equities to move quickly based on the latest headlines in an evolving situation. However, the bond market has moved decisively and is the important indicator we are watching. The 2-Year Treasury went from a yield of 5% to about 4% (bond prices rise when yields decline) in less than 5 days. This is an enormous move in the bond market and is telling us the bond market expects the Fed to ease up if not stop any further interest rate increases. After the dust settles, that should alleviate the pressure that rate increases have put on stocks and bonds.

What does this mean for investors?

Looking ahead, it is important to note that the current situation is not necessarily comparable to the 2008 banking crisis. While Silicon Valley Bank is facing significant challenges, it is unlikely that the sector as a whole will be affected.

Although short-term market reactions can be harsh, the banking industry is in a much stronger position than it was in 2008, and the players involved are less influential. As an investor, it is important to resist the urge to react emotionally to the news.

Evidence-based portfolios are designed to be highly diversified and not reliant on any individual company or sector. Therefore, the direct exposure to Silicon Valley Bank is minimal for most investors. Although short-term volatility may be uncomfortable, it is not necessarily harmful if investors stay invested for the long term.

Investors should be compensated for the risk and volatility associated with their portfolios, and the markets are expected to reward them over time if they remain patient. However, poor investor behavior and emotional reactions can be detrimental to a portfolio's long-term success. Therefore, it is important to stay the course and avoid making decisions that can hurt your portfolio in the long run.

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