When things move as rapidly as they have done over the past month, it’s often difficult to see the forest for the trees.
Whether the recent relative calm marks the end of the turmoil, or a temporary pause amid a deepening crisis, will depend on the answers to the following questions:
Have Policymakers Done Enough to Avert a System-Wide Banking Crisis?
Although the causes aren’t directly related, the most immediate question is how markets digest the UBS deal to buy Credit Suisse and whether the U.S. Federal Reserve, U.S. Treasury, and the U.S. Federal Deposit Insurance Corp have acted aggressively enough to prevent a contagion from developing from the failures of Silicon Valley Bank (“SVB”) and Signature Bank.
Scenario #1 – The “good scenario” – problems are confined to the collapse of a few regional banks in the U.S., caused by idiosyncratic factors. Confidence quickly returns, risk premia drop and credit conditions ease. Implications for the rest of the world are minimal. The U.S. Fed reverts to raising interest rates to contain inflation, and interest rates are not cut until next year.
Scenario #2 – The “not too bad scenario” - problems continue to emerge in the financial sector, but they are confined to the U.S. U.S. banks cut back their supply of credit to the private sector and financial conditions remain tight. The resulting impact on economic demand/growth means that the Fed does one more 25bps hike at most, and a rate cut before the end of year.
Scenario #3 – The “bad scenario” – SVB’s collapse does turn out to be the start of a global financial crisis. Other financial institutions run into trouble, either because of similar problems to SVB or, more likely, because SVB is an early indication of other unknown vulnerabilities lurking in the financial sector. Although all central banks step up their emergency liquidity assistance, this does not prevent a loss of confidence in the system and a significant tightening of credit conditions. We already expected recessions in many major developed markets this year. Those recessions would be much deeper and more widespread in this scenario.
Everything is in a state of flux but, as things stand, something between the first and second scenarios seems to be shaping up to be the most likely outcome, with the third scenario more of a distant tail risk. The global economy is likely to feel at least some lasting effects, which will affect the path of monetary policy, but the impact should be relatively contained – from what we can see at the moment.
“A full-blown repeat of the Global Financial Crisis of 2007-08, therefore, looks unlikely.”
All that said, a key point to stress is that the global banking system as a whole remains well-capitalized. Likewise, the new tools that have been put in place over the past few years to provide liquidity to financial institutions are working and can be expanded if needed. A full-blown repeat of the Global Financial Crisis of 2007-08, therefore, looks unlikely.
However, containing crises is a bit like a game of whack-a-mole, with new fires starting as existing ones are extinguished. A key issue over the next quarter will be whether problems arise in other institutions or parts of the financial system.
“The key issue is whether these institutions have hedged their interest rate risk and, if not, whether they are forced to divest assets and thus crystallize losses.”
How Could the Situation Escalate?
There are three areas to watch.
First, we could see more institutions follow SVB in struggling with unrealized losses. According to the U.S. Federal Deposit Insurance Corporation, unrealized losses at U.S. banks and financial institutions stood at $620 billion at the end of 2022. The key issue is whether these institutions have hedged their interest rate risk and, if not, whether they are forced to divest assets and thus crystallize losses. The most likely trigger for this would be a loss of confidence by their depositors and an outflow of deposits. However, policymakers have been very quick to step in to prevent banking sector problems from spiralling out of control. Both the Fed and the Suisse National Bank have provided significant liquidity support to their banks, while the European Central Bank went out of its way to emphasize its ability and willingness to do the same if needed at its March policy meeting. In addition, the Fed announced that it will enhance its dollar swap lines to the other major central. The aim appears to be to pre-empt the risk of a breakdown in dollar funding markets – a key vector of contagion across the global banking system in 2008, during the height of the euro-zone crisis, and during the early 2020 financial market panic.
"While it’s tempting to dismiss the problems at SVB, Signature Bank, and Credit Suisse as idiosyncratic, they have revealed that problems are lurking in the financial system as interest rates rise.”
There are some sources of comfort. The U.S. banking system in aggregate does not have unrealized losses on “held-to-maturity” securities in excess of capital. In addition, if an institution did need to raise cash, it should be able to use central bank facilities to do so, thereby avoiding the need to realize losses. So, on balance, we don’t believe that unrealized losses on bond portfolios will be the source of a system-wide crisis. Although, it’s possible that some smaller banks might run into similar problems as SVB, which would add to the sense of uncertainty and trigger a renewed market sell-off.
Second, even if unrealized losses do not cause further problems, we could see more institutions get into trouble for other reasons. While it’s tempting to dismiss the problems at SVB, Signature Bank, and Credit Suisse as idiosyncratic, they have revealed that problems are lurking in the financial system as interest rates rise. Potential risks in our mind include smaller European banks and shadow banks, particularly open-ended funds that might suffer from maturity mismatches.
Finally, Credit Suisse aside, the problems so far have been caused by a failure to adequately manage interest rate risk. An altogether more serious crisis would develop if credit risks/loan defaults started to emerge. The good news on this front is that the global banking system is much better capitalized than in the past. But with banks likely to tighten lending in response to the events of the past month, it’s possible that a vicious circle develops, in which credit tightens, economic growth slows, and default rates start to rise. The biggest risks lie in economies with overvalued housing markets – Canada for example.
What Does All This Mean for Monetary Policy?
At the risk of stating the obvious, it all depends on whether the crisis escalates and worst-case scenarios materialize.
A reasonable base case is that we avoid a system-wide crisis on the scale of 2007-08 but further problems emerge at individual institutions. If so, central banks will provide liquidity to markets to ease financial strains, acting as the lender of last resort, while at the same time raising interest rates in order to get on top of rising inflation.
“A key issue over the coming months will be the extent to which the crisis of the past month causes banks to reduce credit availability (loans).”
While markets have spent the past several months focussing on inflation and jobs, recent developments are a reminder that money, credit and the financial sector matter, too. They are a critical channel through which monetary policy operates and perhaps the first areas to exhibit signs that higher interest rates are starting to take effect.
A key issue over the coming months will be the extent to which the crisis of the past month causes banks to reduce credit availability (loans). This in turn would weigh on consumer demand and business investment and therefore accelerate the slowing of economic growth. At its worst, it could lead to a rise in loan defaults, which then feeds back into a further tightening of credit conditions, creating a deeper recession and ultimately requiring a substantial loosening of monetary policy. There is a growing risk that the stresses on small banks and commercial real estate develop into an adverse feedback loop; with small banks reining in lending, which causes an increase in commercial real estate loan defaults, which drives capital values down further increasing loan to value ratios and forces small banks to increase their loan loss provisions, which triggers an even greater tightening in bank lending standards. In a worse-case scenario, we could have a rolling crisis that lasts for years – echoing what happened during the savings and loan crisis during the mid 1980s to the mid 1990s.
As things stand, we think that bank lending will contract in most advanced economies but that the negative feedback loop through rising credit risk (and a system-wide crisis) will be avoided. But the tightening in credit conditions will nonetheless add to the pressure on the global economy that we already expected to slip into recession later this year. With that in mind, we expect equities to struggle from here. While the exact implications of recent events for monetary policy are still unclear, it appears that investors want to have their cake and eat it too, welcoming the boost to valuations from lower bond yields but taking limited notice of the downside risks to growth.
Over the next 3-6 months, we think the rally in bonds will slow, while equities falter and the U.S. dollar rebounds close to its recent high.
We think falling inflation and a loosening of monetary policy is largely priced into financial markets. That underpins our view that the recent rally in government bonds will begin to run out of steam soon. However, we don’t think a recession is fully discounted. This is why we expect that developed market equities to make a new cyclical low, and the U.S. dollar to climb back towards its recent high. We think, though, that this will set the stage for a sustained rebound in developed market equities, starting with the U.S. and weakness in the USD as the economic outlook begins to brighten later in 2023.
For further details on our views on risky assets, I recommend a review of our recent commentaries
In summary, the headline news is likely to be ugly over the next few months and financial markets volatile as a result. At this time, we believe that any banking crises that come up as the financial tide goes out are likely to be liquidity issues, not due to solvency issues. Central banks are well equipped to deal with liquidity issues and therefore the financial impact is likely to be limited. Markets will be volatile, but this storm shall pass. We have positioned ourselves in anticipation of this storm and in time will use this “obstacle” as an opportunity to position ourselves for the next cycle.
Chief Investment Officer
Counsel Portfolio Services