Rates risk reverb
Things have got real. Higher rates have triggered a banking crisis, provoking actions from policymakers, investors and bank deposit customers. It’s not a run on the system and it’s not 2008, but the rapid emergence of financial instability is a cause for concern for investors. It worsens the growth outlook and will tend to favour defensive allocations. Certain fixed income strategies should benefit. The end of the rate cycle is (could be) nigh. If things get bad, rates can be cut. After all, there is nothing like a financial crisis to raise the spectre of deflation.
The aftermath of the collapse of Silicon Valley Bank (SVB) in the US is even more uncertainty about the economic and market outlook in the short term. After a year of rising interest rates, one interpretation of recent events is that tighter monetary policy is starting to bite. After all, part of the SVB problem was the interest rate hit it took in the securities portfolios on its balance sheet. As these were longer duration than the liabilities (customer deposits), when there was a requirement to meet deposit outflows, the duration mismatch triggered realised losses sufficient to wipe out the bank’s capital. I can’t tell you the number of times I have heard versions of the Warren Buffett quote about when the tide goes out this week. But there is truth in it. Tighter monetary conditions eventually start to reveal financial weaknesses. As I suggested in my last note, this cycle is likely to keep on springing surprises.
Hit from higher rates
As is common in financial crises, there are both idiosyncratic and systemic elements to the story. Poor management generally and inadequate risk controls are typically present when there is a run on a bank. Once these are revealed, the institutions in question lose the confidence of depositors and investors alike. There is a macro/systemic story too. In the US, recent years have seen massive growth in bank deposits. This accelerated during the pandemic because of additional quantitative easing - the Federal Reserve (Fed) creating more bank reserves which are the DNA for bank deposit growth - and the fiscal support that was offered. Deposits grew more quickly than the ability of banks to make loans, so the ‘excess’ was invested in securities. Nothing wrong with that from a credit point of view as the securities in question were Treasuries and mortgage-backed assets. However, this also meant taking on a lot of interest rate risk, meaning there could be trouble if and when rates rose. The balance sheet issue is common throughout the US banking system. The extent to which interest rate risk was taken differs widely. In the last week, confidence in US regional banks has suffered as it is in that sector that the interest rate risk problems are more likely to be found than in the large money centre banks that operate under a stricter regulatory regime.
There is also a focus on deposits as a systemic risk. Banks don’t pay much remuneration to customers for holding their deposits – especially because in recent years there has been no real competition for deposit funds (low interest rates, plentiful supply of household and corporate cash). Now, though, rates are higher and there is the opportunity to invest in money market funds or Treasury Bills and get more yield. Theoretically that opens the door to deposit flight out of the banking system. The risk is probably overdone for the system, but smaller banks could be vulnerable to deposit runs either because of falling confidence (deposits moved to larger banks perceived as safer) or because of the availability of higher interest rates elsewhere.
The upshot of this is banks will need to raise interest rates on customer deposits. This will impact the net interest margin (NIM) and be negative for earnings. At the same time, conditions for loan growth are deteriorating as the economy slows. All in, this will add to the tightening of credit conditions. This raises recession probabilities and will add to the existing evidence that smaller and medium-sized companies will find it more difficult to access credit. Investors have already made asset allocation decisions to the detriment of regional banks in the US.
The situation in Europe has both idiosyncratic and systemic elements too. The Swiss authorities have taken steps to shore up confidence in their financial system but some structural resolution to the Credit Suisse issue seems inevitable. The immediate risks this week were centred around deposit flight but also the potential contagion risks for other large banks that are counterparties in financial markets. These risks have been contained for now but the traffic lights on financials in general are flashing more amber than they were.
The inevitable comparisons with 2008 are being made in some quarters. My view is that the genesis of this crisis is an interest rate one. Higher rates have exposed some weak risk management practices and where there are duration mismatches between assets and liabilities, any requirement to make good on the liabilities is going to result in realised losses. The global financial crisis was a credit crisis – the problem was poor-quality housing-related assets on bank balance sheets. However, we may be at a time in the cycle where it morphs from an interest rate story to a credit story. If so, the outlook for credit and equity markets becomes more difficult.
Rate volatility at post-crisis high
It is important to be clear on the rates outlook then. Market pricing for interest rates has been volatile over the last week. The US two-year Treasury Note yield has traded in a 130-basis point (bp) range in the last eight trading sessions. That is unprecedented. Most commentators think the Fed will still raise interest rates on 22 March, but the market is not even fully pricing in a 25bp hike. The European Central Bank (ECB) did raise rates on Thursday and did a good job of separating concerns about financial stability and the fight against inflation. I expect Fed Chair Jerome Powell will do the same in any public comments he makes after the Federal Open Market Committee meeting. A 25bp hike is probably the best bet but after that who knows. A Fed on hold could be the second quarter story.
Balancing financial and inflation risks
Despite the inflation numbers staying uncomfortably high (core inflation is clearly sticky despite falling to 5.5% in the US in February), we must be close to the peak in rates. Now it becomes important that central banks don’t allow a conflict between financial stability and inflation credibility. However, should we get more banking sector problems and broader financial market volatility, the rate view might need to change. If 2008 was a credit crisis and this, so far, is an interest rate crisis, the good news is that rates can be cut quicker than credit issues can be resolved.
The takeaway from recent events is a more risk-off attitude amongst investors and a negative tilt on the economic outlook and on credit and equity markets. Tighter credit conditions because of the banks’ need to act more conservatively on both sides of the Atlantic is already being reflected in wider credit spreads in the bond market. US and euro investment grade spreads have risen around 40-45bp this month. The move has been over 100bp in high yield. For the US investment grade market, the level of spreads is approaching that which marked the peak in spreads in October last year and the nadir of the sell-off in 2018. Yields are higher than in recent cycles and the short-term outlook is putting a 6% yield back in play. For the US high yield market, the index yield is approaching 9%. It got to just over 11% in the early days of the pandemic and 10% in 2015.
So despite the increased financial risks, the credit markets are offering even more value today. This is true at the market level and is true when credit investors are seeking opportunities that have emerged because of indiscriminate selling over the last week. My fixed income colleagues have a much more constructive view of European banks where the regulatory environment is all-encompassing and where balance sheets are less at risk from rising interest rates. In the intermediate maturity range of the euro investment grade market, yields are approaching 4.5% and average bond prices remain low. We have seen in the past that the Fed does not have the monopoly on liquidity tools – the ECB is well placed to re-start long-term repurchase operations if there are any liquidity issues.
However, the cat is out of the bag on risk
We must be open to the prospect of more evidence of financial instability and contagion risk. Rates have risen a lot and economic growth, while still reasonable, is slowing. The global financial system became awash with liquidity in the 2020-2022 period, and it is not surprising there are risks associated with the management of that liquidity and what happens when it starts to be reduced. Now we are not in a systemic risk position – people are not taking deposits out of the system – but the cat is out of the bag on financial and corporate sector fragilities. For the banks, the issue is where those deposits are, and what the assets are like that back them up. The news overnight was that large US banks have had to put some of their own cash into deposits at another under-pressure bank. Expect to see more policy and industry-wide initiatives to support confidence in the coming weeks. At times, it might seem like the summer of ’08.
We are focused on the banking sector and its current vulnerabilities. But some of the US banks that have been in the news in the last week have something else in common – exposure to the technology sector. A concentrated exposure through the deposit base or loan portfolio is problematic when the technology sector is itself in recession. Funding for start-ups was a major source of deposit growth at SVB but as the sector faces reduced sales growth, the cash quickly burns as companies need to pay computer programmers’ salaries and other costs. The result will be a more difficult environment to raise venture capital for start-ups in artificial intelligence, health technology and green tech. The large-cap listed technology companies, that tend to have cash, might take advantage of this at some point and start hoovering up early-stage companies to ultimately get a technology advantage and be in a stronger position when the cycle turns. An interesting one to watch.
Where does this all leave market views? I think it is hard to be bearish on rates now. We are surely close to the top of the cycle and financial risks have increased. The market has already moved to a more bullish rates outlook with 10-year US Treasury yields down to 3.5% (remember I suggested that 4% would see buying again). Credit yields have not moved lower, so the short duration part of credit markets remains attractive in this heightened risk environment. Credit generally looks attractive with the qualification that spreads could spike higher at any point in this last phase of the monetary cycle. While past performance does not guarantee future returns, history tells us that those spikes are potentially buying opportunities.
For equities, the story hasn’t changed. The US is still expensive and has an aggregate level of earnings that is likely to move lower. Banks may see lower earnings, technology already has, and the energy sector is unlikely to match 2022’s performance with global energy prices lower. Any policy initiative to support confidence will be met with equity market rallies, but for the next few quarters the fundamentals look weak.
The games they come thick and fast. Luckily, I was in South America when United had their recent blip. They have got back to winning ways even if performances look shockingly tired. United could end up playing more than 60 competitive matches this season depending on how far they go in the FA Cup and Europa League competitions. To come out of that with one or more trophies would be a real achievement. The Premier League looks like a two-horse race and my money and hopes are on north London. I wouldn’t be happy with City winning three in a row. That’s our record!