March 20 2023
There are some weeks when content for Ear to the Ground is hard to come by. This week is certainly not one of those weeks. We touched upon Silicon Valley Bank (SVB) in our previous edition. The UK arm was successfully sold to HSBC. The parent company has, however, filed for bankruptcy, buying time to repay creditors. This comes despite the US Federal Deposit Insurance Corporation guaranteeing bank deposits, even those above the £250,000 limit. The collapse of Signature Bank also has created something of a crisis of confidence within certain areas of the US financial system, in particular the regional bank network which exists.
In a sign of coming together, we have also seen 11 major banks in the US provide $30bn in cash deposits to First Republic, a regional lender, in order to help shore up its liquidity position as it too succumbed to heavy withdrawals. At the time of writing however this package does not appear to have alleviated the worries of shareholders, with the share price down a further 26%.
In perhaps evidence that it is not the whole financial system which depositors are scared of, the larger, top tier banks have witnessed a significant increase in deposits. Bank of America has reportedly seen more than $15bn in deposits, whilst other top tier banks are trying to speed up the application process to allow deposits to be made. Conversely, it could be argued that this is simply just the safest option. Share prices certainly suggest that investors believe there will be some impact on profitability in the future.
In a further sign that banks are willing to shore up against any other potential negative sentiment towards the sector, there was a record $152.9bn borrowed via the Federal Reserve primary credit lending facility this week. This is higher than the peak seen in the global financial crisis and dwarfs the level that was seen at the height of Covid.
As a result of this and other measures we have seen the US Federal Reserve balance sheet increase by almost $300bn over the last week. This represents circa half the level of quantitative tightening which has been executed to date. We would not like to suggest that this is quantitative easing however. It should perhaps be more perceived as being a sign of stress within the financial system at present.
The weekend however has proven to be another very busy one for both the regulatory authorities, the banking sector and central banks. A deal was finally reached which has seen UBS take over Credit Suisse in a full merger. This deal, however, has not been without casualties. A deal was reached at a share price which was a serious mark down from that seen at close on Friday. Shareholders have therefore taken a significant haircut. The outcome was worse for bond holders down the capital structure. Junior bond holders, in the form of bonds known as AT1’s, saw their value marked down to zero. UBS meanwhile have also received a guarantee from the Swiss authorities regarding any future losses which may arise due to them agreeing to take over Credit Suisse. Whilst there of course may be no losses, if there are someone will ultimately need to absorb them.
Also over the weekend we saw a coming together of central banks with coordinated action, whereby the US Federal Reserve, Bank of Canada, Bank of England, Bank of Japan, European Central Bank and Swiss National Bank all announced a liquidity boost in US dollar swap arrangements. This was put in place to “serve as an important liquidity backstop to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses.” Whilst there was a call from US regional banks for the Federal Deposit Insurance Corporation to guarantee all deposits to an unlimited amount for the next two years, this is, as yet, still not forthcoming.
In previous situations like this we have historically seen central banks coming to the rescue, not just in the form of liquidity but also with interest rate cuts. This is what the market seems to be expecting. The range for interest forecast interest rate expectations has so far this year varied significantly. Just a few weeks ago, on the back of stubborn inflation data, the market was anticipating that interest rates in the US could peak at over 5.5%. Although there was expected to be a reduction towards the end of the year, a rate of c.5.5% was still expected.
Looking at market expectations now, however, they forecast that whilst we will probably see a rate hike this week of 0.25% that could take us close to peak. The market then forecasts that we will witness a series of interest rate cuts into year end, with the potential that we could be looking at somewhere between 3.5% and 4%.
Not quite everyone shares this view however and refer to the decision by the ECB, despite the turmoil, to hike interest rates by 0.5%. Although this was in line with expectations, there were some who questioned whether a hike of this magnitude was now appropriate. The hike was made in the face of the region’s stubbornly high inflation. Policy makers were keen to point out however that they believe the euro area banking sector resilient, with strong capital and liquidity positions. They iterated, however, that they were monitoring the situation closely and would respond as necessary to preserve price and financial stability in the market. This, therefore, raises the question as to whether we are going to see a ‘separation principle’, whereby financial tools will be used to provide liquidity when needed, but interest rates will be continued to be used to tackle inflation. For now, it would appear that this would suggest that we possibly have further rate hikes to come.
It was believed that higher interest rates, and perhaps the rate at which they have been hiked, could potentially cause ‘incidents’ in the market, but it has perhaps taken some by surprise at these most recent ones and their scale. SVB and Credit Suisse most certainly had their idiosyncratic issues and we suspect the market will be looking to see if the pace of interest rate hikes which we have seen in the developed world unearths some more.
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