Key points
- Global regulators continue the battle to stabilize markets.
- Tighter banking standards may help do the work of higher rates.
- Fallout from Swiss regulators’ decision to wipe out certain Credit Suisse (CS) debt.
- The operating environment for banks remains positive, notwithstanding a few poorly managed franchises.
- Economies currently have momentum, but slower growth is likely later this year.
Issues in the financial sector have continued to dominate headlines in financial markets during the past week. In the U.S., Janet Yellen has been pushing for deposit guarantees, in order to stem deposit outflows from smaller and mid-sized banks, in the wake of the Silicon Valley Bank (SVB) collapse.
However, Republican opposition in a dysfunctional Congress has made progress hard work for the Treasury Secretary. There is a sense that more can and will be done if banking stress continues to worsen. However, with large banks benefitting at the expense of smaller institutions, it seems that support may ultimately be contingent on greater regulation being applied to the smaller regional players, so that there is more of a level playing field going forwards.
Broadly speaking, this all points to tighter standards with respect to bank lending, which infers a tightening in financial conditions. Estimating the impact of this is difficult and uncertain. However, with Fed Chair Powell acknowledging that this impact may equate to an interest rate hike of 25 or 50bp, it is easy to understand that a lower terminal rate on Fed Funds should be priced.
In light of this, this week’s Fed decision to hike U.S. rates by 25bp, taking effective cash rates to 4.85%, was seen in a dovish light, in the hope that the rate cycle may now be close to peaking. Ultimately, much will depend on incoming growth and inflation data over the next couple of months. However, it is hard to argue too much with the narrative that a subsequent 25bp at the start of May could represent the last hike in the cycle.
In this regard, we would not be surprised if incoming economic data in the month ahead is a bit softer, with mild weather in January and February giving way to an inclement month in March. Yet, we suspect that core inflation may remain elevated for some time, and it will also take a while for softness in the economy to have more of an impact on the robust labour market.
Therefore, we are doubtful that we will see any rate cuts until the end of this year and in light of this, we believe that market rate expectations embedding a quicker pivot towards more accommodative monetary policy appear to be misguided. This leads us to maintain a short duration stance at the front of the U.S. yield curve.
Meanwhile in Europe, much of the week’s focus has been on the demise of Credit Suisse and the fallout on the Tier-1 capital market, which sits at the heart of banks’ funding models. With respect to CS, we were surprised to witness Swiss authorities changing the law in order to pre-emptively bail-in Additional Tier 1 (AT1) holders, without concluding a point of non-viability, which would have triggered a formal Resolution process.
We were also surprised to then observe that the Swiss would abrogate the established waterfall in the capital structure in order to make payments to equity holders, notwithstanding a zero sum for AT1 debt. These steps threatened the entirety of the USD275 billion AT1 market, since it appeared that debt was being made junior to equity, thus implying the need for a sharply higher cost of capital, thus triggering more widespread stress across the banking sector.
Thankfully, European regulators at the European Banking Authority, European Central Bank (ECB) and also the Bank of England (BoE) were all quick to disparage the Swiss approach, asserting the importance of Tier 1 in banks’ funding models and asserting that, within the European Union (EU), the waterfall of payments would always be respected. This served to shore up confidence, causing bank stocks and debt to rally, having plunged at the start of the week.
Although spreads remain wider over the week, the outlook for banks in Europe looks much calmer once again. Meanwhile, it is becoming clear that we are witnessing something of a growing Swiss premium as investors reflect on the understanding that the framework and institutions in the country are much less robust than one would have expected.
Indeed, it may be difficult to project many buyers for future AT1 issues from Swiss banks. That said, CS failed as an entity, as it was badly managed and entangled in one scandal after another. Ultimately this led to a loss of confidence and recent events have served as a reminder that confidence is everything in banking. It can be hard to win, but quickly lost. In that context, it isn’t too surprising that AT1 investors should lose when a bank fails.
Yet, with CS now out of the picture, when we survey the outlook for European banks, we are struck by the notion that the operating environment is as good as it has been for over a decade. Higher interest rates have led to improving net interest margins across the sector and credit impairments remain relatively low.
In this way, although SVB and CS may have echoes of Bear Stearns and Lehman about them, we think that the situation today is very different to 2008. Back at the time of the GFC, banks were seeing growing credit losses on U.S. mortgages, and credit quality was deteriorating at an alarming rate. High leverage and weak regulation compounded these issues.
By contrast today, balance sheets are in much better shape. In this way, we do not think we should see ongoing systemic risk, and this suggests to us that the probability of a near-term recession remain very low.
Slower growth is likely later this year. But for now, economies retain momentum. In the Eurozone, there is plenty of talk of resilience in the face of shocks over the past several months. With growth and inflation coming in materially stronger than may have been anticipated several months ago, so we continue to think that the ECB may need to hike rates another couple of times before rates are able to peak. In that case, with tightening in the EU now set to outpace the U.S., we are moving more towards a view that the euro may continue to appreciate versus the U.S. dollar.
Meanwhile, in the UK, the BoE also hiked rates by 25bp this week to 4.25%. The BoE gave a relatively dovish assessment in terms of the outlook and it is clear that the Bank is hoping that wages and inflation fall, so that they don’t need to inflict further pain on the housing market or consumer incomes.
Yet this week’s CPI at 10.4% serves a challenge to this narrative. An acceleration in core prices leaves inflation close to its highs, and real interest rates still well into negative territory. Up to this point, the UK economy has also held up relatively well in the past few months.
However, house prices are coming under growing pressure, as incomes are squeezed in a cost-of-living crisis. Ultimately, we feel that this will necessitate the BoE maintaining a more dovish stance than may be warranted and, in this context, we think that an overshoot on inflation is likely to be more protracted than elsewhere. It is also likely that this outcome weighs on the value of the pound, in our view.
Elsewhere, newsflow in Asia and in emerging markets was relatively quiet over the past week. During the past month, volatility in developed markets has been very much to the fore, with markets away from the centre of the storm happy to remain quiet by comparison.
To give recent moves more context, in the past week we have observed two of the 10 most volatile days in European Investment Grade spreads since the inception of the Euro credit market in 2000. Spreads in financials have hit Covid-wides and market dislocation has been extreme.
Similarly moves in interest rate expectations have been more erratic than any period outside of the start of the pandemic and the collapse of Lehman in 2008. Extreme volatility has led to material dislocations and illiquid trading conditions.
Looking ahead
Although we entered March with a cautious view on risk assets, part of this caution had seen us over-allocate towards bank debt on an assumption that this would be an area of relative safety, thanks to an improving outlook for profitability, even as fears for a ‘hard landing’ in the economy start to build.
In that sense, we did not foresee the current banking crisis and so have not been positioned for this. Subsequently, it has been hard to take advantage of recent market weakness in a way which we might have liked. Nevertheless, we are confident that we will see further opportunities as the year unfolds.
We are sceptical of the notion of a near-term recession, but view recent bank stress as examples of early tremors in the economy. When central banks hike rates aggressively, so financial conditions will tighten and pockets of stress will always emerge. However, by the time that policy cycles are done, it is more common to see further evidence of things becoming broken.
We think that market participants will be surprised that the Fed won’t quickly come to the rescue as soon as the outlook starts to darken. Financial stability is important, but there are many tools which can be deployed to deliver this. Otherwise, the central bank focus remains on inflation, and in this context, we continue to see headwinds for risk assets.