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As of 14 March 2023
The -9.8% US regional banking sector sell-off at time of writing is one of the largest one-day negative returns in the history of the KWB Nasdaq Bank index. The sell-off that started last Friday comes at a time when consensus expectations had begun to favour the probability of the US Federal Reserve (Fed) engineering a soft landing, based on leading indicators of economic activity, consumer sentiment, rebounding manufacturing new orders and potential signs that the US housing market was starting to bottom out.
But it appears that the markets now see banking stress impacting the Fed’s inflation-fighting strategy, as evidenced by significant downward moves in interest rates, which have dropped in recent days (by 41 basis points for 10-year paper and 99 basis points for two-year paper, respectively, from the end of day on March 8 to the time of writing). This suggests that markets expect the Fed to be increasingly concerned about financial instability, perhaps even more so than the inflation worries that have been at the centre of the central bank’s attention for the past year-plus.
It's worth noting that the global backdrop has been more resilient to the regime shift towards higher interest rates and higher inflation than we had expected, and equity markets have largely taken these moves in their stride. However, we also recognise that inflation is uncomfortably high for central banks. In this environment of sticky inflation, where central bank terminal rates are being repriced, we believe that corporate earnings and multiples, as well as credit spreads, remain vulnerable.
The impact of policy tightening is making its way through the system, although the long tail of historical liquidity has meant that both the timing and magnitude of the impact is less predictable than it’s been in the past. This suggests more room for policy error and liquidity-induced accidents like the Silicon Valley Bank Financial Group (SVB) crisis. The history of financial markets suggests that policy tightening regimes often have unanticipated knock-on effects, like the collapse of two Bear Stearns hedge funds in 2007.
Key areas impacted by tightening financial conditions include:
Regarding the banking system, the Fed’s rate hikes have prompted an inversion of the yield curve, which reduces net interest margins and profitability, and, over time, leads banks to tighten lending. In addition, the Fed has let its balance sheet passively run off to the tune of roughly US$95 billion per month while also draining its liabilities, including bank reserves, amid its cycle of quantitative tightening. Taken together, this can have a nonlinear impact on banks’ liquidity past a certain point through funding markets.
Right now, it's still unknown if SVB’s fate will pose serious contagion risk or have systemic impacts. The Federal Deposit Insurance Corporation (FDIC) and state regulator have stepped in to protect depositors while the Fed has announced a new lending facility, but further regulatory ramifications are unclear. From a macro perspective, this event emphasises that the typical transmission mechanism from central bank tightening through the financial system (and, eventually, the real economy) is likely still intact and is likely to accelerate. We will be closely watching market volatility and policy reactions in the US and other markets for further cues.
While the US is at the epicentre of the stress, developed markets outside the US are affected due to their higher-beta nature and because any US liquidity tightening will impact global growth. However, there are clearly different dynamics in play from region to region and we expect these to be taken on board by investors over time. For example, China seems largely insulated from recent US events as its economy benefits from reopening, with other Asian regions benefiting as well. While the market has also pared back rate expectations in the eurozone, the European Central Bank will face a tough balancing act between the need to support financial stability and the continued uphill struggle against core inflation pressures.
At this early stage, it is difficult to map potential outcomes. We think investors should closely monitor developments and the potential risks for portfolios. Ultimately, decisive US policy action and the market slide — which is helping to address the problem by bringing down yields and therefore the extent of unrealised losses — may lead to stabilisation and opportunity, but it is too early to tell. For now, we would advocate a more defensive portfolio positioning.
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