- Stress in the global banking system leads to slower credit growth
- The Fed is likely to separate its tools for its objectives
- We retain our duration exposure, anticipating lower growth and inflation expectations
For the first time since 2008, cracks have begun to form in the global banking system. Stress in the sector has materialised rapidly, and without much warning. As an unexpected side effect of one of the sharpest increases in interest rates on record, liquidity at many prominent US banks has become a concern.
The price of high quality assets typically held on bank balance sheets (such as US Treasury bonds and Agency Mortgage backed securities) - have fallen sharply over the past year . This, coupled with deposit flight caused by relatively unattractive interest rates paid by banks and a lack of fresh funding in sectors such as tech, helped to create a liquidity mismatch.
The Fed, Treasury and FDIC quickly stepped in to prevent the situation from deteriorating further. The Fed’s emergency funding vehicle, the discount window, has proven to be the facility with the most take up from the sector. With it, banks can borrow from the Fed against the market value of their assets with no haircut. The funding is short term in nature and expensive. Both of these disadvantages are likely to increase demand for the newly created Bank Term Funding Program, which offers 1-year funding against the par value of their assets. Terms are also more attractive, with a lower rate offered. However, much of this funding was concentrated during the week of SVB’s collapse, since then net funding from these facilities has been minimal. Other liquidity boosting programs, such as the Federal Home Loan Banks program, look to have raised significant capital through bond issuance – anticipating major demand.
There is no fundamental reason, in our view, for the jitters we are witnessing to metastasize into a systemic banking crisis to the magnitude of 2008. Large banks have better capitalisation and higher liquidity ratios than at any time in recent history. Credit Suisse’s troubles were rooted in issues that predate interest rate movements and should be seen as a separate issue. Default protection against Credit Suisse bonds had long decoupled from the rest of the European banking sector. Europe is far more dependent on bank funding than say, the US, where capital markets are more broad. An adjustment period to positive interest rates after many years of negative rates cannot be discounted.
That’s not to say that we think that this episode will have no broader implications for the economy. Regional and community banks are a meaningful share of the US banking sectors total assets, and dominate markets like commercial real estate lending. The sector also accounts for nearly 40% of US commercial bank loans and leases. Deposit flight into larger banks is a foregone conclusion, and there is already evidence that this is leading to slowing credit growth in these banks as a result.
Perhaps the most overlooked consequence of the last few weeks has been a sharp repricing in the expectations for the Fed’s policy rate. Economic stability concerns have meant that inflation has taken a back seat for now. The market has pulled forward predictions for future hikes in a way that it now seems likely that the Fed will only hike one more time before ultimately pausing. There is also now the expectation that the Fed will be forced to aggressively cut rates as soon as Q4 this year, presumably to ease financial conditions ahead of an imminent recession.
But with core inflation still far above target, and no major signs of stress in the labour or consumer market, the Fed is very unlikely to meet these expectations. The Fed looks likely to separate financial stability and price stability goals going forward. It will use its balance sheet tools to add backstop liquidity where necessary, and use the policy rate to bring inflation closer to its average target.
We have been conservatively positioned since 2022, with high cash allocations across our portfolios. The rapid change in market conditions seen in March is a reminder as to why we maintain this cautious stance.
In line with our base-case, we expect inflation and growth expectations to revert to their downward trend in place since last year. Taking advantage of this period of higher yields across the curve, we are maintaining long-duration US Treasury exposure to capitalise on the downward longer-term trend in yields that we expect later in the year.
Global Economic Data Highlights
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