Article
Raise rates fast and break things
Banking stress adds to market volatility for investors and policymakers.
April 3, 2023
Takeaway:
- Market volatility and investor anxiety have increased amid banking sector stress.
- This is not a 2008 moment; the banking sector’s much healthier stress today appears contained compared to during the Great Recession.
- For investors, the bond market looks set to stay volatile as policymakers’ path to a “soft landing” narrows.
Banking sector stress complicates growth story
Historically, bank failures are more norm than exception
Number of Banks Failures in the United States
Source: FDIC, Credit Suisse Asset Management as of 1 March 2023
Bank failures are not a new story. According to the FDIC, there have only been three years in the past thirty when there hasn’t been a failed banking institution in the United States. Yet the speed and magnitude of the Silicon Valley Bank failure have already compounded reignited fears of a 2008-like contagion and elevated fears of a global recession this year.
The recent banking sector stress – starting in the U.S. before moving to Europe – adds another hurdle to a global economy that already was under pressure caused by high inflation and interest-rates hikes by central banks. The collapse of Silicon Valley Bank in the United States sparked a selloff of bank stocks – which are now trading at their lowest levels seen since the COVID-19 selloff – and a tightening of credit conditions, which may have greater implications for the real economy.
Both equity and bond market volatility surged during COVID...
Bond and equity market volality
Source: Bloomberg, Credit Suisse Asset Management as of 24 March 2023
This is not a 2008 moment – banks are stressed but not broken
Despite the doom and gloom investors may read in the headlines, we do not believe that this is a 2008 moment.
- Sources of stress are different. In short, 2008 was a solvency issue, whereas today’s banks face a liquidity issue. The collapse of Silicon Valley Bank, the catalyst of the global banking rout, was due not to a rapid deterioration in credit quality, but rather to a good old-fashioned run on the bank. In this scenario, depositors withdraw their cash en masse.
- The global banking sector remains sound…for now. Compared to the situation leading up to the Great Recession, the global banking system appears much stronger today. On the asset side, banks are much better-capitalized thanks in part to increased regulation and scrutiny after the Great Recession. On the liability side, the share of non-current loans and leases as a percentage of total loans remains at the lowest recorded levels, which means that banks have a larger buffer to write down losses before they eat into the banks’ capital.
- Whereas the policy action during the Great Financial Crisis was too little too late, today’s policymakers acted quickly to prevent the banking stress from becoming systemic. Policymakers worked swiftly and in a coordinated fashion, restoring some confidence in markets. On the weekend that Silicon Valley Bank failed, the FDIC took the extraordinary step of guaranteeing all deposits – even those beyond the standard USD 250,000 limit already in place – and the Fed initiated a novel short-term lending facility called the Bank Term Funding Program to enhance the liquidity positions for U.S. banks. Other central banks have also enacted similar liquidity-boosting measures worldwide to bolster investor and depositor confidence.
For the Fed, the difficult task of engineering a “soft-landing” has become even more challenging
Investors expect rate cuts in near-term after banking turmoil
Note: Base case derived from consensus of economists polled on Bloomberg
Source: Bloomberg, Credit Suisse Asset Management as of 24 March 2023
Volatility in the banking sector can have the same effect as rate hikes because both result in tighter credit conditions and slower economic growth. During the recent bout of banking turmoil, the Fed acted quickly with a public show of support and provided extraordinary liquidity assistance to U.S. banks. Despite these actions, investors expect more from the central bank in the form of rate cuts. Policy rates in the United States are already the highest in recent memory; markets during the recent global banking turmoil quickly repriced their expectations about where policy rates will be over the next two years. Investors now anticipate a much more dovish rate path in the near term and even expect rate cuts to occur in as early as the second half of 2023 and to continue through 2024.
Despite the market’s more dovish expectation, the Federal Reserve continued on its rate-hiking path at its March FOMC meeting and reaffirmed the path communicated in December foreshadowing more rate hikes to come in 2023 before modest cuts are implemented next year. Perhaps more tellingly, in the accompanying monetary policy statement, the central bank noted (emphasis added by author):
“The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.”
Source: Federal Reserve issues FOMC Statement, The Federal Open Market Committee, https://www.federalreserve.gov/newsevents/pressreleases/monetary20230322a.htm (data as per March 27, 2023).
In other words, the Federal Reserve is still much more concerned about containing inflation risks through rate hikes than it is about easing banking stress further through rate cuts.
In this environment, interest-rate volatility will linger and policymakers’ decisions will become increasingly data-dependent. Renewed banking sector anxiety and the tightening of credit conditions heighten the already elevated risks of a global growth slowdown.
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