Financial Update from Brewin Dolphin - 17 March 2023
The Weekly Round-up
Friday 17 March 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses turmoil in the banking sector and the impact this could have on interest rates.
The past week has been very challenging for investors. As discussed last week, the failure of a US regional bank was enough to create some alarm within the market, and we don’t need too long memories to recall the challenging era of the global financial crisis. It would be tempting to describe Silicon Valley Bank (SVB) as a small regional bank, as it is small compared to the banks we normally associate with the US. However, it is large compared to most regional US banks (which most of us haven’t heard of). The US has an unusual proliferation of these small regional banks. The failure of SVB and Signature mark the 562nd and 563rd failure since 2001. In fact, 2022 was relatively unusual for not seeing any US bank failures.
Measures taken last weekend meant that uninsured deposits at the failed banks were protected, in the hope that this would reduce the necessity for large depositors to flee other banks en masse. SVB’s main problem was that its holdings of long-dated securities were trading below their par value and, if sold to fund deposit withdrawals, would crystalise a loss and expose an inadequate capital position. To prevent this from being an issue for other banks, the Federal Reserve announced that it would allow borrowing against such bonds at their par value.
First Republic – next in line?
Despite measures that would seem to address the specific issues faced by the now demised SVB, sentiment to the sector remains weak. The third US regional bank in the firing line, by order of its uninsured share of deposits, is First Republic Bank. The outlook for the bank appears precarious as it has seen deposits drain away. Despite protection for failed bank shareholders, there is no explicit protection for uninsured deposits at other US banks. However, in order to stem the crisis, 11 US banks committed to adding deposits worth $30bn to First Republic. Each bank’s share, ranging from $1bn to $5bn, would be virtually entirely uninsured and would earn the same rate of interest as existing bank customers. This was an industry keen to stem the sector’s bleeding, with a show of solidarity and a demonstration of skin in the game.
In Europe, concern over banks centred around Credit Suisse, which far from being small and regional, is classified as a global systemically important bank (G-SIB). Its challenges are quite different from those in the US as it benefits from a strong capital and liquidity position. What it has lost in recent years is a reputation for competent banking, which has weighed on the shares and, in the current environment, threatens to undermine confidence in the institution. Regulators have been able to endorse the robust financial position of Credit Suisse and extend it further liquidity, but over the week counterparties have become increasingly wary of having exposure to Credit Suisse.
Banks need the trust of their creditors and counterparties in order to operate. The strength of Credit Suisse’s financial position should be sufficient to protect counterparties, but shareholders will bear the brunt of losses emerging as part of the company’s restructuring. We have written separately on Credit Suisse, but the latest twist is that regulators and policymakers have reportedly considered pressing Credit Suisse into a merger with another financial institution, most obviously UBS, but neither party is particularly keen on the marriage.
Stability: financial vs price
Banks serve as the transmission mechanism through which monetary policy decisions impact the overall economy. Therefore, the turmoil currently being endured has the scope to affect the future path of monetary policy. Since last week we have seen a sharp drop in the projected path of interest rates around the world. This reflects the fact that banks control the issuance of loans to the broader economy. If they feel nervous, they are likely to supply less credit. The extent of this is difficult to quantify and must be balanced against other factors impacted by the crisis.
The Federal Reserve will announce its change in monetary policy next Wednesday. A lot could happen between now and then to see calm restored to the banking system. The European Central Bank (ECB), on the other hand, had a scheduled policy announcement on Thursday. The ECB pressed ahead with a half percentage point increase to its key interest rates, despite speculation that it would temper the hikes in deference to the broader tightening of financial conditions.
Despite the increase in short-term interest rates, expectations of rate rises thereafter fell, as reflected by lower bond yields, which in turn reduce the cost of loans over longer maturities. UK five-year swap rates, which determine many UK mortgage rates, have fallen by almost half a percentage point over the last fortnight (but remain above the lows seen at the beginning of January). US mortgages are tied to 30-year bond yields. These have fallen by around a quarter of a percentage point.
The US housing sector remains in focus, and signs of green shoots in the construction and retail sectors continue to come. Housing starts surprised investors by increasing in February. This seems consistent with a decline in mortgage costs that preceded it and had been reflected in indications of increasing traffic of prospective buyers. Indications are that the US economy continues to expand briskly during the first quarter of 2023. These indications were buoyed by a small rise in retail sales during February.
Low energy price gains
If the strength of growth serves as a headache for the Federal Reserve, whose monetary policy response has exposed cracks in US financial stability, the inflation data compounds the challenge. Consumer prices rose in line with expectations, skewed as always by changes to energy prices. The most significant energy price for CPI is oil and its effect on gasoline. This is likely to be a drag on CPI in future months, and will boost disposable incomes of American consumers.
Looking through these to core inflation (excluding food and energy) also gives a distorted picture. The data is dominated by increases in shelter costs, which we can be confident will reverse in future months due to the lagged response they have to changes in house prices. Fed chair Jay Powell prefers a measure now colloquially referred to as ‘supercore’ inflation, which covers services excluding energy and housing costs. This captures prices that are heavily affected by wages. The measure accelerated during February, offering little excuse to stop raising interest rates.
Hard data hot, soft data not
At the moment, the hard economic data justifies further rapid interest rate increases. However, the nebulous impact of banking turmoil on the willingness of banks to extend credit may tempt the Fed to be more cautious (expectations of a half point increase have been tempered to just a quarter point at next week’s meeting).
Above, I referenced the strength in hard data. Over the last year, an interesting divergence has emerged between hard and soft data. The first of the regional manufacturing surveys from the US (New York and Philadelphia) were aligned in suggesting a slowdown in economic activity during early March.
The National Federation of Small Businesses was more ambiguous. It suggested that more firms had individual positions that they found hard to fill, but fewer firms were planning on increasing hiring or raising prices.
During the European session, sentiment remains weak in the banking sector, but weekends are banking regulators’ best friends at times of stress. Discussions over the future of Credit Suisse and First Republic will no doubt continue, as neither seems to have wholeheartedly recaptured the enthusiasm of investors.
From an economic standpoint, the Federal Reserve’s key interest rate announcement on Wednesday will be the focus. The committee faces a real dilemma over how to respond to the competing forces of financial and price stability, and the competing influences of hard and soft data.
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