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by  BlueBay Fixed Income teamM.Dowding Mar 17, 2023

Passionate, insightful, contrarian at times and always a true thought-leader in his field, Mark Dowding shares fresh fixed income insights every Friday. His musings on the week cover macro developments, bond market trends and his latest positioning thoughts, with the odd joke thrown in for good measure. Subscribe to receive the latest weekly commentary.

Key points

  • Poor risk management has led to isolated stress at several US banks
  • A loss of confidence has put the global banking system under pressure
  • Governments globally have acted to reassure markets
  • Investors are looking at 2008 for clues, but the banking system is totally different in 2023
  • The ECB raised rates by 50bp this week and we expect the Fed to continue trying to restrain prices

In the wake of the SVB collapse, we have seen some wild price action in financial markets, most notably focussed on short-term interest rate expectations. Fears that we could see a run on deposits at other regional banks triggered a concern that we could be witnessing a systemic event, which would have far reaching consequences for the economy.

However, steps taken by the Fed and FDIC to protect uninsured deposits, by launching a Bank Term Funding Program (BTFP) facility which would provide liquidity in exchange for assets pledged at a par value, helped to assuage some of these concerns.

In reviewing the issues that brought down SVB, the roots of its demise appear embedded in some chronic failings in risk management and some spectacularly bad risk taking; this coming in one of a small handful of large regional banks, not subject to the same standard of regulation as apply to the Systemically Important Banks (SIBs).

In that context, SVB looks like an isolated case and although we have seen an amount of deposit flight from smaller institutions in the past few days, it is reassuring to note that further bank failures have been avoided.

Meanwhile, across the Atlantic, concerns related to banks saw Credit Suisse come under significant pressure. The embattled institution has been suffering from negative newsflow and a loss of confidence for some time.

However, with US banking stress acting as a catalyst to push CDS spreads north of 500bp, so this has seen risk managers pulling trading lines and investors cutting positions. This saw this spread approach 1,000bp in the middle of the week, forcing the Swiss National Bank to announce liquidity support, in an attempt to avert a death spiral at the bank.

It might appear that further steps to resolve the crisis at CS will be needed, but public support can buy time, while this is considered. Yet, with markets appearing to move so quickly, hopefully steps will be taken soon and the Swiss won’t drag their feet.

Banking crises at SVB and Credit Suisse have brought back memories of 2008. Indeed, there has been an instinctive desire to look for parallels between SVB and Bear Stearns, and then CS and Lehman. However, the truth is that the issues we are witnessing today are very different in nature.

Back at the time of the GFC, banks were much less regulated, ran excessive leverage and were poorly capitalised. Moreover, it was credit impairment in US mortgages which acted as a catalyst that then triggered a collapse. In 2023, the banking landscape is totally different.

In fact, higher interest rates have meant that the operating environment for banks is as favourable as it has been for many years. In addition, counterparty risk has been mitigated by centralised clearing of derivatives and so weakness in one institution should not threaten another. Yet, the truth is, that at the heart of the banking industry, confidence is everything. If confidence is impaired, then it is difficult to restore.

In this context, it has been interesting to observe bitcoin behaving as a safe haven as stress in banks has been seen to accumulate. However, we think these concerns will prove only temporary in nature and that policymakers are well placed to be able to manage events, by supplying liquidity and guaranteeing deposits where this is required.

In discussion with global policymakers this week, there has been a sense that when interest rates rise, as they have, then we should expect some areas of stress along the way. In that context, regional US banks may have been a bit of a blind spot, but the problems here can and will be addressed.

This may well mean much more widespread coverage of deposit guarantees funded via a bank levy. It almost certainly means more regulation for the smaller and mid-sized banks. We think there may be an imposition of a Net Stable Funding Ratio (NSFR) akin to that which exists in the EU and which serves to limit the extent of maturity mismatch between securities holdings and where banks are funded.

Nevertheless, there is a broad sense that if SVB is an isolated incident, then this will be over, done with and largely forgotten within the space of the next few weeks. In that context, we think that those claiming that the SVB collapse signals an imminent recession and calling for the Fed to change course on monetary policy will be misguided.

Although lending standards may tighten and this may infer some additional tightening in financial conditions, it is not clear that too much has changed in the real economy itself. We should remember that just one week ago, Chair Powell testified to Congress, noting that interest rates may continue to need to move materially higher than where they stand today, over the course of the months ahead.

A relatively robust CPI report serves as a reminder that, aside from ensuring financial stability, the big job that the Fed and other central banks have at hand is restraining prices. This will mean cooling growth and curbing strength in the labour market, which threatens to continue to push up prices.

In this context, several policymakers noted that the swift and robust response to SVB’s issue was partly necessary, so that the Fed can have a clear hand in ensuring that it is able to deliver on its mandate.

In light of this, we feel pretty strongly that the FOMC will hike by 25bp next week and we continue to remain on a trajectory, which will likely see rates hit a peak close to 5.5% in the next few months and then remain at that level for at least a couple of quarters.

Given this view on rates, when yields rallied dramatically at the start of this week, we took the opportunity to move short in US duration at the front end of the yield curve. Movements on Monday were certainly historic, with December 2023 contracts rallying by over 100bp in a matter of hours, in the wake of erratic price action that had seen many investors triggering stop losses on short positions.

Volatility was also seen this week in terms of JGB yields, where 10-year rates dropped to levels last seen before the BoJ widened its target band from 0.25% to 0.5% in December. We view this move as closely linked to positions in rates being stopped out across other global markets.

Intrinsically speaking, our analysis on the fundamentals in Japan has not changed. We continue to expect the wage outcome in the Shunto round to come well above where many have expected, noting that a slew of unions are pushing for close to a 5% increase.

We can continue to see inflation pressures in Japan slowly building and in light of this, we continue to see an ultra-accommodative monetary policy of Yield Curve Control as no longer justified on an economic basis.

In the Eurozone, the ECB hiked rates by 50bp this week as widely expected, bringing the deposit rate to 3%. With core inflation continuing to be problematic, we anticipate further rate hikes ahead with rates likely to peak around 3.75% in the summer. Policymaker conversations continue to highlight the surprising resilience of the Eurozone economy and resilience in inflation along with it.

There is some concern that policy has been behind the curve, but we think that the pace of rate hikes should now start to slow, with rates now comfortably above where the Governing Council sees the expected long-term neutral rate. Obviously, any threat to European banks could imperil this trajectory. However, we do not see many reasons for concern across the sector, away from what is happening at CS.

In the UK, Chancellor Hunt’s Budget saw some easing in fiscal policy, extending help with energy bills, as well as tweaking pension limits and offering childcare allowances, in an attempt to lure more of the working age population to become economically active in terms of the labour participation rate.

However, after the disastrous failed give-aways under Kwarteng and Truss last autumn, there is a sense that the government needs to tread very carefully for fear of re-igniting fiscal sustainability concerns. Meanwhile the irony of a ‘Back to Work’ budget occurring on a day of widespread national strikes, certainly speaks to some of the more entrenched issues the country is facing.

Meanwhile we continue to see rising prices putting the Bank of England in a tricky spot, not wanting to tighten much more for fear of triggering a downward spiral in house prices.

Turning to credit markets, the fact that SVB was an ‘A’ rated issuer this time last week, only for bonds to be worth less than 50 cents a day later, serves as a reminder to the importance of credit analysis, particularly as we reach the end of the economic cycle.

Rising volatility should mean that markets demand a somewhat higher credit risk premium, though we think that fears of imminent recession and credit impairment on a more widespread scale may be overplayed.

Balance sheets remain relatively strong and we continue to reserve more of our concerns with respect to private markets, where we are concerned that companies are burning cash, need to write down valuations and have also been overly reliant on leverage as a source of juicing returns.

We would also note that from an IPO perspective, deal flows are currently as low as they have been since 2002, meaning that many of the holders of these companies have limited opportunity to exit at the current point in time.

Looking ahead

As we look ahead to the Fed next week, there certainly is a sense that we have witnessed a few tumultuous days and it is tempting to think that beyond this, we may see volatility drop in the second half of the month.

We have seen some extreme re-pricing of certain assets and there has been a sense that time feels like it has been sped up and markets are on steroids in terms of moves, which may have played out over several months, now being manifest in literally a few hours. This can feel pretty exhausting.

However, if we step back we would sense that fundamentally speaking not too much has really changed in the past couple of weeks, particularly if you move away from the screens. Intrinsically we will see markets overshooting in times of volatility and that can make for interesting opportunities to enter trades at attractive levels.

There has certainly been plenty to reflect on after a crazy week that has seen a ‘billionaire bailout’, the CFO of Lehman in 2008 helping preside over another large bank failure, and the surprising realisation that a large chunk of the funds that have been raised for venture capital over the past few years have gone instead to finance a giant US duration trade, at a time when interest rates were at record low levels.

Elsewhere, we also thought it was noteworthy to observe how Barney Frank (of Dodd-Frank fame), was seen to have been one of those pushing for an easing of regulation he co-sponsored, after he had joined the board of (now collapsed) Signature Bank. Strange times indeed….

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