Little is more volatile than financial markets. One minute equity markets are stumbling over yet another mountain of additional interest rate hikes by central banks, the next we are waiting to see if those same central banks need to act to prevent another banking crisis.
Until last week, the demise of Silicon Valley Bank (and Signature Bank) in Europe was mostly a distant memory. Also because the US Treasury, the Deposit Insurance Corporation (FDIC) and the Federal Reserve quickly came up with a relief programme, the Bank Term Funding Program. This allows banks to deposit a range of different (bond) instruments at par value with the Fed in exchange for liquidity. This breaks the downward spiral of falling bank balances (deposits) leading to forced sales of bonds, which are heavily at (a paper) loss due to the sharp rise in interest rates.
In theory, this liquidity instrument should be effective as it removes one sting, paper losses becoming realised losses on the balance sheet. This also diminishes the impact of the other problem that brought Silicon Valley Bank down (falling deposits). Incidentally, Silicon Valley Bank additionally had a lot of concentration risk, but that aside.
Confidence crisis
What the Federal Reserve has less direct influence over is “confidence. And that is the reason volatility is now spilling over into Europe. Credit Suisse has been under fire for months as a result of a flawed business model and a reorganisation that just won’t work out. With the developments in the United States on every investor’s radar, it’s bad timing when your biggest investor, Saudi National Bank, says it doesn’t want to spend any more money. Even if it has a good reason to do so, regulation.
The functioning of the banking sector is largely determined by the combination of trust and uncertainty. When the latter becomes the decisive factor, confidence disappears from the picture and even an emergency liquidity programme like the Bank Term Funding Programme does not make much difference. The lack of confidence causes huge falls in share prices,which quickly destroys banks’ capital ratios. Although the cause of Silicon Valley Bank’s and Credit Suisse’s problems are different, they share an investor confidence flight driven by insecurity. This is considerably more exciting for Credit Suisse, as it is a ‘Global Systemically Important Bank’. At the same time, you might expect such a bank to have more buffers because the regulatory environment is a lot tougher than for, say, regional US banks. But yes, that trust huh.
Scylla and Charybdis
In Investment Officer’s latest IO Weekly podcast, I said I expect both the ECB and the Federal Reserve to raise interest rates. And looking at the latest US inflation figures, that picture has not changed. I am always amazed at how investors frantically look for that one figure that came out lower than expected or that one indicator - I see them too - that points to a collapse in inflation later this year.
But what those investors forget is that after all those setbacks, the Federal Reserve and the ECB can’t take their foot off the brake pedal until they have sufficient conviction that inflation really is on track to meet its target. I keep a list of the inflation measures that Powell and his colleagues consider most important, supplemented by some inflation indicators that give a good picture of the underlying trend. There are seven in total. The 3-month annualised price increase of all seven(!) has increased over the past two months and the average is 5.0 per cent. It is simply too early to have conviction on the inflation target.
Nevertheless, I am now less convinced that the Fed and ECB will raise interest rates at the upcoming interest rate meeting. With concerns about a banking crisis spilling over to Europe, the likelihood of intervention increases. Central banks are, by definition, extremely vigilant when it comes to financial sector stability. On the other hand, if the Fed stops, it is likely to be seen as a sign of panic. You understand that I currently see few paths leading to higher stock markets.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Monday on Investment Officer Luxembourg.
The Dutch version of this article is available on InvestmentOfficer.nl.