The fixed income market this year has seen more twists and turns than a potboiler.


The year started with a morale-boosting rally in bond markets following a bruising 2022. Speculation that major central banks were closer to ending their aggressive tightening spree had pushed up prices across the board in the initial weeks. But the optimism did not hold for long as a slew of data showed that inflation is stickier than anticipated.


Amid this environment, the collapse of Silicon Valley Bank (SVB) and Signature Bank, as well as the takeover of Credit Suisse by UBS have completely changed the macro landscape and bond yields are falling again.

 

Now, policymakers face the question of choosing between increasing rates further to rein in persistent inflation or relent soon to temper market anxiety.

 

The assumption that inflation generated in the post-Covid period will be transitory has proved to be a mirage. Various factors are at play and growth has held up well so far despite fears to the contrary. In Europe, a warmer-than-usual winter has reduced energy needs, while China’s reopening is spurring demand. The labour market continues to be tight.

The fallout from the banking turmoil

Financial stability risks have always had wider ramifications for the global economy. It was not long ago that Liz Truss’s expansionary budget caused a Liability-Driven Investment pension fund crisis in Britain, leading to her downfall and an eventual tightening of belt by her successor. The Global Financial Crisis (GFC) also had roots in banking failure and reached a denoument with the bankruptcy of Lehman Brothers.

History tells us that an uncontained banking crisis can plunge the world into a tailspin. It’s not yet clear whether the turbulence in the sector seen now is isolated or has the potential to spread although regulators have acted with alacrity to nip trouble in the bud. Reforms initiated after the GFC have also helped shore up the capital of banks in Europe, with an emphasis on solvency and liquidity.

In the case of SVB, even uninsured investors will fully get back their deposits, which is an attempt to prevent a run on other similar sized small banks. The UBS-Credit Suisse deal was guided by the Swiss National Bank and Swiss Financial Market Supervisory Authority FINMA.

In the US, the collapse of SVB was precipitated by mark-to-market losses on their bond portfolio, which was heavily tilted towards the long-end. Sharp rate increases had caused a drastic drop in the value of their holdings, causing an asset-liability mismatch. On the other hand, Credit Suisse has been going downhill for years, with the recent statement by the chair of the Saudi National Bank (a key shareholder) ruling out any further financial assistance hastening its fall.

In the banking world, fundamentals are important but sentiment and retaining confidence are crucial as well.

Tightening financial conditions

The unravelling of SVB and Signature Bank could also cause a flight of deposits to the so-called systemically important big banks. In order to arrest migration of deposits, smaller banks may need to increase interest rate on such funds, which in turn will raise the cost of capital for borrowers and businesses. In a crisis, banks also typically tend to turn wary of lending in order to preserve capital. These issues could preclude the need for further central bank rate increases as financial conditions are expected to tighten even otherwise. Before the troubles of SVB came to light, US Federal Reserve Governor Jerome Powell told Congress that the terminal rate, the peak rate in the current cycle, could be higher than expected by most officials at the end of 2022, while signalling an aggressive increase if data backed such a move. But markets have drastically altered their near-term expectations following the SVB debacle and UBS-Credit Suisse merger.

Over the past year, front-end yields have increased sharply, a reflection of rapid policy rate increases in the last many months. Long end rates, which capture the market expectations of growth and inflation, have remained below short-term rates, leading to an inversion in the yield curve. The inversion has narrowed somewhat after the SVB collapse.
Brace for more volatility leading to rate cuts
Even after a string of rate increases, inflation remains above the comfort level of policy makers. A structural shift in the global economy and the changing contours of geopolitics mean inflation will continue to stay higher than what we are used to before Covid. Therefore, the neutral rate, that neither boosts nor restricts growth, will be a little higher.

Even so, the crisis in the banking system is clear evidence that the monetary policy actions of the past year is gaining traction. In our view, rates do little to move the cycle one way or another. It’s only when something breaks that lending literally halts. We are witnessing that moment now. We expect the result of this will be greater volatility, growth will be affected, and inflation will soften. We expect a risk-off mood to dominate markets for now until central banks begin to start cutting rates.

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