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
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
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.
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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