March 27, 2023Scroll down
Despite banking turmoil, Fed presses ahead with 25 bps hike
Last Wednesday, the Fed did exactly what we expected, continuing its tightening campaign with a 25bp increase to its policy rate, messaging one more hike in the cycle. At the press conference, Chairman Powell elaborated that the banking crisis has created some uncertainty which led the Fed to consider a pause, though the consensus of policymakers was to forge ahead and keep the pressure on inflationary forces that represent a greater threat. Powell’s guidance reflected a belief that lending will naturally get tighter as banks’ risk aversion increases, effectively doing the Fed’s work for it and necessitating fewer explicit policy actions to bring inflation back on target. The Fed chair also emphasized that despite stress in the regional banking sector, overall credit conditions still register as benign. In addition to Powell’s commentary, we have been keenly following FOMC dot plots—which show individual Fed officials’ outlooks for the Fed funds rate—and we note that nobody has rates coming down in 2023. Indeed, most of those submitting projections still expected the policy rates to peak at 5% – 5.25% this year and for that level to be maintained for some time. Even so, Treasuries rallied post-FOMC, as traders doubled down on bets that the central bank will soon reverse course, once again demonstrating the market’s refusal to take the Fed’s policy statements at face value.
Stress at regional banks will hit small business, economy hard
While we don’t think the Fed will soon cut rates, we agree with Powell’s suggestion that developments in the banking sector are resulting in an organic tightening of financial conditions, possibly allowing the Fed to pause at a lower terminal rate than might otherwise be needed. Stress around liquidity, closer scrutiny by regulators, and the rapid increase in rates are likely to spur a lending pullback among some regional banks, resolving the persistently loose conditions that have frustrated the Fed since it began the current tightening cycle. Since the pandemic, regional banks have provided a vast majority of lending to small firms, underwriting local small business formation. One channel through which contractionary monetary policy works its magic is by reducing investment by small businesses through suppression of regional lending, and this effect has clearly been accelerated by the recent banking crisis, as can be seen below.
This contraction will play out in the job market, as well. According to the U.S. Small Business Administration, small businesses accounted for nearly 63% of net new job creation, with nearly 47% of all private sector employees working at small businesses. Commercial and industrial loans have slowed meaningfully, cutting off a source of capital that feeds short-term funding of activities such as hiring, paying workers, purchasing supplies and equipment, and building inventories. As higher borrowing costs and the associated belt tightening hit main street with the lag we’ve been discussing in Perspectives for months now, we expect to finally see a slowdown in growth and job gains. The incremental tightening of credit conditions and added uncertainty in the wake of the Silicon Valley Bank (SVB) collapse undoubtedly raises the risk that a soft landing turns into a hard one.
Is the Fed Funding program another round of QE?
One factor holding up stock prices in recent weeks has been a growing belief that Federal Reserve and FDIC support of bank depositors is actually a stealth round of quantitative easing (QE). Looking at a huge jump in the Fed’s balance sheet since the banking crisis broke (see below), it’s easy to see why that view has gained traction.
We take a different view, attributing the recent $300 billion increase in the Fed’s balance sheet to an effort geared at alleviating pressure from the banking sector—mitigation of systemic risk—rather than deliberately injecting new money to stimulate the economy or markets. We note that half of the increase in the lending facility was in the “primary credit” category through the Fed’s discount window: a form of temporary borrowing, rather than new credit creation for the economy. The rest of the funding was loans to bridge the gap between FDIC insurance and the shortfall at failed banks. Moreover, a key difference between bank support of the past few weeks and traditional QE is that the Fed is lending money to banks in this case, rather than purchasing securities. That means borrowing from the Fed expands a bank’s balance sheet and tightens leverage ratios. In contrast, outright purchases of securities by the Fed actually provide the seller with additional balance sheet capacity for future expansion. For our technically inclined readers, the implication is that by virtue of the emergency nature of these funds, any increase in reserves is likely to be more than offset by a significant decrease in the overall money velocity in the banking system. The upshot is that this increase in the Fed’s balance sheet isn’t quite so worrisome.
Long-troubled bank succumbs to a crisis
When SVB unexpectedly failed, global investors began nervously looking around, wondering which institution might be next, pulling deposits from those that appeared the weakest links. Just two weeks ago, that resulted in a flight of capital out of Credit Suisse—including a decision by the firm’s largest investor, Saudi National Bank, to stop liquidity infusions—culminating in a US$68 billion bailout from the Swiss National Bank. When that wasn’t enough to save the firm, the world’s 45th largest bank, with around US$1.1 trillion in assets, was sold to UBS for just US$3.2 billion. How surprising was the collapse of Credit Suisse and how concerned should investors be that it represents much bigger problems for the global banking sector, given its status as a “systemically important” financial firm?
How big a threat is Credit Suisse failure?
In our view, much like SVB, Credit Suisse represents a somewhat special case: it was a bank whose troubles started long before central banks turned hawkish. One of the biggest incidents occurred a full year before the first Fed rate hike, when two financial firms closely tied to the bank, Greensill Capital and Archegos Capital, failed in quick succession. Credit Suisse’s headaches compounded last year, when the bank was accused of facilitating money laundering by international criminal syndicates. Since 2000, Credit Suisse was fined a total of US$11.4 billion for various infractions, representing quite a multiple to the ultimate purchase price paid by UBS. So, as disturbing as it is witnessing the collapse of a 187-year-old Swiss institution, we see the bank’s demise as having been accelerated by the ongoing bank liquidity crisis as opposed to a falling domino leading to a 2008-style breakdown of the system.
Understanding the Tier 1 bond controversy
When a company fails, equity holders generally expect to be more or less wiped out, owning the most subordinated securities within a firm’s capital structure, though bondholders imagine they might not lose everything. Certainly, most bond investors expect they’ll be paid before stockholders see a dime. As such, it was a big surprise to owners of Credit Suisse AT1 bonds to see the firm’s equity holders getting in on the action with the UBS takeover, while the AT1 bonds promptly went to zero. How could this happen? The first thing to note is that the bank’s AT1 securities were a type of debt called a “contingent convertible” security (a “CoCo”), which is specifically designed to absorb losses in times of financial stress. They do this by undergoing a mechanical write-off triggered when the bank’s capital ratio falls below a set threshold. This feature provides a bank like Credit Suisse with the ability to quickly strengthen its balance sheet when the going gets tough by shedding some of its liabilities. Of course, by the same token, this feature makes the Tier 1 bonds inherently riskier. To compensate for that additional risk, Tier 1 bonds yield more: around 7-8% on average prior to the crisis. Unfortunately for AT1 owners, Credit Suisse’s downfall illustrates that when investing in fixed income, the devil is in the details. The bond’s term sheet clearly stated that the instrument could be written down during a viability event in which the bank has received extraordinary support from the public sector. In this case, it seems many investors might have chased an attractive yield without fully understanding the risks that expected return entailed. That said, a US$17 billion wipeout tends to wake investors up, and the average yield on CoCo bonds now tops 13%.