Those keenly following economic data for signs of a recession in the US and globally were in for a surprise in recent weeks. Financial-sector stress came to the fore and dwarfed positive economic data. This illustrates two things: first, last year’s aggressive monetary policy rate hikes have created unintended consequences; and second, the financial sector is a key conduit for recessions. Let’s take these in turn.
The depth of the surprise is best illustrated by then-Fed Chair and now US Treasury Secretary Janet Yellen’s 2017 claim that we “would not witness another banking crisis in our lifetimes”. Ironically, the recent episode of developed market banking stress appears oddly similar to the run-up to the 2008 global financial crisis, with one big difference: the key source of vulnerability this time around arose from steps to make banks safer.
Unlike 2008, the trigger was not exotic financial products, but the safest assets there are, US Treasury and agency bonds — the very assets banks were encouraged to hold by the post-2008 regulations. Of course, the value of these bonds — many acquired during the period of rock-bottom interest rates — fell as interest rates rose. It is somewhat of a mystery that even though central banks had telegraphed historically large and fast rate hikes, management and regulators of these failed banks (and likely others) apparently ignored this basic bond math and the adverse implications for asset valuations and capital buffers.
The subsequent policy response was inconsistent with the new frameworks established after 2008, a fact hardly conducive to boosting confidence as to their validity. In the US, where it was understood that non-systemically important banks would be allowed to fail (as a quid pro quo for less intrusive regulation), and their uninsured deposits to be settled out of receivership proceeds, a “systemic risk exemption” for the smaller banks was declared and all deposits guaranteed retroactively. In Switzerland, creditor seniority rules were set aside and some equity was bailed out while junior AT1 bonds were not.
Thus, rather than instilling confidence, these measures triggered further uncertainty. In the US, are all uninsured deposits now guaranteed (in violation of established laws and far exceeding allocated funds)? Or will depositors in smaller banks be well-advised to transfer deposits to larger “systemically important” banks, thus continuing deposit flight? Globally, is AT1 capital still investible? Are the new frameworks not working, or is the underlying problem so large that it can only be tidied over by violating resolution norms? Is something fundamentally broken?
Addressing concerns
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Governments and regulators have tried to address these concerns by repeatedly stressing the safety of banks. Moreover, monetary policymakers have insisted that they are able to continue inflation-fighting rate hikes as they possess other instruments to safeguard financial stability.
The latter claim is one that investors are well-advised to be sceptical of. The steeply inverted yield curve — when short-term interest rates exceed long-term ones — has been a huge headwind for banks, not just when it comes to valuation losses on their bond portfolio, but also in their very core business of maturity transformation: borrowing short and lending long. While emergency financing can address liquidity issues, it cannot boost a bank’s capital buffers to lend; only lower policy rates can.
At the current juncture, the yield curve is even more inverted than prior to 2008 and there is a real risk that by continuing to hike, central banks are poised to first trigger a credit crunch and subsequent recession before eventually cutting rates.
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Even so, on a positive note, we don’t think this is 2008 all over again. Banks are unlikely to be the epicentre of a new crisis, given generally high levels of capitalisation and official backstops.
Having said that, there are obvious concerns in other corners of financial markets. We already saw much of the cryptocurrency ecosystem implode and tech valuations crater once higher interest rates threw their fundamentals into question. In addition, there are other sectors that during record-low interest rates also recorded spectacular growth, most importantly private markets; while concerns about commercial real estate (which in addition to higher interest rates is being hit by a potential shift to remote working and retail) are circulating.
To some extent, the failed Silicon Valley Bank comprised all three of these risks — in addition to weak management and supervision. Moreover, the upcoming fight over the US debt ceiling could once again raise concerns about the global safe asset.
Safe harbour?
With the banking system woes in the US and Europe, Asia may appear like the safe harbour in a storm. There is some merit to this view, as the late 1990s Asian financial crisis now appears to have triggered more resilient systems than the 2008 crisis in the North Atlantic countries. However, financial systems in North Asian surplus countries, including China, Japan and South Korea, also invested heavily in bonds when yields were low and are recording similar mark-to-market losses. More consequentially, severe financial disruption in the US and Europe — while not our base case — would spill over onto Asian shores.
Against this backdrop, it is unlikely that we have seen the end of financial turmoil. We do not have a crystal ball, but investors are well-advised not to mistake a lull in market concerns and volatility as the go-ahead for renewed undifferentiated risk-taking. Faith in regulatory competence is also dented. Ultimately, aggressive policy hikes will likely have to be undone, even at the cost of accepting a higher medium-term inflationary outcome. A world of rolling financial shocks and credit crunches would be the even less palatable alternative.
Gerwin Bell is lead economist, Asia, at PGIM Fixed Income
