Week ended March 24, 2023
Inflation trumps bank concerns (for now)
WHAT HAPPENED THIS WEEK THAT MATTERED
Investors started the week digesting the demise of Credit Suisse and ended the week with Deutsche Bank under the microscope. In between these bookends were the mid-week rate decisions by the Federal Reserve and the Bank of England. Even with this noise, risk markets performed admirably, with all of the global and US stock indices tracked by EMC gaining on the week. Short and intermediate term bonds also moved higher (yields were lower), although the long bond lost a bit of ground.
Generally bank concerns faded more into the background as the week wore on, although pressure on Deutsche Bank caused banks to return to the forefront on Friday. Deutsche Bank – similar to CS – has been under the microscope for years because of a string of issues. The beleaguered bank’s management was quick to dismiss concerns on Friday morning, and even (rather shockingly) said that they would use the “unreasonable” decrease in their bond prices as an opportunity to repurchase an LT2 subordinated bond. That’s a bold move given just how fast liquidity can drain from banks, a phenomenon we have seen more than once during the past fortnight. The pressure on US-based First Republic Bank, which has been of concern to investors since the failure of Silicon Valley Bank, also waned after the stock lost nearly half of its value on Monday, remaining stable the rest of the week (Friday close at $12.36/share, down 46% WoW).
Rumours surfaced throughout the week that the Treasury Department / FDIC would guarantee all deposits at US banks rather than cap the guarantee at $250,000, but the week closed with no such decision. My opinion is that this would be a bad move and is not necessary. Following the failures of Silicon Valley Bank and Signature Bank (and the shotgun sale of CS), depositors have been warned and should have taken steps to diversify their deposits that are in excess of insured amounts. Assuming this is the case, the migration of deposits has been orderly and at least – so far – does not seem to have spurred further (severe) problems. The KRE ETF (mid-sized US bank index) ended the week up 1.0% as stock prices of US mid-tier banks index stabilised following sharp declines since the beginning of the month.
Although bank share prices might have stabilised for the time being, there are plenty of indicators that funding costs for banks are increasing, and this ultimately will have knock-on effects for the banks and
broader macroeconomies. For example, for the first time that I can recall since the pandemic, CD rates are above the yields on similar-maturity UST bills. This “inversion” has occurred simply because banks are having to pay more to attract deposits, not surprising given the stress in the banking system. I also understand that CDS spreads for banks and insurance companies have widened. This makes sense and is one more indicator that banks are having to pay more to attract funding (both deposits and in the capital markets), because the overall risk of the sector is perceived to be higher. Even if this crisis passes, which it probably will, banks will likely tighten credit in response. This will lead to higher borrowing costs for retail and corporates, as well as to more stringent lending requirements, both of which will act as brakes on economic growth.
Investors were also keenly focused on mid-week rate decisions by the Federal Reserve and Bank of England. There was greater uncertainty than is normally the case surrounding the decisions of both central banks.
The bank crisis in the US had suddenly made the possibility of a 50bps increase in the Federal Funds rate before the crisis morph into a “more likely to be no change (“pause”) or a 25bps increase”. At the end of the day, the Fed did the right thing and increased the Fed Funds rate by 25bps, or to a target range of 4.75% – 5.00% (see FOMC statement here). Inflation remains stubbornly high and is only decreasing slowly. The Fed could not have paused without the risk of possibly having to do an about-face at its next FOMC meeting and raising rates again. That sort of “on again-off again” policy is not what the Fed needs given its credibility has already been greatly damaged by failing to see how persistent inflation would be in the first place.
On this side of the pond, the good news is that there is no banking crisis in the UK (at least so far), but the bad news is that the CPI read for February in the UK was much higher than expected (+1.1% MoM, +10.4% YoY), not only missing consensus expectations (+0.6% MoM, +9.9% YoY) but showing a robust increase MoM (ONS CPI report here). Higher prices left the BoE with no choice but to raise the Bank Rate again for the 11th straight meeting, this time by 25bps to 4.25% (see Monetary Policy Statement, March 2023 here).
Although risk investors were hoping for a pause by both central banks, they digested these increases rather well. In neither case were risk markets particularly rattled. There are other signs that the probability of a recession is increasing. Corporate credit spreads are increasing in high yield, the short end of the UST curve is continuing to rally hard as expectations are brought forward for a Fed pause (to reflect a slower US economy sooner), and oil prices remain under pressure due to potential demand destruction.
All of the equity market indices that EMC tracks, both globally and in the US, were positive if not spectacular this week. With the US Dollar losing ground, it is not surprising to see the best WoW performance come from emerging markets stocks, which benefit from a weaker US Dollar.
Although the 2yr UST yield ended the week slightly lower (5bps), its trading range during the week was wide. The yield gapped out to 4.17% on Tuesday before declining 41bps in the following three sessions to end the week yielding 3.76%. The yield on the 10yr UST was only 1bps tighter WoW (3.38% close) but was also volatile during the week as yields swung wildly. The 2yr-10yr yield curve difference narrowed to negative 38bps. Recall that the 2yr-10yr yield difference was negative 107bps only 11 trading sessions ago. Clearly, expectations regarding the number and magnitude of future increases in the Fed Funds rate have lessened, and the pause and pivot have been brought forward.
Volatility in the UST market is also sharply higher, as measured by the MOVE volatility index (similar to the VIX volatility index for equities). As you can see in the graph below, volatility in the US Treasury market has gapped to a significantly higher level than volatility in the equity market since the beginning of March.
Corporate credit spreads are showing signs of growing stress, with investment grade bond spreads narrowing (“flight to quality”) even as high yield spreads gap wider.
The US Dollar was slightly weaker as future rate expectations came down in the US. Gold was only slightly better, and oil was stronger although volatile this week.
Corporate bonds (credit)
Safe haven and other assets