Events have gone into overdrive since the failure of Silicon Valley Bank and Signature Bank. The weekend of 18/19 March saw authorities in Switzerland seek to restore confidence by orchestrating the takeover of Credit Suisse by UBS. The ECB, the US Federal Reserve, along with the US Treasury, and other central banks have welcomed the rapid response to ensure financial stability.
A turbulent start to the week
Investor nervousness was triggered by one of the clauses in the UBS takeover deal, namely the writing-down to zero of 16 billion Swiss francs (USD 17.47 billion) of Credit Suisse’s ‘Additional Tier 1’, a hybrid debt instrument. This decision was interpreted as favouring shareholders over creditors and thus reversing the usual hierarchy.
This aspect of the takeover has been the subject of much debate, but the European Banking Authority’s communiqué on 20 March reassured markets by reiterating the recommendation that ‘common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down’.
In concluding that ‘AT1 bonds are and will remain an important component of the capital structure of European banks,’ eurozone authorities managed to allay investor concerns, alongside a similar commitment from the UK authorities.
Financial stocks recovered quickly with US and European banking sector indices rising (see Exhibit 1), despite continued nervousness over the prospects of San Francisco-based First Republic Bank. Reports have said that after having deposited USD 30 billion with First Republic, some of the major US banks that were part of the injection indicated they could take a capital stake with the support of the US government.
Bank supervisors react rapidly
The clarification around the treatment of AT1 debt in the UBS takeover of Credit Suisse has enabled investors to view recent episodes as the result of liquidity problems rather than a systemic crisis.
The permanent swap agreements to supply US dollar liquidity (with a switch from weekly to daily operations effective from 20 March) between central banks are precisely the measures typically employed to ease any strain in funding markets in the face of the risk of a liquidity crisis.
As the European Central Bank reminded us in its role as supervisor, ‘the euro area banking sector is resilient, with strong capital and liquidity positions.’ A typical liquidity crisis indicator such as the spread between three-month Euribor and the rate on government bonds of the same maturity (called the TED spread) has not shown signs of any significant tension. This reflects a normal functioning of the interbank market contrary to what was seen during the 2008 crisis.
Even though recent events will leave scars and there is a risk that other institutions come under the spotlight in the coming months, central banks have been prompt and efficient in their supervisory role.
But what about their monetary policy decisions, usually our favourite topic each week?
Policy remains (almost) on track
As noted in our article last week, the ECB did not hesitate to tighten its monetary policy further on 16 March. This can be seen as a form of reassurance: it shows that in the face of localised and specific issues affecting a small number of banks, it’s business as usual on the interest rate policy front.
On Wednesday, the Fed announced a 25bp increase in the US federal funds target rate, taking it to 4.75%-5.00%. Although this was in line with what had been expected, it did not prevent the US dollar from falling. In early trading on 23 March, the EUR/USD exchange rate moved to above 1.09, its highest since early February.
Fed Chair Jerome Powell’s blew hot and cold at the post-meeting press conference. In line with his comments in Congress on 7 and 8 March, his analysis of the state of the US labour market remained optimistic (employment gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low) and inflation is deemed ‘elevated’.
However, already in the second paragraph of its press release, the Fed said ‘recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation’ (see Exhibit 2 for the Fed’s latest projections).
We believe the Fed has changed its forward guidance: it believes that ‘some additional policy firming may be appropriate ‘. This wording is somewhat less hawkish than the phrase used previously (‘ongoing increases will be appropriate’).
Chair Powell indicated some policy rate-setters had considered voting for a pause in the rate rises at this meeting, but in the end, the decision to raise the fed funds rate by 25bp had been unanimous.
Still a lot of nervousness
The Fed looks likely to continue to ensure that its stance of monetary policy will be sufficiently restrictive to return inflation to its 2% target over time while taking into account the changing environment.
Investors remain nervous about the strength of the banking system, particularly in the US, as shown by the reaction to Treasury Secretary Janet Yellen’s comments on 22 March. Testifying at a Senate hearing, she said that ‘she has not considered or discussed anything to do with blanket insurance or guarantees of deposits’.
In short, Ms. Yellen said that the administration did not envision and had not discussed a deposit guarantee without Congressional approval. Faced with a systemic risk, however, the US Treasury could possibly find a way to implement it.
The issue of a bank deposit guarantee was also discussed at length at Chair Powell’s press conference, but no commitments were made.
In our view, the level of sensitivity in markets to any hint of adverse developments indicates that further episodes of market stress are likely to occur, even if many asset classes still have strong fundamentals.
We remain neutral equities with a preference for emerging markets, which should benefit from the post-pandemic reopening of the Chinese economy.
In the short run, we consider it appropriate to reduce our overweight exposure to high-grade corporate debt: credit spreads have been volatile in recent days and further spread widening cannot be ruled out given investor nervousness.
 AT1 securities are a form of contingent-convertible bonds. Cocos are a hybrid of bank equity and debt. In good times, they act like relatively high-yield bonds; in bad times, and when trigger points – such as a bank’s capital falling below certain levels relative to assets – are reached, the bonds convert to equity, cutting the bank’s debt and absorbing losses. Source: The Economist