Written by Brad Tank, Chief Investment Officer – Fixed Income at Neuberger Berman
Banking stresses may have tightened conditions enough for policymakers to pause their hiking cycles indefinitely.
When US and European two-year government bond yields have plunged a full percentage point in a week, with intraday moves unseen even during the Global Financial Crisis, and when a major Swiss bank has had to tap emergency liquidity, it might seem strange to say that, fundamentally, things haven’t changed. But hear me out.
The core of our macro outlook has been pretty steady for almost a year now. We have been saying that high inflation is likely to prove stickier than many have anticipated, that central banks would be aggressive and decisive in fighting it, and that this would have a lagged, negative effect on the economy and financial markets through 2023 and into 2024.
We think those effects are now beginning to be felt in earnest.
Delayed reckoning
Recent weeks challenged that outlook. Inflation started to decline even as economic data seemed to get stronger and stronger. The fall in European natural gas prices and the sudden reopening of China’s economy was a double boost.
As Joe Amato wrote, however, we weren’t convinced that this would save us from a “delayed reckoning” with the impact of tighter monetary policy on growth. “The more things change,” the more they stay the same, I agreed a few weeks later, pointing back to our long-term outlook and cautioning about reading too much into apparent market optimism. Let’s not forget that monetary policy acts with a lag, and that central banks aren’t done yet.
Breakages
That brings us to another important point in our outlook, something that got particular attention in our second Solving for 2023 theme: “Adjusting to higher rates continues to disrupt.”
If 2022 was the year rates went up, 2023 would likely be the year the economy and financial system adjusted. “Be watchful for weak points that could cause broader disruption,” we wrote. “When financial conditions change so fast, we think it’s prudent to look out for breakages somewhere in the system,” said Niall O’ Sullivan. Joe warned about “nasty surprises.”
Until the last week or so, we’d gotten lucky. Apart from the UK liability-driven investment debacle, this monumental tightening cycle had been relatively uneventful.
Solvency
The collapse of Silicon Valley Bank (SVB) was a sharp reminder that we can’t raise rates and drain liquidity this fast, and invert the yield curve this profoundly, and expect to come away unscathed.
With a big chunk of its liabilities made up of flighty venture-tech business deposits and a big chunk of its assets in a large book of US Treasuries, SVB’s solvency was vulnerable to a combination of rising yields and deposit withdrawals – which is exactly what happened, gradually over the past year and suddenly during the week of 6 March.
When an attempted capital raise failed, SVB went under. Signature Bank collapsed soon after, for similar reasons. Concern mounted about lurking duration mismatches throughout the banking system, given the amount of deposits that had been recycled into low-yielding Treasuries over the past few years. The KBW Nasdaq Bank Index plummeted more than 25%.
In response, the US Federal Reserve, Treasury and Federal Deposit Insurance Corporation jointly announced a backstop of the uninsured deposits at both banks, as well as the creation of a Bank Term Funding Program offering loans for up to one year secured by Treasuries and other qualifying collateral, valued at par.
In Europe, Credit Suisse also had to turn to the authorities for help, borrowing as much as CHF50bn from a Swiss National Bank liquidity facility and announcing plans to shore up its capital structure, after its shares plunged 30% to an all-time low on the SVB news.
What do central banks do next?
So, the shock waves of central banks’ monetary tightening have hit. What do the central banks do next?
We got a hint from the European Central Bank last week. It had committed itself to last Thursday’s 50-basis-point rate hike, but it’s notable that it dropped its previous promise to continue “raising rates at a steady pace” and trimmed its 2024 and 2025 inflation forecasts by 30 and 20 basis points, respectively. Our Head of European Fixed Income, Patrick Barbe, points out that this is the first dovish signal from the ECB in some time.
It’s a toss-up as to whether the Fed pauses or moves by another 25 basis points this week. We lean toward the latter. It does seem likely that we can expect a shift in messaging akin to what we heard from the ECB.
Financial conditions
Is that policy response simply an emergency measure in the face of stress in the banking system? In our view, it’s not only about that.
It’s true that last week’s US inflation data showed that consumer prices are still hot, still broadening and embedding themselves in the core, and still getting stickier. Measures like the month-over-month “trimmed mean” and “sticky” CPI remain considerably higher than the headline numbers.
But central banks can’t do anything about today’s inflation. Their job is to think about tomorrow’s inflation. Tomorrow’s inflation is most likely to be determined by the state of demand in the economy and tightness in general financial conditions. And over recent days we’ve seen weaker factory gate prices, weaker manufacturing data, weaker retail sales – and the biggest move tighter in the Bloomberg US Financial Conditions Index since the height of the Covid-19 pandemic. The message delivered by many financial institutions this past week is that funding costs have risen meaningfully while lending standards are being raised aggressively.
Indefinite pause
These are signs that the economy and financial system are beginning to adjust to the past 12 months’ policy tightening – and the broader impact of the current banking stresses is part of that mix, not something separate.
It’s worth remembering that it’s not a policy objective for any central bank to hit some previously signalled rate target, but to tighten financial conditions sufficiently to slow growth, job creation and, ultimately, inflation. Last week was a major step function in that tightening, which will contribute greatly to achieving those objectives.
As such, assuming these banking stresses do not evolve into something more serious, the ECB and the Fed may perceive that they are at or near their objectives with current policy. The Fed, in particular, is further along in its tightening cycle and should have more flexibility to pause – and markets are indeed pricing for 2023 fed funds rate cuts once again.
We don’t think this hiking cycle is definitely over – policymakers will want to see confirmation in the inflation data over the coming months – but after this week, we do think they’ll be on indefinite pause.
