What does the US banking crisis mean for markets? – Special Report
March 14, 2023 4:27 pm
Cracks have started to appear in the US financial system with the collapse of Silicon Valley Bank. Even though the Fed stepped in with a rescue plan, it wasn’t enough to calm nerves in markets. Instead, investors are betting this episode will force the Fed to stop tightening. Such speculation seems exaggerated, and if Fed officials push back against it next week, stock markets could resume their decline while the dollar storms higher.
Financial stress
The collapse of Silicon Valley Bank has unleashed shockwaves across financial markets. Government regulators immediately rushed to the rescue, vowing to protect the deposits of people and businesses in that bank, while the Fed announced a new program that makes it easier for banks facing similar problems to access emergency funds.
But this forceful policy response was not enough to calm investors. Bank shares fell sharply in the aftermath amid concerns about a domino effect, gold prices soared as traders searched for shelter from the storm, and US yields came crashing down on bets that the instability will force the Fed to pause its tightening cycle.
There is an old saying that the Fed tightens ‘until something breaks’ and investors believe we have already reached this stage. Market pricing suggests the Fed could hit the pause button as early as next week, assigning almost a 20% chance for no action at all.
Inflation is public enemy Number 1
Admittedly though, this looks like an overreaction. The broader banking system and especially the big players are well capitalized, so there is no threat of a Lehman-style meltdown. Most of the stress is in smaller banks, which will receive a helping hand from the Fed’s rescue plan.
The real enemy is still inflation. Fed officials have argued that the metric they care the most about is services inflation excluding rents, which in the latest CPI report rose by 6.9% from last year. That’s extremely hot, and coupled with the recent strength in employment and consumption data, it doesn’t allow the Fed much room to pause.
Just last week, Fed Chairman Powell told Congress that interest rates might exceed the 5.1% peak the FOMC projected back in December. Since the economic data pulse remains strong, the updated interest rate projections next week might show a terminal rate closer to 5.3% or even 5.5%. That could ‘shock’ investors, who are currently pricing in a peak below 5%.
In other words, speculation about abandoning rate increases seems overblown. There’s a difference between financial stress and economic stress. The Fed has already taken measures to shore up the banking system, and the economy’s resilience suggests rate increases are likely to continue.
Market implications
If the Fed sticks to its guns next week and highlights that fighting inflation is still the priority, that could be the catalyst for some huge market moves. In this case, the terminal Fed rate would probably move up, pulling US bond yields higher alongside it.
Yields are essentially the price of money. That means yields act like a force of gravity in the markets. When yields move higher, that exerts downside pressure on most other assets. The logic is that if an investor can buy a US government bond that pays decent returns, they are less likely to take chances in riskier plays.
Therefore, a hawkish Fed and a recovery in yields would spell bad news for riskier assets such as stocks. Cryptocurrencies could get hit even harder, considering that the latest rally was fueled mostly by the decline in US yields.
Gold is vulnerable too. The precious metal has rallied more than 5% since last week, capitalizing on bets that the Fed is about to take the sidelines. But if yields move back higher, then bullion would become less attractive and it could surrender some of those gains.
In the FX arena, the big winner would be the US dollar as its rate advantage over other currencies widens again. In contrast, the main loser might be the Japanese yen, which is very sensitive to any moves in foreign yields. As such, dollar/yen could experience a particularly sharp reaction.
In conclusion, the banking system isn’t collapsing. The most prudent course of action for the Fed is to keep raising rates to tame inflation, while supporting the banking system with different tools. A reminder of this next week could come as a rude awakening for markets.
Cracks have started to appear in the US financial system with the collapse of Silicon Valley Bank. Even though the Fed stepped in with a rescue plan, it wasn’t enough to calm nerves in markets. Instead, investors are betting this episode will force the Fed to stop tightening. Such speculation seems exaggerated, and if Fed officials push back against it next week, stock markets could resume their decline while the dollar storms higher.
Financial stress
The collapse of Silicon Valley Bank has unleashed shockwaves across financial markets. Government regulators immediately rushed to the rescue, vowing to protect the deposits of people and businesses in that bank, while the Fed announced a new program that makes it easier for banks facing similar problems to access emergency funds.
But this forceful policy response was not enough to calm investors. Bank shares fell sharply in the aftermath amid concerns about a domino effect, gold prices soared as traders searched for shelter from the storm, and US yields came crashing down on bets that the instability will force the Fed to pause its tightening cycle.
There is an old saying that the Fed tightens ‘until something breaks’ and investors believe we have already reached this stage. Market pricing suggests the Fed could hit the pause button as early as next week, assigning almost a 20% chance for no action at all.
Inflation is public enemy Number 1
Admittedly though, this looks like an overreaction. The broader banking system and especially the big players are well capitalized, so there is no threat of a Lehman-style meltdown. Most of the stress is in smaller banks, which will receive a helping hand from the Fed’s rescue plan.
The real enemy is still inflation. Fed officials have argued that the metric they care the most about is services inflation excluding rents, which in the latest CPI report rose by 6.9% from last year. That’s extremely hot, and coupled with the recent strength in employment and consumption data, it doesn’t allow the Fed much room to pause.
Just last week, Fed Chairman Powell told Congress that interest rates might exceed the 5.1% peak the FOMC projected back in December. Since the economic data pulse remains strong, the updated interest rate projections next week might show a terminal rate closer to 5.3% or even 5.5%. That could ‘shock’ investors, who are currently pricing in a peak below 5%.
In other words, speculation about abandoning rate increases seems overblown. There’s a difference between financial stress and economic stress. The Fed has already taken measures to shore up the banking system, and the economy’s resilience suggests rate increases are likely to continue.
Market implications
If the Fed sticks to its guns next week and highlights that fighting inflation is still the priority, that could be the catalyst for some huge market moves. In this case, the terminal Fed rate would probably move up, pulling US bond yields higher alongside it.
Yields are essentially the price of money. That means yields act like a force of gravity in the markets. When yields move higher, that exerts downside pressure on most other assets. The logic is that if an investor can buy a US government bond that pays decent returns, they are less likely to take chances in riskier plays.
Therefore, a hawkish Fed and a recovery in yields would spell bad news for riskier assets such as stocks. Cryptocurrencies could get hit even harder, considering that the latest rally was fueled mostly by the decline in US yields.
Gold is vulnerable too. The precious metal has rallied more than 5% since last week, capitalizing on bets that the Fed is about to take the sidelines. But if yields move back higher, then bullion would become less attractive and it could surrender some of those gains.
In the FX arena, the big winner would be the US dollar as its rate advantage over other currencies widens again. In contrast, the main loser might be the Japanese yen, which is very sensitive to any moves in foreign yields. As such, dollar/yen could experience a particularly sharp reaction.
In conclusion, the banking system isn’t collapsing. The most prudent course of action for the Fed is to keep raising rates to tame inflation, while supporting the banking system with different tools. A reminder of this next week could come as a rude awakening for markets.
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