Interest Rate Volatility

6 April 2023

Pascal Blackburne

Over the past few weeks, interest rates have experienced remarkable volatility, with daily swings of 20 basis points becoming the norm. This is unprecedented in recent history. Bond markets are clearly taking recession risks seriously: from 5.1% in early March, US 2-year Treasury yield dropped all the way down to 3.6% during the most acute phase of last month’s banking turmoil, and now sit around 3.8%. Stock markets, meanwhile, recovered fast from the mid-March correction, even managing to close the month in positive territory. But while their relative optimism regarding the economic trajectory may be justified, thanks to opportune central bank liquidity measures and a (rapidly) recovering Chinese engine, we still fear that investors will eventually face stubborn inflation – constraining equity market perspectives.

The recent bank failures, or near-failure in the case of Credit Suisse, served as a stark reminder that banking is an intrinsically risky business, transforming low-interest short-duration deposits into higher yielding long-duration loans. However strong the assets on its balance sheet (and in this respect 2023 by no means resembles the situation of 2007-2008), if a bank finds itself subject to a “run”, meaning that a significant proportion of depositors want their money back, it simply lacks the necessary liquidities. Which, in turn, is the very justification for the existence of central banks – as “lenders of last resort”.

The Silicon Valley Bank (SVB) balance sheet consisted mainly of safe long-term US Treasury bonds. Because intended to be held to maturity, these bonds did not have to be marked down when their market value fell below the purchase price. Put differently, SVB was not required to book the (significant) theoretical losses on its bond portfolio caused by the sharp rise in interest rates… until forced sales in order to fund deposit withdrawals made these losses very real. But why not have gone instead to the lender of last resort with the bonds, asking for them to be exchanged against cash? Because Federal Reserve (Fed) rules also considered the market value – and not face value – of financial assets pledged as collateral. A practice that was promptly adapted in the wake of the March events. The Fed now accepts bank assets at their face value, effectively eliminating the liquidity problem that sunk SVB and a couple of other US regional banks. A true game changer!

To our knowledge, the European Central Bank has not yet followed suit, but we have no doubt that it will do so when necessary. For the time being, Ms Lagarde claims that European banks do not face the same “asset-liability mismatch” because regulators require them to buy derivatives to hedge part of the duration risk. A correct claim indeed, although with derivatives comes a different form of risk, namely counterparty risk.

What also makes the European banking situation stronger than in the US is the fact that the additional regulation introduced after the Great Financial Crisis has been enforced, unlike in the US where – under the Trump presidency – banks with less than USD 250 billion in assets were exempted from reporting liquidity ratios and no longer subjected to interest rate monitoring in their stress tests.

As for the SVB saga, it seems unfair to us to blame management for piling up long-term government bonds. In a negative interest rate world, and awash with “easy” money flowing into deposits, the bank had little choice but to buy such bonds. We also have to wonder why Wall Street analysts did not see SVB’s troubles coming. After all, the incremental interest rate upmove due to the Federal Reserve hiking cycle started over a year ago and high-tech startups (SVB’s main clients) had been taking money out of their accounts for some months, in order to finance their “cash burn” – finding it more difficult to raise capital. Indeed, private equity funds are no longer that eager to inject additional money.

But perhaps most importantly, the mid-March US regional bank turmoil pertained to liquidity, not solvency, issues, which the Fed has now fixed. Alarmist comparisons with 2007-2008 are thus not pertinent.

That said, we must admit to being more puzzled by banking giant Credit Suisse’s rapid unravelling. Surely it can hardly be attributed solely to press coverage of comments by Saudi National Commercial Bank’s Chairman, a major Credit Suisse shareholder, stating that it would not participate in another capital increase. Were there perhaps balance sheet issues that only insiders knew of? Did it suit the major international investment banking competitors to see one player less on the field? In any event, here too, what must be retained is the swift and decisive intervention by Swiss authorities to protect the financial system. Which should serve to definitely reassure depositors that authorities will do “whatever it takes” to solve any future banking troubles – with or without the help of central banks’ unlimited money printing press.

But while this solid protection makes a major equity market correction unlikely, at least in the short-term, we still struggle to see much upside potential from current levels. Besides, high-tech stocks are behaving like interest rate derivatives nowadays, in the sense that their present value consists mainly of discounted possible future earnings. They thus fluctuate strongly with the ongoing bond market gyrations, to which the more traditional companies seem to be rather insensitive. Hence our (current) preference for investing in established companies, that generate cashflow day in day out and with limited refinancing risk.

Inflation, however, continues to be our longer-term concern – and the limiting factor for sharply higher equity market levels. Consumer prices indices are admittedly receding, but they remain well above central banks’ target. And a new flare-up in inflation is a distinct possibility, should greater Chinese demand drive energy and commodity prices higher or, as is currently the case, oil producers cut their output further. Meanwhile, core inflation indices (excluding energy and food prices) remain at stubbornly elevated levels (5.7% was the latest print for Europe), suggesting that price pressures are spreading beyond only food and energy, notably into rents, insurance and wages. The widespread belief among investors, especially in Europe, that inflation can successfully be managed down to the official 2% target over the coming months is premature, to say the least, in our view. Should this opinion change suddenly, they will no longer be satisfied with the yield currently provided by long-term bonds (which barely covers the depreciating value of money over the full term, considering a 2% average inflation rate). At that point in time, it will no longer just be interest rate volatility that stock markets have to deal with, as is the case today, but a reset to a new – considerably higher – interest rate level. Making then for much greater equity downside risk. We are paying close attention.

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