When the Fed raised interest rates sharply the capital value of US government bonds fell. Nothing particularly unusual there. However, the Fed was no innocent bystander. It had blood on its hands. That’s because many banks had been acting rationally in holding the longer-dated government bonds that the regulators had urged them to do. They were acting rationally because, at the time when they bought these bonds, the Fed had told everyone that rising inflation was ‘transitory’ and that interest rates were therefore likely remain at low levels.
Furthermore, because of Covid-19, the US government made widespread stimulus payments directly into people’s bank accounts. Where the cash was saved, just about every bank was obliged to buy more long-dated government bonds. Then, when inflation suddenly didn’t look quite so ‘transitory’ the Fed rapidly increased interest rates and many of those bonds held widely by banks soon sat on their balance sheets as unrealised losses. This means that US banks will now be a lot more reluctant to lend.
So far, the contagion has been contained. But it would be wise to assume there will be after-shocks as businesses which have enjoyed cheap loans progressively discover that rising interest rates make it more expensive for them to renew those loans.
Remember, a lot of these banks are regional banks and their customers are small and medium-sized businesses. Businesses who employ a lot of people. They fund their lending with deposits and a lot of those deposits have fled to megabanks and money market funds. Thus, the rapid collapse of an atypical Californian bank looks like the mechanism whereby the US economy could be about to suffer a widespread credit squeeze. The recession that the US bond market has been signalling for months, might start here.
The stockmarket is responding to this. The collapse of SVB saw indiscriminate fear-driven selling of bank shares. As the fear of contagion decreased, bank share prices crept back up. But they have not returned to previous levels because less lending alongside the need to offer higher deposit rates to attract people back likely means lower profits. We can also be sure that US regional banks will see stricter regulation in due course. That means smaller players will be taken over and lending will become tighter.
On the rates
We can expect these events to bring the timing of the peak of US interest rates much nearer. Where does this leave investors? Right now, we have three conflicting views. The US bond market that says interest rates will be cut soon to cope with a recession. However, the US equity market is currently ignoring this and thinks that company profits will do well enough – and if they don’t then rate cuts ought to support share prices. And finally, we have the head of the US central bank still chanting that interest rates may need to be higher for longer. They can’t all be right.
