Damned if they do, damned if they don’t
There’s been a lot of talk of recent events in the banking sector, and while everyone has been focusing on which bank is potentially next, I think the more important issue is central banks’ reactions to it. In particular, how central banks will manage the ongoing battle against inflation versus the expectation to ease market fears through the banking crisis and tightening credit conditions. Are these lines getting blurred and what will this mean for the future of central bank policy?
For the past few weeks, the spotlight of the financial markets has been on banks, but for all the wrong reasons. It started in the US with the collapse of Silicon Valley Bank (SVB) and some other regional banks (Silvergate and Signature Bank). The troubles and sentiment travelled across the pond with Credit Suisse facing problems of its own. While SVB was small and focused on tech start-ups, Credit Suisse is much larger, prompting fears of a Lehman 2.0 moment.
Step-in central banks… as has been the case so often since the turn of the global financial crisis.
Central banks save the day
In the US, the Federal Reserve (Fed) essentially sent a “don’t worry, we got you” message to all regional banks in the form of guaranteeing depositors of SVB and Signature Bank full access to their capital and announcing a new, wider Bank Term Funding Program, helping to alleviate short-term liquidity concerns.
In Europe, the Swiss central bank provided a $54bn loan to Credit Suisse in the hopes that it would prevent the slide in its share price. This ultimately failed and to prevent the collapse of such a major bank, the Swiss government and regulators intervened, forcing the sale of Credit Suisse by rival UBS for almost $3.25bn, well below its market value. £14bn of Credit Suisse’s AT1 bonds were written off as part of the transaction, despite shareholders getting paid, which severely impacted the wider AT1 market. The European Central Bank (ECB) and the Bank of England (BoE) quickly announced that AT1 bonds under their jurisdiction will be treated senior to equity holders, restoring a sense of calm in the AT1 market.
What was clear with these central bank responses was that they knew they had to intervene and they had do it quickly. Credit Suisse could very well have been a Lehman Brothers 2.0 given its scale. This time, unlike 2007/08, the central banks are standing by the banks that are getting into trouble with no hesitations. To demonstrate this point, a number of central banks teamed up and announced a plan to increase liquidity through a US dollar liquidity swap line to preserve financial stability.
What this means for the fight against inflation
Each of the Fed, the ECB and the BoE had their interest rate setting meetings amidst the banking chaos. Each central bank could have justified a move in any direction. In the end, the Fed and BoE, seemed to acknowledge there is some threat to the economy following the banking crisis but still reiterated that inflation is a big problem, hence smaller-than-initially expected 25bps hikes. This clearly demonstrated that they were not dealing with inflation in isolation anymore.
The ECB, however, surprised markets. Just hours after Credit Suisse seemed to be bailed out by the Swiss Central Bank, it announced a 50bps rate hike. It said that inflation was likely to remain high “for too long”, which forced it to continue with its planned course of rate hikes. Moreover, Christine Lagarde, the ECB’s President, said the central bank would treat the heightened tensions in financial markets separately from its strategy for bringing down inflation. Even the Swiss Central Bank themselves gave the same rhetoric and moved forward with a 50bps hike. Unlike the Fed and the BoE, they clearly have one enemy in mind, in the form of inflation!
The future of central bank decisions
The market believes that the Fed is due one more rate hike followed by rate cuts. Whilst I also believe there will be one more rate hike, I think central banks will maintain rates this year and save any cuts for 2024. Any support that is provided to further sure up the banking crisis and prevent a contagion will be constrained to the industry like with the Fed’s loan facility rather than broad-based accommodative measures like rate cuts for three main reasons.
1) Inflation > Recession
Central banks are more afraid of inflation than a recession. They have experience of a recession and know they can handle it, going through the global financial crisis. With inflation however, it is not something central bankers seem fully equipped to deal with, so has the potential to cause more problems than a recession could. As such, they probably won’t think about cutting rates any time soon.
Central bankers are increasingly concerned with their own independence and credibility, and wouldn’t want to lose any more than they already have done. There is still concern that inflation is well above the Fed’s (and other central banks’) targets and not falling fast enough. As such they will, just like the ECB, treat inflation (as a first priority) and banking tensions separately.
3) Policy Divergence Aversion
The ECB were quick to make their thoughts clear about dealing with inflation in isolation and this may pave the way for other central banks. With the ECB going down with this route, it will be hard for the Fed and the BoE to do anything different but follow suit. They may feel like they cannot be the ones that cause any major central bank policy divergence, because that could bring a whole host of further implications.
Whilst I do believe that central banks will want to keep the fight against inflation and support to the banking sector separate, I’d acknowledge that between now and then, things in the banking sector can still get very messy and affect rate paths. If things do get worse, and it is apparent that banking issues are spreading and spreading quickly (not that I think this is likely), central banks will forget about the above three points and prioritise the avoidance of a full-blown financial crisis.
Head of Investment Research