Head of FX Strategy
Summary: The US authorities have stepped with liquidity measures and also announced a new lending program for banks to prevent the risks of a contagion from the collapse of Silicon Valley Bank (SVB) on Friday. Fed pause bets for March are increasing, but the authorities’ response on containing the financial risks suggests that the room to fight against inflation has been maintained. Risks to inflation also tilt further to the upside with the added liquidity measures, and the longer-run impact on US tech sector innovation will remain key to consider in portfolios.
As risks of a contagion from the US bank SVB’s collapse rose last week, authorities have stepped in to contain the fallout and prevent a broader impact on the financial sector. New liquidity measures from the Federal Reserve and the announcement that both SVB and Signature's depositors will be made whole have shielded the banking industry from contagion risks.
The Fed also announced a new lending program called the Bank Term Funding Program (BTFP) which allows any insured depository institution to borrow from the Fed for up to a year using banks' investment securities as collateral. The banks can borrow funds equal to the par value of the collateral pledged, even if the market value of the collateral has been eroded due to high interest rates. This will allow banks to meet withdrawal demands, without having to sell their bonds at a loss as was the case with SVB last week.
So the authorities have not just responded to the idiosyncratic risks posed by SVB, but the breadth of measures from the US regulators suggest they were wary of some systemic risks. Whether those risks have been pre-empted will be key to watch, but near-term relief is likely. The announcement of BTFP will put the depositor concerns at ease about their exposure to smaller regional banks, and clearly puts a floor on any panic brewing in the system for now.
US President Joe Biden will be speaking on Monday morning US time on the SVB situation, and his administration will be briefing Congress. Focus will be on any measure being announced to strengthen oversight and tighten regulation to avoid further banking sector stress as the Fed continues its inflation fight.
The risks of a financial crisis have further complicated the monetary policy response function in the US. Markets went from pricing in a 25bps rate hike for the March meeting to 50bps after Powell’s testimony last week back to 25bps after risks of a contagion in financial sector arose. Terminal rate pricing has gone down from 5.7% last week to 5.0% now. Some banks are also calling for the Fed to pause in March to re-assess the impacts of their policy tightening.
But the Fed has responded to the financial risks very strongly, further suggesting that the room to fight against inflation has been maintained. Further, steps to add liquidity to prevent a financial crisis could mean more risks of inflation. Some may also argue that with the backstop in place, the Fed can continue to raise interest rates without harming held-to-maturity assets, since they can still be traded in at par if banks need liquidity. This enables the Fed to go higher for longer. Could we start to see more tightening expectations being priced in again if the fallout from SVB is contained but US CPI comes in hot once again on Tuesday?
The SVB crisis has highlighted the pains of the US tech sector, where demands for withdrawals possibly ramped up as liquidity pressures worsened. While the Fed has been nimble on addressing financial stability risks, fear waves are rippling through the entrepreneurial sector in the US especially in the tech space, and that may potentially leave some long-lasting scars on the productivity of the tech sector. VC funding could continue to weaken as interest rates remain high, impacting the innovation in the tech sector.
US equity futures and Asian equities have responded positively to the news of a backstop funding, but Treasury yields continued to slide and the US dollar weakness also extended further as calls for Fed’s tightening path continued to ease. Risk rally could extend into the US session after a sharp drop in equities last week.
Friday’s US jobs report was mixed but the headline continued to hint at labor market tightness. Tuesday’s CPI release will be the next big test of the Fed path from here, and if it is evident that inflation risks remain prominent, while the Fed can convince the markets that financial risks will be responded to, then yields could reverse back higher once again and USD could strengthen. Equities will likely continue to be under pressure, and the pressure on smaller businesses (best represented by RUSSELL 3000 index) or the tech innovation could mean these parts of the market could continue to shed their froth. This continues to emphasise that flight to quality will be key for portfolios as the Fed tightening cycle continues.
However, even if the Fed goes ahead with a 25bps rate hike next week, there will be considerable uncertainty on the outlook if the market continues to believe that the Fed won’t hike rates higher and keep them there for longer. How the Fed addresses these market concerns will be key to watch from here.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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