People stand outside an entrance to Silicon Valley Bank in Santa Clara, California, on March 10. The sustained rise in interest rates has helped drive the turmoil currently shaking markets, but a sudden shift to central banks cutting rates appears unlikely. Photo: AP
Opinion
Macroscope
by Nicholas Spiro
Macroscope
by Nicholas Spiro
A pause in interest rate rises, rather than cuts, might be the best investors can hope for
That there is still much uncertainty over where benchmark US rates are heading attests to the unpredictability of the financial and economic landscape
What is clear is that while rate increases set off the recent market turmoil, rate cuts would be an indication of the severity of the damage to confidence
Are the world’s hard-hit consumers and businesses about to get some relief as leading central banks start to cut interest rates? As recently as the beginning of this month, posing such a question would have been regarded as wishful thinking.
On March 7 – just before the turmoil in the global banking system erupted – traders were betting the US Federal Reserve would raise rates by a further 100 basis points to a peak of just over 5.6 per cent by September, according to Bloomberg data. At the time, this seemed like a sensible wager given the persistence of high inflation and the resilience of the US labour market.
Fast forward three weeks and those bets seem a distant memory. Not only are derivative markets pricing in a high probability of the Fed keeping rates on hold at its next meeting in May, traders expect rates will be cut by at least half a percentage point by the end of this year.
Markets are also pricing in lower borrowing costs in other countries, including Canada and Australia, and believe rates in the euro zone are unlikely to rise much further.
The sharp repricing is one of the most conspicuous effects of the crisis of confidence in the banking sector that has led to the failure of three mid-sized American banks, prompted the emergency takeover of Credit Suisse by its local rival UBS and left another mid-tier US bank, First Republic, teetering on the edge of implosion.
What began with a run on Silicon Valley Bank – whose huge unhedged bet on borrowing costs remaining low backfired spectacularly, exposing the perils of poor management of interest rate risk and an unstable deposit base – quickly morphed into fears about hidden dangers in the financial system.
02:30
Thousands of jobs at risk after UBS’ US$3.2 billion takeover of Credit Suisse
Thousands of jobs at risk after UBS’ US$3.2 billion takeover of Credit Suisse
Within the space of a fortnight, the threat of high inflation was supplanted by the risk of more severe blow-ups in the banking sector and other rate-sensitive industries, in particular commercial property.
This has created an acute dilemma for central banks. Cutting rates to relieve pressure on a stressed banking system would threaten the progress made in bringing down inflation, which is still uncomfortably high, especially in the services sector.
In its latest economic outlook, the Organisation for Economic Cooperation and Development said central banks should “stay the course” despite the turmoil-induced tightening in financial conditions. Some big investors, such as BlackRock, agree and believe expectations of rate cuts this year are overdone and underplay the severity of the inflation shock.
These arguments are compelling, partly because they recognise the extent to which the inflation regime has changed since the Covid-19 pandemic erupted. Central banks can no longer loosen policy as easily as they could when prices were subdued. Moreover, the stresses in the banking sector have abated somewhat in the past week, suggesting further turmoil could be averted.
Yet, the pressure on policymakers to halt their rate-raising campaigns and start cutting rates has increased sharply. Although both the Fed and the European Central Bank have raised rates in the face of financial instability – they say they can fight inflation and address banking vulnerabilities simultaneously using different tools – they struck a decidedly dovish tone, signifying that a halt to the rate-raising cycle is imminent.
A customer stands at an ATM at the entrance of a First Citizens Bank branch location in the Encino section of Los Angeles on March 27. North Carolina-based First Citizens is set to buy Silicon Valley Bank, the tech industry-focused financial institution that collapsed earlier this month. Photo: AP
The big risk right now is a credit crunch. Lending standards in the US were already tightening before the collapse of Silicon Valley Bank and will tighten further amid higher deposit and wholesale funding costs. Tougher financial conditions act as a substitute for rate increases. Markets are effectively doing central banks’ job for them, increasing the risk of a “hard landing” for the economy.
In the last two weeks, the amount of global corporate debt in distress has risen by US$69 billion, most of it in the United States, according to Bloomberg data. Fears are growing that US commercial real estate – which is heavily dependent on funding from the country’s vulnerable mid-sized banks – could be the next domino to fall amid a toxic combination of rising rates and the work-from-home revolution.
If vulnerabilities in the banking sector metastasise, central banks will have little option other than to start cutting rates. This is why the prospect of rate cuts later this year is a bleak one. Desisting from further tightening – the most likely course of action in the coming months – is one thing. Cutting rates is quite another.
Central banks will only loosen policy abruptly if the recent turmoil turns into a full-blown crisis. Even hinting at rate cuts amid high inflation and strong labour markets in many countries could spook markets, sending an ominous signal that policymakers and regulators are more concerned about financial instability than previously assumed.
That there is still much uncertainty over where benchmark US rates are heading – some investors expect another increase in May – attests to the unpredictability of the financial and economic landscape. What is clear is that while rate increases were the trigger for the recent turmoil, rate cuts would be an indication of the severity of the damage to confidence.
The world’s consumers and businesses might have to settle for a pause in the tightening campaign. All things considered, that might not be the worst outcome.
