Between a rock and a hard place is an uncomfortable place to be. Just ask the US Federal Reserve and the European Central Bank.
The upheaval in global bank shares last week means central banks will have to choose their poison. Do they pause their rate hikes to see if they take hold and tolerate higher inflation for a bit; or do they keep hiking and deal with the financial instability caused by their own policy decisions?
After a decade and a half of near-zero interest rates, the rapid rise in rates was always going to lead to unforeseen consequences. Silicon Valley Bank (SVB) proved to be one such ticking timebomb in debt markets that had become accustomed to borrowing almost for free.
A tumultuous week for markets began as investors digested the news that the US authorities had come to the rescue of SVB depositors – the 16th largest bank in the country – and the smaller Signature Bank. Since the global financial crisis, 513 regional US banks have failed, but SVB was the largest of them.
Speculation that the Federal Reserve might not hike rates at all this week, given the stakes at play, saw the biggest rally in short-term bonds in decades. The yield on 2-year US Treasuries – a proxy for Fed expectations – plummeted by more than half a percentage point, the biggest drop since the day after Black Monday in October 1987.
On Wednesday, the Swiss central bank was next to take centre stage, stepping in to provide a £45 billion loan to Credit Suisse after its largest shareholder – Saudi National Bank – said it was unable to provide backing, sparking a 30% slump in its share price and a broader sell-off in European banks’ shares. The FTSE-100 index suffered its sharpest one-day drop since Russia invaded Ukraine.
On Sunday, news broke that UBS would buy its Swiss banking compatriot for $3.25 billion. The deal, which should close by the end of the year, will include UBS assuming its former rival’s losses.
The European Central Bank (ECB) was the first to show its hand on Thursday and didn’t flinch, announcing another half a percentage point increase in its benchmark interest rate, taking it to 3.0%. The central bank concluded that inflation remains too high to be ignored and that the current financial instability was a price worth paying to keep its plans on track. There were reports though that the decision was only made after Credit Suisse had secured its lifeline and financial markets had stabilised.
Eurozone bank shares hit two-month lows in response to the news, but later recovered lost ground as the ECB lifted its growth outlook and asserted that the region’s banks were in a much stronger position than back in 2008.
Both the Federal Reserve and Bank of England are in a period of self-imposed purdah ahead of their next policy meetings this week, and so were unable to offer clarity on their assessment of the situation or its effect on monetary policy decisions.
On Tuesday came news that US CPI inflation rose 6% on an annual basis, compared with 6.4% in the previous month. It should have been the key market event of the week but was overshadowed by the banking crisis. The absence of any nasty inflation surprises spurred a relief rally in equity markets around the world. The news strengthened hopes the Federal Reserve will go for a smaller rate rise when it meets this week.
Sentiment improved on the back of news that China’s economic activity picked up in the first two months of the year, boosted by a recovery in consumption and infrastructure investment and signs of recovery in its beleaguered property sector.
Ahead of Jeremy Hunt’s Budget on Wednesday, official figures showed that UK job vacancies had fallen for an eighth successive month, although at 1.1 million, the total number of vacancies remains high, and well above the period just before the pandemic.
The Chancellor duly laid out his plans to encourage people back to work, which included plans for additional free childcare, the abolition of the limit on lifetime pension savings and an increase in the pension annual allowance to £60,000.
“The additional amount that can be saved each year will help those such as the self-employed or entrepreneurs, who may not be in the position to save on a regular basis but want to increase their contributions when times are good or later in life when they are more stable and settled in their businesses,” commented Claire Trott of St. James’s Place.
But Hunt’s Budget was delivered against a backdrop of news that people face the biggest fall in spending-power for 70 years as the rising cost of living eats into wages. The government’s independent forecaster said that real household incomes would fall by 6% this year and next.
As a rollercoaster week for equity markets came to an end, there was news of another crisis at First Republic Bank, which was bailed out by 11 of the largest banks in the US. European shares saw their steepest weekly drop in five months, although the S&P 500 index eked out a small gain over the week.
“We have seen some extreme re-pricing of certain assets and there has been a sense that time feels like it has been sped up and markets are on steroids in terms of moves, which may have played out over several months, now being manifest in literally a few hours,” observed Mark Dowding of BlueBay Asset Management. “This can feel pretty exhausting. However, if we step back, we would sense that, fundamentally speaking, not too much has really changed in the past couple of weeks. We will see markets overshooting in times of volatility and that can make for interesting opportunities to enter trades at attractive levels.”
No one knows what the future holds, and this has been driven home emphatically in recent years. Any complacency about the stability of household finances has surely been wiped out by the developments that have unfolded since the turn of the decade.
The threat posed by the COVID-19 pandemic had only just begun to recede when Russia’s invasion of Ukraine last February ushered in another period of crisis. Both events, along with developments including the escalating effects of climate change, have had a direct impact on household purse strings, contributing to a spike in fuel, food and other prices that sent UK inflation to a 41-year high in late 20221. As with the pandemic, the effects of the Ukraine conflict may continue to ripple through the global economy for some time yet.
Inflation has begun to fall again since the start of 2023; however, households continue to suffer the effect of high prices. For many households, any rainy-day savings will likely be shrinking or even vanishing altogether, in order to cover living costs.
When we factor more personal life events into the equation, such as illness, accidents and bereavement, the case for having some form of safety net in place becomes even more compelling.
It can take years to build up those emergency funds, but a matter of days or weeks to deplete them. In some cases, one household crisis could empty out the rainy-day fund entirely.
If the worst does happen, protection insurance policies, such as Income Protection and Critical Illness insurance, are invaluable. The former aims to help cover outgoings such as mortgage repayments, rent, bills and other household essentials in the event of you being unable to work because of illness or an accident. It typically pays out between 50% and 65% of your income after a pre-agreed deferral period (usually three to six months) has passed, and most policies will do so for as long as needed.
Critical Illness insurance aims to pay out a lump sum on the diagnosis of certain specified critical illnesses or medical conditions.
While the prospect isn’t a nice one to think about, having to worry about financial matters in the event of something bad happening is even worse.
Source: 1 Office for National Statistics, ‘Consumer price inflation, UK: October 2022’, 16 November 2022
In The Picture
Last week the UK Chancellor delivered his Spring Budget. Watch our experts discuss their highlights from the day:
The Last Word
We continue to monitor the situation closely to make sure that there is no unintended inertia or complacency. As the situation evolves, we’re in regular contact with our fund managers so that we can act in the best interests of our clients.
Robin Ellis, Head of Portfolio Strategies, discusses our reaction to the banking events that occurred last week.
BlueBay is a fund manager for St. James’s Place.
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