Markets Weekly podcast – 27 March 2023

Julien Lafargue (JL): Welcome to this new edition of Barclays’ Market Weekly podcast. My name is Julien Lafargue, Chief Market Strategist at Barclays Private Bank, and I will be your host today.

As usual, we will go through last week’s events before moving on to our guest segment. And, today, I’m delighted to be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank. But first, let’s take a look at last week and all the events that we had to cope with.

First and foremost, well, the Fed hiked interest rates by 25-basis points to a range of 4.75% to 5%. This was largely as expected, although expectations had moved quite a lot prior to the meeting. In reality, this was really the only option available to the Fed. A pause would have sent the wrong signal, maybe that the Fed was more worried than the markets were about the financial turmoil. On the other hand, the 50-basis point hike would have sent the message that the Fed didn’t really care about what was happening in the banking sector.

Although it was a hike, it was a relatively dovish one as the statement provided by the Fed and the FOMC softened the central bank’s commitment around potential future increases of interest rates, adding a section saying that the full effects of the banking crisis are yet to be determined.

That being said, the famous “dot plot” forecast was on the other side of the spectrum and rather hawkish when compared to market expectations and pricing. The dot plot was, in fact, little changed from the December one with the 2023 dot still at 5.1% and with the dot for the medium of 2024 actually increasing slightly to 4.3%. It’s important to bear in mind that at the time, and this remains the case currently, the fed funds rate futures are pricing in a rate of 4% by the end of this year. What that means is that the market is looking at moves of north of 100-basis points worth of interest rate cuts between now and December.

This is something that chair Jerome Powell pushed back against, saying that interest rate cuts in the second half of this year were not really on the cards, and he stressed the Fed’s commitment to look at incoming data before making any decision as to whether the central bank will need to hike interest rates further or not. But, clearly, the path forward, at least in the Fed’s mind and as things stand today, is not for any cut to be implemented before the end of the year. Obviously, the Fed also took the opportunity to reassure markets, saying that the US banking system is very much resilient.

But the other key event of last week was the BoE meeting. And the BoE did just like the Fed, ie met expectations, hiked its key bank rate by 25-basis points to 4.25%, and that, again, despite the recent turmoil in the banking sector. We had two members of the BoE dissenting to this decision, but that has been the case for some time. And like the Fed and the ECB, the BoE kept its options open for its next meeting in May. The central bank clearly emphasised its willingness to take more action if price pressure persisted, but also was encouraged by underlying price developments and signs of easing in the labour market.

To be fair, you have to look very closely to find those encouraging signs, because headline inflation actually unexpectedly accelerated from 9.9% year-over-year to 10.4% last month while the core inflation jumped from 5.7% to 6.2%.

The BoE decided to see the glass half full and, because most of the increase in inflation was put down to one-off factors and volatile items, they’re not expected to lead to a sustained period of higher prices. Just like the Fed, and the ECB before that, the BoE judged that the banking sector in the UK remains resilient, but policymakers said they would monitor credit conditions to determine whether recent effects would lead to a further tightening in conditions and impact households and firms around the inflation outlook.

So, in summary, it was really a week of financial turmoil with the rescue of Credit Suisse by UBS and the deal that we’ve gotten familiar with now. And it was a week where central banks decided that it wasn’t the right time to stop their fight against inflation.

But, before we move on to Michel and discuss a bit more the fixed income market in particular, I just wanted to share a quick thought.

If a month ago someone had told you that SVB, the 16^th largest US bank, would fail, and that person would have also told you that Credit Suisse would fail and be saved in extremis by UBS, and that despite all this the ECB would hike by 50-basis points and the Fed and the BoE would hike by 25-basis points, I wonder what would have happened?

Well, first, I’d like to meet this friend or this person who told you that because he would be, or she would be, a great strategist. But, as an investor hearing that, you would probably have decided to move all your investments into cash and take the least amount of risk possible expecting that, I don't know, the S&P would drop at least 10% if not 20%.

The reality is, and that’s important, the S&P 500 is flat over the last month. The Nasdaq 100 is, in fact, up 6.6% as of today. On the other hand, being in short-term risk-free rates, let’s say US T-Bills, would have lost you money. Six-month T-Bills are down almost 4% on the same timeframe.

So, headlines might seem very concerning, but it’s always important to put them in perspective with what the market is anticipating and how the broader market is positioned. That being said, let’s talk about all that, and specifically on the fixed income market, with Michel.

Michel, great to have you back on the podcast. I’ll start maybe by asking you a question that we’ve received from clients over the past couple of weeks. Have we seen, as of now, the peak in policy rates, given all the turmoil we’ve had in markets and in the banking sector in particular?

Michel Vernier (MV): Look, if we would have had this conversation a month ago, and we had this conversation, obviously, the answer might have been slightly different, although it hasn’t changed as much from our previous stance. But to cut it short, we may have well seen the peak and, if not, we are actually very close indeed. Now, after the large moves, just a quick overview of what actually happened and why that move that we’ve seen is so extreme.

Back at the beginning of March, the forward rate market implied a peak of the US policy rate at around 5.75%, almost 6%, for the peak in the policy rate. In a matter of less than a week, the market priced for almost 100-basis points lower, at a peak at 4.8% roughly right now. In the meantime, exactly as you said, the Fed actually increased rates by 25-basis points, which seems appropriate right now despite the unfolding of the US midsize banking turmoil.

It seems prudent that now the Fed treads carefully and perhaps they may even have to pause. Now, interestingly, a month ago we wrote in our Market Perspectives publication about this possibility. In our article Dangers of Complacency, we alluded to the risk of the Fed being way too confident, over-confident of being able to hike rates regardless of what is happening without causing any harm to the financial stability.

Now, coming back to the Fed, they first need to try to gather as much data as they can when it comes to the US banking sector, in particular, in order to get a better picture with the current US banking sector and the liquidity situation. One thing that seems sure is that the situation has added to the tightening level and Fed chair Jerome Powell even mentioned this during the last FOMC meeting, because he said a tightening in financial conditions would even work in the same direction as the rate hike by FOMC in principle. He said, as a matter of fact, you can think of it as being the equivalent of a rate hike or perhaps more than that. That’s what he basically said.

JL: So, Michel, let me jump in and maybe ask you a follow up question on it based on what you just said, is how much tightening have we seen on the back of what’s been happening in markets recently? How much would you say that corresponds maybe in terms of hikes?

MV: Yeah, that’s the billion-dollar question, I guess. Look, I mean back in 2008, we had the so-called TED spread in the market and it was kind of fairly easy, in a way, to read that spread and you would basically have been able to calculate it.

Now, that TED spread was based on Libor as well, and that doesn’t exist in the same form as it did back then, as an unsecured funding rate. Now, we have to kind of use other proxies, I guess. Now, what we do first is we can look at spreads in the unsecured bank bonds market and we’ve seen a widening of around 50-basis points, but that’s kind of the fact for medium-term bonds as such. In the short-term space, you can look at commercial paper for example, also unsecured paper versus Treasuries, and these have risen round about 25-basis points lately. So, probably we’re talking about 25- to 50-basis points when it comes to tightening.

But we have to take this with a pinch of salt because, also, we have to remember that most of that tightening occurs within the US smaller banks and they cannot be compared to the larger banks, which haven’t or which are not finding themselves in the same challenges. So, we may witness even further tightening in their funding requirements, but maybe 25-to 50-basis points is probably a fair starting point.

But saying all this, now the Fed cannot afford to disregard inflationary pressures. You know, their preferred inflation gauge is currently the US PCE, is at 4.7%. That’s still well above their target of 2%, and Powell said that at least some additional policy firming may be appropriate. So, look, it will be very much data dependent.

We know from history that inflation reacts with a large delay of two to four quarters, if not longer, and instead of hiking excessively from here, the Fed, and as a matter of fact the rest of the central banks’ strategies, so ECB and BoE foremost, is probably to hold the rates close to current levels as much as they can. For the Fed, that means a 5.25% peak seems a possibility. For the BoE, the market prices in a terminal rate short of 4.5%. We think that also seems realistic, maybe 4.25% as well.

In Europe, by comparison, the terminal rate is indicating a discount rate of around 3.3%, so 3.5% seems possible. But, look, we think that seems reasonable, but I think a 25-basis points discrepancy in the end won’t really matter that much because I think we are very close to the peak.

But the big discrepancy, and that’s something which I’d probably want to highlight here as well, is the pricing of the rate market when it comes to the rate path in the next 18 months. And you already mentioned it, Julien. In the US, the market prices in around 4% policy rate end of 2023, so almost 100-basis points. And, or by the end of 2024, it’s even more than 200-basis points worth of cuts.

Now, this, to me, sounds very much like a recessionary if not almost crisis environment. While the hiking cycle seems now at a late stage, the extent of cuts seems not set in stone yet. But the recent events and the pricing they serve, at least, as a reminder that the markets work in cycles and rate are not to stay at 5% or 4% forever.

JL: That’s great, Michel, so thanks a lot. So, we’ve touched on the potential peak in policy rates and what we expect rates to do. That was obviously a key topic of last week for investors, but I think the other batch of questions that we received was centred around the financial turmoil that we’ve seen in markets and a question that kept coming was around the US banking sector and the banking crisis, and whether it was akin to what we’ve experienced in 2007 and 2008. Do you have any view on that?

MV: Yeah, it’s still fairly early but, you know, the market tries exactly to assess now if we have now a systemic risk or if this situation with Silicon Valley Bank is an insulated case. Now, the good news is that the problem has been pretty much located and the problem is not concerning the major banks in the US banking industry but more the midsize banks and the challenges they face.

Now, first, the situation of Silicon Valley Bank (SVB) seems a bit unique in some ways. The balance sheet of SVB is less than a tenth of JP Morgan, for example. It’s not a small bank but still small compared to the major banks in the US. And, also, what we need to look at is SVB was on a highly aggressive growth path. The balance sheet grew, for example, from around $60 billion to $210 billion within a matter of five years and this should already raise, normally, alarm bells.

Now, secondly, the risk management of the bank was extremely poor and, adding to that, the regulation in the US for smaller banks are, in hindsight, too relaxed when it comes to liquidity standards, for example. And this, by the way, is not the case in Europe where all banks go through the same monitoring process. So, that may need to be adjusted.

So, first what happened is that SVB had immense deposit growth over the last years and because it’s not a typical money-centre bank which also lends to clients on the other side of their balance sheet, so mortgages, for example, or other loans, it invested the bulk of this money, deposited with the bank, into longer duration Treasuries and mortgage bond securities to earn some higher rates as well. And that was at the time where rates were particularly low still. So, they created a large mismatch within their own balance sheet, short deposits and long bonds. That’s a recipe to go wrong, and it actually did.

By the way, UK pension funds found themselves in a very similar situation back in October. So, it’s not unique in a way. It seems that a lot of banks or generally business models need to be readjusted, and that’s what is to be expected in a world where interest rates are much higher. But we don’t see a similar situation like seen in 2008. We know it’s kind of a handful of banks in the US, which had a similar growth path and also we’re talking about liquidity, we’re not talking about solvency. The majority of the banks look actually very solvent.

The situation, however, must be monitored because we have much tighter financial conditions and that can have negative repercussions to growth in general and, as said, it adds to the financial tightening as investors need to monitor that.

JL: Great. So, if we’re not back in 2007/2008 there are still question marks around one specific part of the market and that is bank bonds. We’ve seen what happened with AT1 bonds in the case of Credit Suisse and, clearly, I’ve received a lot of questions from clients who either were investing in that space or were just holding different bonds from banks asking whether they’re still safe in the current environment in Europe. Do you have any concerns around those bonds?

MV: The situation with regards to bonds, and in particular bank bonds, has ever become so complicated in general. I mean there has definitely been a lot of work been done, not only on the balance sheets for the banks. They look roughly two and a half, if not three-times more resilient than they looked before the credit crisis in 2008, which is great news. Equity ratios are much, much higher. The loan portfolios don’t look as risky as they did back in 2008. And, also, the market needs to, or at least has been woken up right now that there is a different layers of bonds. And for people who are not familiar with the bond market as much, it is a reminder that being vigilant and doing your homework is very important.

Now, we’re talking here about, you know, when we talk about a wipe out of bank bonds, and what has happened recently with Credit Suisse bonds in particular, it was the so-called additional tier 1 bonds, AT1 bonds, which had the feature that they can be written down in certain circumstances to zero. And investors who know the market should be and would have been, very familiar with that concept.

By the way, in the UK because these bonds are highly risky, there is a strict ban for any retail clients to buy these bonds because of this risk. So, normally, it’s only the highly professional, big institutional investors who are engaging in that market. But, of course, it does ring alarm bells if something like that happens.

Why has it happened? The regulator in Switzerland wanted to make sure that deposits of Credit Suisse and also senior bonds of the bank are safe, which basically means other parts of the bonds have to bail in so that taxpayers won’t need to bail in these bonds or bondholders anymore. That was the whole concept post 2008. However, we think generally the bank bond market seems very resilient, specifically when it comes to super senior bonds in the bank market. But, it’s important to be able to distinguish between these highly risky AT1 CoCo bonds and, also, senior bonds.

Now, even saying that, even within senior bonds, there are different types, which are called bail-in bonds and non-bail-in bonds, and that is also something which is probably going to get repriced in the future within the bank bond market. But, overall, the super senior tranches of bank bonds look, actually, fairly resilient and we don’t think that the European bank bond market is currently facing major challenges, not more than they have done in the very recent past as well. So, we don’t consider now here major challenges.

JL: Great. Thank you, Michel. There is so much happening in the fixed income market whether it’s on the rate side or on the credit side. We’ll definitely have you back in the coming weeks.

Before we conclude, I just wanted to point out the fact that this week should be relatively quieter, at least we, I guess we hope so, especially when it comes to macroeconomic data. Obviously, we’ve heard from more central banks as well. So, we’re just going to be monitoring inflation trends in the eurozone and in the US towards the end of this year.

For me, a last note before ending this podcast, I think it’s important to realise how the news flow works. There was a study by Axios recently that’s shown that the average big news stories tend to last for around seven days, a week, before the public moves on to the next crisis. And we’ve been talking about banks and the turmoil in the banking sector for about two weeks now.

There will never be a source of absolute calm and the next brick on the wall of worry may come from geopolitics, it may come from other issues that we haven’t thought about just yet, but there will be another issue that’s for sure. But as I said earlier, bear in mind what markets have done over the past month or so and how resilient it’s been. It doesn’t mean that it’s going to be resilient like that all the time, but it shows that we need to differentiate between what the headlines are telling us and what’s happening in reality.

We’ll be discussing that again next week but, in the meantime, I wish you all the best in the trading week ahead.