Market View

Are central banks fighting yesterday’s battle?

In many ways, parts of this week seemed to follow the usual story that we had become accustomed to over the past year: central banks continued to hike interest rates in response to inflationary pressures. 

Jeremy Sterngold
24032023 central bank

Expect the unexpected 

This week in the UK, we saw inflation come in higher than forecasted. Inflation continues to hit double digit levels, meanwhile retail sales picked up. Economic activity, as shown by the Purchasing Manager Indices (PMI), demonstrated that economic expansion continued across the Eurozone. Based on these latest developments, it is easy to understand why central banks continued to hike rates and pre-empt further rate increases.        

Banking headlines 

The shocks across the global banking sphere that have unfolded over the last fortnight, and perhaps in the weeks to come, have dominated financial publications. As written about over the past weeks in A knife-edge decision and Distinguishing between the signal and the noise, for investors and central banks, there has been a lot of news flow to digest. The question now becomes: “does financial stability outweigh price stability?”.  

Last weekend we saw the Swiss government and regulator swing into action and force through a merger of two Systemically Important Financial Institutions (SIFI), namely Credit Suisse and UBS. These institutions were designed as such to ensure that these large banks were made to hold more capital and could not lead to a widespread credit crunch such faced by the world between 2008 to 2010. While the regime appears to have worked in terms of resolution not resulting in large losses faced by taxpayers, the merger of the largest banks in Switzerland is hardly the most desirable solution. Furthermore, prioritising shareholders over bondholders has opened a can of worms which regulators are keen to squash. Indeed, the communications coming from the UK and Eurozone regulators have pushed back on this very point. 

The confidence crisis that was first stoked by Silicon Valley Bank seems to have spread more globally. Despite the liquidity support offered to regional banks in the US, they remain under pressure. Concerns are now primarily focussed on First Republic Bank and over in Europe, Deutsche Bank. With banks under pressure and subordinated debt holders questioning how quickly lawmakers changed the rules, the cost of capital for banks has increased globally. 

The future of inflation

While we could have focused today’s article on the Federal Reserve and Bank of England’s decision to increase rates by 0.25% this week (to 5% and 4.25% respectively), in light of the wider situation affecting banks, this seems a bit like driving whilst looking in the rear-view mirror. The clearest indication of this was Fed Chair Jerome Powell’s comments on pausing their rate hiking cycle. He noted that they considered it earlier in the week, however given the sanguine moves across markets following the UBS deal, they opted to continue raising rates. Equally, sources close to the European Central Bank noted it was feared that changing the approach towards rate hikes may fuel concerns of ‘what do policy makers know that we don’t know?’. As such, the decisions this week represented a show of confidence in the banking system while providing no guidance towards future decisions. 

However, the material increase in equity and bond financing rates for banks likely means that lending standards and costs will increase over the short to medium term. This may cause households and businesses to pare back spending fearing difficulty in obtaining credit. As such, the long and variable lags that we discussed over the past few months seem to have been brought forward. The bond market has caught onto this with government bond yields trading well below the rates that central banks raised them to. Anticipating a material reduction in consumption, bond investors are indicating that the fight against inflation is over and financing stability priorities ultimately mean that central banks will cut rates before the year is out. 

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