An amazing and scary month

March was a month for the history books, marked by the collapse of a systemically important financial institution and a bond market wipeout. Caution may be the need of the hour

Finally, the month of March has come to a close, a period of stress and exaggerated market moves. Investors saw huge volatility and fear around the banking system’s viability in both the US and Europe, with the Silicon Valley Bank (SVB) and Credit Suisse going bust.

There was a series of mini runs on the regional banks in the US, and the authorities had to come in to guarantee SVB depositors. JP Morgan Chase and other large American banks are trying to put together a private sector rescue of First Republic. The Additional Tier 1 bond markets got a shock when $17 billion worth of Credit Suisse bonds were written down to zero, effectively destroying more than 5 per cent of the asset class in one stroke. Highly controversial, the write-down also seems to have violated the basic capital structure seniority principles.

March also marked exactly one year since the Federal Reserve (Fed) began its hiking cycle starting in mid-March 2022), and it is interesting to see how various variables have moved in the last 12 months compared to the previous tightening episodes.

First, a fortnight ago, we saw the collapse of SVB and the biggest single-day decline (March 13) in US two-year Treasury yields since 1982. The decline was approximately 60 basis points and steeper than declines seen on Black Monday (1987), or 9/11, or even at the onset of the global financial crisis (GFC). This was followed on March 15, on fears of Credit Suisse collapsing, by the single biggest decline in German two-year yields since reunification. The only other time bond market volatility, as measured by the MOVE index, was at such elevated levels was at the height of the GFC ( fourth quarter of 2008).

The fear is that with the $17-billion wipeout in Credit Suisse bonds and the severe countertrend volatility in rates, there must be large losses sitting in the portfolios of funds, insurance companies and banks. The moot point is whether these losses can be absorbed, or whether we are going to see more casualties. Given how skittish markets are at the moment, any sign of cascading losses among financial counter-parties can trigger another round of severe risk-off and a rush into safe-haven assets.

What has been surprising is that equity market volatility has hardly risen through all this fixed-income chaos. The VIX index, measuring equity volatility, has still not reached its highs of even 2022, forget the GFC. At 30, it is nowhere near the highs of the mid-1980s, or the GFC , or during the height of Covid. Despite all the turmoil, the S&P 500 is up 7 per cent for the year and the Nasdaq is up 17 per cent. Even the Stoxx 600 in Europe is up 7 per cent. The banks are the main casualties of this stress, with the KBW banks index in the US down by 19 per cent, though the equivalent European bank indices are still up marginally.

To date, the pain has been felt far more in the fixed-income markets rather than equities, where the lower bond yields seem to have cushioned the markets. With financial conditions tightening sharply, following the fixed-income stress, equity market investors are betting that the Fed will be forced to cut rates in 2023 itself. The same regional banks that are under pressure account for more than 40 per cent of lending in the US, and almost 65 per cent of all commercial real estate lending. It is a given that with pressure on liquidity and survival itself at stake, lending standards will be tightened sharply among all the smaller banks in the US. This will tip the economy into a recession, probably faster than most think. In a normal recession in the US, earnings expectations typically get cut by 15-20 per cent; we are yet to see these earnings cuts in analyst numbers. Yet equity markets are going up, celebrating the possibility that the Fed hiking cycle has come to an end.

An interesting tug of war is developing between earnings estimates needing to come down and yields topping out earlier and at lower levels than investors were pricing in before the banking crisis. What is more powerful in driving the market’s outlook, yields or earnings?

In all the chaos of mid-March, markets missed the fact that it was the first anniversary of the Fed beginning its tightening cycle. This has been one of the steepest hiking cycles we have ever seen, (450 basis points in 12 months) only surpassed by the 1980 cycle. Surprisingly, the Fed is as far away from its twin objectives of 2 per cent inflation and full employment (defined as the non-accelerating inflation rate of unemployment) as it was when the hiking cycle began. We are still very far from either metric normalising. Inflation is still too high and unemployment is still too low.

Over the past 12 months of the hiking cycle, the worst affected asset classes are bonds and commodities. Oil prices are down by more than 20 per cent, copper by 10 per cent and the CRB index by 7 per cent. Gilts and EU sovereign bonds are both down by more than 10 per cent; US treasury bonds by about 5 per cent. While the S&P500 and the Nasdaq are both down mid-single digits, most international equity markets are actually up over the last 12 months at a time when monetary policy has been tightened globally. This price action fits into the narrative of fixed income having a tougher time adjusting to normalisation of monetary policy, given how far behind the curve central banks have been, and the starting point of normalisation, with negative real rates across the world.

We all know that monetary policy works with a lag, though the extent of the lag is unclear and varies. In this cycle, what we have seen is that gross domestic product in the US is tracking weaker than in any other interest rate cycle. This is also the weakest performance for the S&P 500 in the first year of a hiking cycle (going back to 1955: source DB). The core CPI has also declined only slightly more than the average for the first 12 months of hikes, despite beginning this cycle from much higher absolute levels. The ISM manufacturing survey has already moved below 50, much quicker than the norm in prior cycles. US M2 money supply has begun to contract, something we have not seen in prior cycles. Just as this indicator peaked at more than 25 per cent year-on-year growth, which was unprecedented, during Covid, a contraction is also unusual and not seen before. What is also clear is that when you look at the Fed’s favoured indicators of inflation be it the core personal consumption expenditures (PCE) or core services ex-housing PCE inflation, the improvement is marginal in the last 12 months or even three months, and we are still running way above the Fed targets.

It has been a month for the history books. Huge volatility and financial system stress. The first systemically important financial institution ever needing a bailout; the largest ever wipeout of a bond category; a bank collapsing in a matter of hours due to the ability to withdraw money with a click.

All one can say is that major losses are still sitting in unknown books. It is highly unlikely we can sound an all-clear. Expect more episodes of heightened volatility and stress to hit the markets. Caution may be the need of the hour.

The writer is with Amansa Capital