At the close of business last Friday, global equities were higher on the week, having withstood several bouts of volatility as investors reacted to a steady stream of banking-related headlines. The yield on the US 10-year note fell 30 basis points from a week ago to 3.41% as investors expect the recent surge in financial stability concerns will cause banks to tighten lending standards, increasing the chances of recession. The price of a barrel of West Texas Intermediate crude oil fell $10 to $66.50 amid concerns over weaker global growth, while volatility, as measured by the Cboe Volatility Index (VIX), rose to 24.6 from 23.6 last Friday.
The closure of three tech-focused lenders over last week in the United States and the need for a capital injection for First Republic in the US and Credit Suisse in Europe has sent shock waves across financial markets in the form of substantial uncertainty.
In our view, the closure of Silvergate Capital Corp., Silicon Valley Bank, and Signature Bank has injected key risks into the macroeconomic backdrop. Based on the information we have so far, the likelihood of current events evolving into a broader systemic risk is low. As of this writing, it should be noted that the coordinated efforts between the U.S. Treasury, the Federal Deposit Insurance Corporation, and the U.S. Federal Reserve (Fed) have gone some way to mitigate real risks and sentiment issues over the worst-case scenario that had been percolating since March 10.
From an economic perspective, this past week’s events have reinforced our base-case expectations on the U.S. economy. The odds of the U.S. falling into a recession in late 2023 have increased. We continue to expect growth to slip into negative territory around the fourth quarter of 2023. The impact of Fed tightening typically takes some time to hit the real economy. Considering that the Fed only started to raise interest rates last March, it’s fair to say that the economy has yet to absorb the full effects of recent rate hikes. Bank lending standards are likely to become even tighter.
It’s never easy to predict what the Fed might do next, particularly in a time of duress. However, we think it has now lost the luxury of framing its actions and decisions solely around inflation. The central bank must now reassess the potential costs and benefits of each incremental rate hike.
The key questions confronting the Fed in the coming weeks:
- Should it raise rates further on March 22, or will it consider making a dovish pivot?
- Should the medium-term interest-rate outlook be updated to reflect a lower terminal rate?
- Should it separate its financial stability tools from its inflation fighting tool?
- How might the decision to protect depositors affect inflation?
We think there is a high probability that the Fed could mirror what the Bank of Canada did on March 8th and signal a pause in tightening. In this scenario, a final 25 basis point increase on March 22 would likely include language noting that the U.S. Central Bank is expecting to hold the policy rate at its current level while it assesses the impact of cumulative interest-rate increases. The Fed could also make references to the need to monitor events in the financial system while signaling that spillover risks from the bank closures are contained. This scenario would enable the Fed to incorporate language to signal its willingness to increase the policy rate further, if needed, to return inflation to the 2% target. In our view, this scenario would be dovish in the short term, effectively capping policy rate expectations for the next few meetings while promoting a measure of stability. Over the medium term, flexibility around the direction of future moves could be maintained while reminding markets that inflation remains an important consideration that could outlast current developments.
That said, what’s now clear is that the Fed—and other central bankers—have lost the luxury of focusing singularly on the fight against inflation. Markets no longer expect the Fed to hike 50 basis points at its meeting next Wednesday. A 25 bp hike is more likely. Investors are now pricing in several rate cuts later in the year.
CANADAN ECONOMIC NEWS
Our finance minister is scheduled to deliver her federal budget on March 28th. For Canadians earning in excess of $235,675.00, their federal tax rate is currently 33 per cent. This represents a 6.3 per cent increase from 2022. The NDP party, which holds the power in federal politics, wants this increased to 35 per cent. If enacted, this could bring the top combined marginal tax rate to 56 percent in British Columbia. What is more alarming is the capital gains inclusion rate, which currently sits at 50%. Again, the NDP would like this increased to 75 precent. We will watch this budget closely.
US ECONOMIC NEWS
On Thursday morning, eleven of the largest banks in the United States, after some prodding from the US government, organized a rescue plan for First Republic Bank. It is a San Francisco-based lender whose business model somewhat resembles that of Silicon Valley Bank, which is now in FDIC receivership. Under the plan, the group will deposit $30 billion with First Republic for an initial period of 120 days. First Republic’s board of directors announced it had suspended the dividends on its common stock.
Many regional banks have faced heavy deposit outflows in recent days, with customers often moving funds to the same large banks that are now participating in the rescue. US Federal Reserve chair Jerome Powell and US Secretary of the Treasury Janet Yellen and the FDIC welcomed the support of the group of large banks, saying it demonstrates the resilience of the banking system. The Fed added that it stands ready to provide liquidity to eligible banks.
EUROPEAN ECONOMIC NEWS
Shares of Credit Suisse, the embattled Swiss lender, came under renewed pressure this past week as the regional banking crisis in the US increased concerns over financial stability worldwide. Saudi National Bank declined to provide it with additional funds. A slide in the bank’s shares prompted the Swiss National Bank (SNB) to provide Credit Suisse with a 50 billion Euro line of credit.
Despite acute financial stability concerns, the European Central Bank raised its deposit rate to 3% from 2.5% on Thursday but offered no guidance as to its next move after dropping its commitment to raise interest rates significantly.
JAPAN, CHINA and EMERGING MARKETS ECONOMIC NEWS
The People’s Bank of China cuts its reserve requirement ratio by 0.25% to a weighted average of around 7.6%, effective March 27.
Chinese President Xi Jinping will visit Moscow next month in a show of support for Russian President Vladimir Putin.