Investors have slashed their bets on additional rate hikes by the U.S. Federal Reserve and the Bank of Canada as the failure of Silicon Valley Bank sharpens the tension between fighting inflation and managing financial stability risks.
As recently as last week, markets were expecting the U.S. central bank to increase its benchmark interest rate by another percentage point in the coming months, and to hold off rate cuts until 2024. But by Monday, markets were doubting that the Fed will raise rates at all at its next meeting on March 22, and pricing in cuts by this summer.
The abrupt shift in interest rate expectations roiled global bond markets. Two-year U.S. Treasury bond yields fell by 100 basis points over the past three trading days, the swiftest drop since the 1980s. Yields on two-year Government of Canada bonds dropped 42 basis points on Monday alone. (A basis point is 1/100th of a percentage point. Bond yields and prices move in opposite directions.)
Bond investors have vacillated in recent months, sometimes expecting central bankers to throw in the towel early on rate hikes; other times expecting them to double down in the face of stubborn inflation. The failure of SVB last week adds another element to the equation: concern about the stability of the banking system.
“The Fed has been looking for reasons to inform them that the level of interest rates is restrictive enough to push inflation lower,” said Ian Pollick, Canadian Imperial Bank of Commerce’s head of fixed income, currency and commodities strategy.
“And while everyone was looking on the left side of the equation, which is the macroeconomic environment, there hadn’t been a tonne of looking on the right side of the equation, which is financial stability. Obviously something broke in the process.”
The rapid rise in interest rates over the past year has cratered bond prices, leading to large unrealized losses sitting on the balance sheets of many financial institutions. That proved to be a land mine for SVB, which was forced to sell a portion of its bond portfolio at a loss to meet customer withdrawals – and the sale sparked a run on the bank.
Some analysts have argued that SVB’s experience was relatively idiosyncratic and based on poor risk management decisions by the technology-focused lender.
But following on the heels of the U.K. bond crisis last fall – which saw pension funds squeezed by a sudden shift in asset valuations – the SVB episode has heightened concerns that aggressive monetary policy tightening has left underappreciated cracks throughout the financial system.
The Fed was sufficiently concerned about contagion spreading from SVB to other banks to announce a US$25-billion lending facility on Sunday. That will allow U.S. banks to swap their bonds for cash in the event of a bank run.
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“The actions taken by policy-makers to backstop the system, very quickly, is an important step in the right direction,” Mr. Pollick said.
“But there is a concern here that when you think about the Fed tightening further, financial stability relative to price stability is a trade off that we haven’t really seen since the savings and loan crisis back in the 1980s and 1990s.”
The Fed is in an awkward position, after Chair Jerome Powell delivered a hawkish message during a Congressional hearing last week, saying that he expected to raise rates several more times. That guidance seems out of place as financial stability concerns come to the fore.
The Bank of Canada, by contrast, paused its monetary policy tightening campaign last week, although central bank officials have left the door open to more rate hikes.
Interest rate swaps, which capture market expectations for upcoming central bank decisions, are now pricing in no further Bank of Canada interest rate hikes, and rate cuts beginning this summer.
Taylor Schleich, director of economics and strategy at National Bank Financial, said that markets may be overreacting by pricing in Bank of Canada rate cuts by the summer. But the failure of SVB could have a tangible impact on the economy, if banks get nervous and pull back on lending. That, in turn, could make inflation fall even faster than the central bank is expecting.
“Even if this does remain an isolated incident, it’s certainly going to have a lingering impact on sentiment for markets and probably for banks as well, and businesses,” Mr. Schleich said.
“Certainly financial conditions got a lot tighter very quickly. And that does translate into the real economy.”