Something was bound to fall apart.
Roughly one year after central bankers started to put an end to an era of easy money, the absence of major casualties was almost puzzling.
Sure, there has been plenty of misfortune distributed across financial assets, from cryptocurrencies to tech stocks to real estate. But no real cracks in the global financial system – until Silicon Valley Bank.
The largest U.S. bank failure since the global financial crisis is bringing old fears about the stability of the banking system to the surface. The fallout continued to spread Wednesday, as news of a potential funding crunch at Credit Suisse clobbered bank stocks around the world.
The sudden turbulence serves as a harsh reminder that undoing the excesses of a credit boom is a messy business.
At the start of every rate-hike cycle, there is a sense among many investors that the party is over – and for good reason.
“When central banks throw their rate hammer around with abandon, things tend to break – if not in the real economy, then in the financial system,” wrote Paul Ashworth, chief North American economist at Capital Economics, in a note.
Stock markets tend to become more volatile, though they don’t reliably turn negative when central bankers turn hawkish. Nor is a recession a sure thing. A downturn in the credit market, however, is hard to escape. Last year was no exception, with high-quality U.S. bonds posting one of their worst calendar years on record.
There are almost always unintended consequences that roil some pocket of the financial system. And there are valid reasons to believe this cycle could be considerably more painful than the past year has let on.
For starters, it generally takes 18 to 24 months for policy changes to fully transmit through the financial system.
More importantly, policy rates have been hiked with incredible speed and force, at a time when the world is awash in debt. In less than one year, the U.S. Federal Reserve has raised its policy rate by 450 basis points. In the aftermath of the global financial crisis, it took more than eight years just to see 100 basis points of tightening.
“I think the worst is yet to come,” said Sébastien Mc Mahon, chief strategist at iA Investment Management. “There was just so much interest rate risk out there.”
Global debt levels have been rising for decades. Ever since the West’s last inflation crisis, in the 1970s, interest rates have trended downward, steadily making it more affordable to borrow. The global financial crisis then ushered in a decade and a half of near-zero interest rates, during which households, governments and corporations binged on debt.
Then came the pandemic – and a level of emergency stimulus that dwarfed anything previous. Those actions are generally seen as having prevented a depression-order economic calamity, but they also generated the largest single-year increase in global debt since the Second World War.
By the end of 2021, global debt soared to almost US$300-trillion, equivalent to roughly 350 per cent of annual GDP. That “extraordinarily high debt level” represented a 30-percentage-point increase in just five years, according to the Institute of International Finance.
By the time inflation forced a sudden policy U-turn last year, the world was deep in debt and especially vulnerable to a rate-hike cycle.
Last summer, the U.S. Federal Reserve flagged an area of growing concern. The country’s banks, having received huge inflows of deposits through the pandemic, put much of what remained after loan activity into longer-term U.S. Treasuries and mortgage-backed securities.
The problem is that when interest rates rise, those bond holdings drop in value, creating a mismatch between a bank’s assets and its liabilities. This is exactly what happened at Silicon Valley Bank.
“The Silicon Valley Bank’s woes may not have been directly related to the ultra-aggressive rate hikes, but they are clearly a side effect,” Bank of Montreal chief economist Doug Porter said in a note.
So what happens now? Even as concerns rise over financial stability, inflation is still running strong.
“The Fed is on a very hot seat,” Mr. Mc Mahon said. “We have a fragile financial system and lingering inflation, and we don’t know what they’re going to do.”
Tim Shufelt