11 Apr 2023
Three interest rate rises this week from three central banks very much in the spotlight of the unfolding story of the jitters pervading the financial sector: a quarter percentage-point each from the US Federal Reserve (the Fed) and the Bank of England; and joining last week’s rise from the European Central Bank (ECB), a similar half point increment from the Swiss National Bank (SNB). With UK inflation rising in February to 10.4% from 10.1%, in the opposite direction to the markets’ expectations of falling back to single digits (on the Chancellor’s projected path to sub-3% by the end of the year, apparently, as in the budget), the Bank of England really had no choice.
The most important, as ever, is the Fed. Despite the recent clamour from markets that the Federal Reserve should at least stop raising interest rates, and from a vocal minority that it should be reducing them immediately in the light of the instability in the banking sector, nevertheless consistent with the previous policy meeting in February Jay Powell raised US interest rates, now to 5%. Inflation remains Public Economic Enemy Number One. But in a web of mixed messages, he certainly left the markets scratching their heads as to what happens next.
While not a policy pivot, Powell significantly retreated from his assertion of only a fortnight ago in his submission to the Senate that while the economy remains as strong as it is and inflation at 6% is stubbornly higher than he wants, interest rates would go further than anticipated and remain there for longer than hoped. He couched his new stance in the following terms: “we no longer state that we anticipate that ongoing rate increases will be appropriate to quell inflation. Instead, we now anticipate some additional policy firming may be appropriate”. What are we supposed to make of that? In this context, what is “additional policy firming”? Another minor rise in rates, or something else?
As Robert Armstrong of the Financial Times points out, given Powell’s references to bank insolvencies and the remaining members of the commercial banking sector being less willing to lend thereby helping protect their balance sheets, the implication is a move away from the blunt tool of interest rates to quell inflation, and a subtle shift in the mechanism by which consumption is reined in by constraining the access to credit.
As we made clear last week, liquidity is the lifeblood of the financial system. Access to credit is an important element of liquidity. It is of course important that banks manage their assets and liabilities but a sustainably solvent banking system is a liquid one, able to attract cash from depositors and to extend credit on a prudent basis. But that liquidity is not confined purely to the financial system; it pervades all strata of the economy: from governments to the corporate sector to us individually at the household level as consumers. If the repression of credit is the subliminal message from the Fed to slow the economy and curb demand, equally the Fed must not allow a full-blown credit drought, known colloquially as a credit ‘crunch’. It is in such circumstances when time-limited liabilities need to be met but refinancing is impeded that in the absence of liquidity, debtors can all too easily become forced sellers of assets (the most liquid first, obviously) and risk crystallising the permanent loss of capital. It creates a more insidious effect: if the most liquid assets are the first to be sold, a greater proportion of what remains is represented by increasingly illiquid holdings. Paralysis becomes inevitable; insolvencies and corporate failures proliferate.
But if the markets and the central banks are at sixes-and-sevens about how best to manage the balance between maintaining financial stability and defeating inflation, there are palpable tensions between the central banks themselves. This is not just in the case of Credit Suisse being rescued by UBS and disgruntled bond investors as well as other central banks accusing the Swiss National Bank of moving the regulatory goal posts allowing not only depositors a guarantee but also placing equity holders above ‘Additional Tier 1’ (AT1) bond holders when it came to restitution: equity holders got some money back, AT1 investors nothing at all (though it has subsequently been shown that Credit Suisse’s own AT1 prospectus pointed out the clear possibility of this; it pays always to read the small print!).
In placing Silicon Valley Bank in administration and offering a time-limited credit facility, despite wiping out the equity investors in the bank, the US Fed has effectively set a precedent by underwriting the security of the bank’s depositors. Andrew Bailey, Governor of the Bank of England, clearly feels strongly that the Fed is going down the wrong path. Openly criticising the Fed, he suggests that the Fed’s actions increase the risk of ‘moral hazard’; that with the expectation the central bank will be the backstop in the event of any potential failure, people will be prepared to ignore risk.
It raises an interesting philosophical point, particularly about banks. The distinction is between investors in a bank and those who deposit savings with it.
Equity shareholders are easy. They are both investors in and owners of the business: in the event of insolvency, after all other liabilities have been met, in the unlikely outcome anything remains they divvy up the pieces; if there is nothing, so be it.
Bond holders are lenders to the bank and, depending on the terms of the issue, they have a contractually defined place in the pecking order of creditors should the bank go bust; but they are investors too, they are accepting risk and expect a rate of return via the bond’s coupon expressed as a yield.
But deposit accounts? How should they be classified? Is a deposit account an investment? Is it a loan to the bank, putting their money to work? Should we distinguish between interest-earning savings accounts and current accounts all too often earning nothing? Is the bank merely a repository, an alternative storage place to bundles of notes being stuffed under the mattress, in other words a big safe to keep cash secure?
In pure capitalist terms, banks ought to be allowed to fail. It is often said that big, national and international banks interwoven into the financial fabric are “too big to fail” (i.e. too big to be allowed to fail) because of the systemic risk. But is that good practice in delivering a tip-top, match fit, resilient system if ‘bad’ banks are constantly propped up, or does it allow laxness and inefficiency to rot the system from the inside out, thereby increasing overall risk?
And in moral terms? In the modern world it is virtually impossible to be a fully active, participating member of the economy and society without a bank account. While depositors may well have accounts with more than one bank to spread their risk, it is difficult to argue against the view that banks are effectively utilities, albeit mainly publicly listed or privately owned (rather than state owned). With that imperative to have an account, why should depositors carry the risk of seeing their savings wiped out in the event their bank goes bust? Should there be a limited safety net (as currently operated in the UK with deposits of up to £85k protected) but beyond that, the risk is entirely that of the depositor? Or, as in the precedent seemingly set by the Fed, is the central bank there in the capacity as the absolute lender of last resort, guaranteeing all deposits unconditionally?
All fiat financial systems rely on confidence. Arguably, since the end of barter or goods being exchanged in return for the currency of gold and precious metals, the global financial system has in its literal sense become a great big confidence trick. As Fundsmith’s Terry Smith says, in today’s world of banking involving merely the pressing of buttons and the ‘transmission of electrons’ in the place of handing over bank notes (which themselves are intrinsically worthless sheaves of paper or plastic, their face value is only met when guaranteed by the issuing central bank) let alone gold or silver, confidence is all there is. But as we move into the new era of high costs of capital and its affordability and we test the boundaries of the financial system’s resilience in a world awash with debt, that pivotal role of the central bank is all-pervading.
Central banks have two duties: one is to manage inflation (“price stability”); the other is to maintain orderly capital and financial markets (“financial stability”). Are these compatible? As the state institutions which price the benchmark cost of money by setting interest rates, if central banks get it wrong and push the costs too high testing the system to destruction, does that impose a moral duty on the central banks to underwrite the full potential liability for depositors, bearing in mind that ultimately one way or another it is society which ends up paying? The other side of the same argument is that a failure to do so means the entire economic and financial edifice is put at risk of crumbling in which case what was achieved by not doing anything? These are moot points but important. That the central banks themselves cannot agree is unhelpful.
In the past two weeks we have seen various methods by which failed banks are ‘bailed out’: forced administration with a time-limited credit lifeline (SVB in California); central bank emergency funding followed by forced takeover with subsequent central bank credit assurances (Credit Suisse); forced acquisition (the UK arm of SVB for £1); emergency capital injection by way of a peer-group funded co-operative lifeboat (First Republic Bank); led by the Fed and including the ECB and the Bank of England, central banks in collusion to ensure the ready availability of currency in geographically mutually interdependent financial systems.
So far, the line is holding and while in a state of some discombobulation and surprise at the speed at which events have unfolded, investors are not panicking and there is no crisis. The muscle memory of 2007-10 is still fresh among a sufficient number of senior market and regulatory participants who lived through the Global Financial Crisis and near-systemic melt-down. But revealing this time is the extent to which even tier 2 and tier 3 regional banks, particularly in the US, can cause significant wider problems when they hit the buffers, not least thanks to the potentially open-ended counterparty risk if the failing banks’ liabilities are being hedged through the prodigious use of derivatives (it’s why, for example, Credit Suisse was bought for a nominal sum and with guarantees from the SNB: calculating the Credit Suisse derivative risk that UBS was taking on was almost impossible accurately to quantify; similarly, HSBC paid only £1 for SVB UK because of the inability to perform full due diligence on SVB’s liabilities in the time available). In a world still adjusting to the rapid increase in the cost of capital, there may yet be more failures requiring even more creative ways of preventing collapse. A full-blown crisis may yet emerge but it need not necessarily happen. But clear leadership from the central banks is a necessity; mixed messages and disagreements about basic principles are unhelpful.
Underpinning all is the need for cool heads and confidence, where confidence is as much about liquidity. Once contagion breaks out, it is very difficult to control. Best not go there in the first place.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
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