Global Economy & Markets, Weekly Roundup 21/03/23

Odds are tilting toward an interest rate hike of 25 basis points by the Federal Reserve
Key Takeaways

The Federal Reserve, due on Wednesday, is expected to increase interest rates by +25 bps to a range of 4.75% - 5.0%. However, the likelihood of staying on hold is not zero, given recent concerns about the US banking sector, the cumulative tightening of 450 basis points in the past twelve months and bank stress leading to tighter lending standards and slower lending growth. 

The Federal Reserve had circa $320 billion in loans outstanding to depository institutions (1.8% of total domestic deposits, as of March 16th) from $15 billion two weeks ago, suggesting that liquidity needs of smaller banks have increased. The Fed has lent $153 billion in the primary lending program (where the Fed values securities collateral at fair value, with a variable cost ranging between 4.75% and 5.25% based on FFR), $147 billion in the two FDIC-operated “bridge banks” (Silicon Valley and Signature) and $12 billion in the newly announced Bank Term Funding Program, where the Fed values securities collateral at nominal value, with a variable cost of 1-Year USD OIS plus 10 basis points, currently at 4.37%.

The European Central Bank stayed the course, increasing interest rates by +50 bps to 3.0% (DFR) and separating the monetary policy concern (inflation) from the financial stability concern (Silicon Valley Bank, Credit Suisse). The ECB dropped its hawkish forward guidance regarding the interest rate path, due to elevated financial uncertainty, highlighting the importance of a data-depended, meeting-by-meeting approach to interest rate decisions. 

Having said that, President Lagarde underlined that if the baseline economic scenario were to persist when the uncertainty lessens, interest rates would have to increase further given strong core inflation pressures. Market pricing (according to overnight index swaps) now points to roughly additional hikes of +25 bps for euro policy interest rates, from additional hikes of +100 bps two weeks ago. Finally, the ECB stands ready to act, if needed, to provide liquidity support to the euro area financial institutions, amid the current turmoil.  

Following massive and rapid outflows of funds, confidence in Credit Suisse has been eroded very quickly. As a result, on Sunday, UBS announced it would acquire Credit Suisse in full for CHF 3 billion (60% below CS’s market capitalization on Friday) or CHF 0.76/ share, with CS’ shareholders receiving 1 UBS share for every 22.48 CS shares, with the deal not being subject to shareholder approval, as the Swiss Government has exercised its emergency powers. The deal is backed by Swiss Authorities (SNB, Swiss Government) with abundant liquidity (CHF 200 billion or 60% of pro-forma UBS/CS deposits) and a federal guarantee of CHF 9 billion (1.1% of GDP) to support UBS in bearing losses arising from the takeover of Credit Suisse. 

In addition, according to FINMA, the extraordinary Swiss Government support triggered a 100% write-down of the nominal value of all AT1 shares of Credit Suisse (circa CHF 16 billion), with the decision transmitting pressures to other AT1 and high-yield issuers. However, pressures eased after the ECB Banking Supervision, the Single Resolution Board and the European Banking Authority issued a statement that common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down. 

After a volatile week with sizeable losses for bank stocks on both sides of the Atlantic (US: -10%, euro area: -11%) and gains for government bond prices as interest rates declined significantly amid a profound repricing of the expected monetary policy path, global equity indices entered the current week in the green. Volatility will continue as financial markets digest the recent events (Silicon Valley Bank, Credit Suisse) and their economic implications.
Global Economy & Markets, Weekly Roundup 21/03/23