JP’s Journal: Another financial crisis or storm in a teacup?

Last week saw the failure of SVB Financial Group, the parent of Silicon Valley Bank. SVB is a commercial US bank that primarily serves technology and life science companies, with deposits significantly placed in US treasuries.

Recently it appears money has been withdrawn from the bank and consequently US treasuries have been sold. This has given rise to losses, as the bonds were bought when interest rates were lower and prices higher. These losses sapped confidence, giving rise to further withdrawals – creating the pattern seen in financial routs. For those familiar with the Great Financial Crisis, the speed of collapse has been astounding, compared to the drawn-out capitulations seen through 2007-09. To see this in context, Goldman Sachs only recently increased its share price target for SVB. The knock-on impacts have been quick, with Signature Bank, an institution with a crypto currency bias, also being shut.

The US authorities have acted swiftly with all depositors covered by Federal guarantee. Any losses arising will be made good by a ‘special assessment’ on banks. The much smaller UK subsidiary of SVB has now been taken over by HSBC. A neater solution, but just reflecting the much smaller scale of the challenge.

So, what are the implications arising from SVB? The bank’s failure has created liquidity strains and it is likely that there will be more competition for liquidity, including rising deposit rates. In the longer term I think we will see tighter credit conditions, especially for corporate borrowers. Overall, the Federal Reserve has acted strongly. By accepting collateral at par rather than marking to current prices, it means that banks that have accumulated more than $500bn in unrealised losses on their held-to-maturity treasury and mortgage-backed securities portfolios will not be forced sellers. This should stop contagion. But, as the case of Northern Rock showed 15 years ago, even strong support may be ineffective if sentiment turns really bad. This will be the first test of how customers react to bank failures in the digital age of ‘click button’ money transfers.

These events drowned out non-farm payrolls, which came in stronger at the headline level, although the higher unemployment rate and moderation in average earnings were seen as bond friendly. At the end of the week the 10-year US treasury yield had settled at 3.7%, significantly below the 4% seen the previous Friday. This pattern was repeated in other major markets with equivalent UK and Germany yields at 3.6% and 2.5% respectively.

These moves were based upon a big shift in interest rate expectations. Last week market pricing indicated a year-end Federal Funds rate of around 5.35%; as I write this on Monday morning, the market pricing is around 4.5%. The same applies, on a smaller scale, to the pricing of UK bank rate: 4.7% a week ago, 4.35% now. I do think there are implications for monetary policy from SVB, most likely making the Federal Reserve more cautious on pushing up rates. This in turn will take pressure off other central banks to follow suit. Overall, it reinforces my message that the monetary policy tightening that has already occurred is taking time to work through the financial and economic system. And it comes back to the question that will increasingly be asked: do central banks want to achieve their 2% inflation targets or is a bit of wiggle room desirable? If they go for 2%, and convince markets they are serious, I want to own more longer dated government bonds.

Not surprisingly, risk assets were hit hard – an index of US banks showed a loss of 17% last week. Globally, investment grade credit spreads widened, but losses were most evident in subordinated financial debt, especially bank bonds. I do not think we are likely to see panic in the sector, as the large banks that make up the bulk of the market are well capitalised and have a diversified business model. But I do see a period of underperformance and this emphasises a theme of mine: financial bonds are highly correlated. Yes, the yields on bank debt are attractive but we have to ensure that portfolios do not become too reliant on financial bonds, with unintended correlation risk. To be clear: our funds and strategies have no exposure to SVB bonds and we remain cautious on specialist US banks.

So while I do not see SVB leading to a repeat of 2007, I am wary of complacency about current economic conditions. Keep duration short in credit, where investors are well compensated, and take required duration in government bonds.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.