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As banks collapse and stocks seesaw, it is tempting to reach for parallels with the run up to the 2008 financial crash, but the collapse of Silicon Valley Bank reminds me far more of the Fed’s struggle to raise interest rates in 2018 and 2019, and the lessons we learnt from it.
Back then, Fed Chair Janet Yellen had promised that quantitative tightening would be like “watching paint dry”, which is to say slow, steady, and unexciting. It has proven anything but.
The Fed has got a long way down the road in unwinding the trillions of extra funds it pumped through the financial system over the past decade, but it is unsurprising that we are now seeing more tremors in the system. The process of detaching the economy from a period of very low interest rates and repeated bouts of quantitative easing will be difficult. There will be no free lunch, and stresses will appear.
In 2019 when the Fed raised its target rate to 2.25-2.5 per cent, it quickly had to backtrack because of the damage it was doing to the repo market, where big financial institutions source short-term cash. Today bank reserves at the Fed have again been falling and the changes in market pricing make clear that traders think Chairman Powell will likewise have to retreat.
Cracks in the system
I don’t see much systemic risk in the banking system right now, but I do think the past week is a sign of things to come, as the impact of the extraordinary tightening in financial conditions we have already seen hits home.
Compared to 2007, our banks are in a much better place. Large banks, in particular, are much better capitalised, have profited from higher rates, and they are sitting on strong liquidity positions that will act as buffers against any stress on markets.
But elsewhere you can see the trouble brewing. Much of the Covid-driven surge in debt came in the public sector and higher servicing costs are markedly eating into government budgets. In some places in Europe there is simply not enough growth to service the existing debt, and that picture is worsening.
Thankfully, there is no real maturity wall this time for corporate borrowers. With core yields so low, corporates have refinanced existing borrowing, ensuring they will be paying cheap rates until 2025. The car loan market, however, is showing signs of stress; venture capital is naturally in the spotlight after SVB’s demise; and there will be scrutiny now of other areas where asset prices have not been marked to market in the past year’s sell-off.
My broader concern is that years of low rates and high liquidity have created many “zombie” companies in the US that normally would have gone to the wall by this stage in the cycle. If they do need to raise more funds, it will be expensive, and the most recent surveys show loan terms will be tighter. We may soon see a rise in insolvencies as a result.
In short, while the Fed needs to show confidence and must push on to address the inflation risk, they must not be too dogmatic about the current situation. There is a chance that they have already gone too far in tightening monetary conditions. The M2 measure of money supply is the most negative it has been in 60 years and if officials continue to pull 95 billion dollars a month out of the system in addition to further rises in rates, they could tip us over the edge. When policymakers meet later this month, they cannot afford to shock markets - and that should mean backing down.