The Jupiter Merlin team look at a dramatic week in markets, as cracks appear in the banking sector and the credibility of the US Federal Reserve hangs in the balance.
15th March, 44 BC: on his way to the Senate, history relates that Caesar was warned by a soothsayer to “Beware the Ides of March!”. Two days past the gory assassination’s anniversary, it needs no second telling as the financial sector takes a nervous look over its shoulder, peering into the shadows to see who is lurking, awaiting to do it mischief. In the US, Silvergate Bank in liquidation and Silicon Valley Bank in compulsory administration, both effectively bust in the blink of an eye, while First Republic needs a lifeboat fund from its peers to stay afloat; Credit Suisse in deep distress in Europe and needing a major emergency infusion of liquidity from the Swiss Central Bank. All in less than a week. What next?
Banking: complex but simple
Commercial banking comprises many very complex structures and operations. But in principle it is a very, very simple business. It is worth spelling out because some who operate banks today seem to have mislaid the basics. Banks lend money to those who need it but who also have the wherewithal to re-pay both the principal sum and the interest charged as the interim cost of borrowing; banks typically source the money they lend from depositors who are attracted by a competitive rate of interest and are motivated by the security of their money not only being put to work but being kept safer than in the tea caddy over the kitchen mantelpiece or under the mattress; banks are required to keep a minimum level of capital in relation to their liabilities to ensure that in the event loans turn sour or depositors urgently need their cash back, the bank remains solvent. Banks’ profitability stems from the differential between the higher interest rate they charge to borrowers and the lower rates paid to lenders/depositors. Margins are tight and under such conditions in which high transactional volumes are inherent, the system must remain dynamic: money has to keep flowing; when it stops, paralysis rapidly takes over and confidence evaporates. Liquidity, i.e. cash, is the system’s lifeblood; confidence is its capital cornerstone; effective controls and rigorous oversight are pre-requisites of a well-run bank.
If all the necessary elements are in place and liquidity is maintained, the system hums along; if any is missing, depleted or overlooked, a bank’s own business risks distress. When it begins to unravel, especially in the modern age of real-time electronic banking, a ‘run on the bank’ as depositors seek to withdraw their funds can happen frighteningly quickly; if left unchecked, the possibility of contagion rises and there is the potential for a systemic collapse. Adapting the words of the famous insurance advertisement, you can in fact make a drama out of a crisis.
But to be clear, a well-managed bank with proper controls and systems, with a stream of regular and new depositors and the underlying capital to offset creditworthy borrowers meaning the bank’s liabilities and assets are matched at the daily close-of-business reconciliation, and which lends on a prudent basis with a good spread of risk across its loan book, does not tend to go bust; at the very least it is not the first to do so when economic and financial conditions get rough.
Owt for nowt for ever: far too good to be true
In these columns over many months we have droned on almost to the point of anaesthetising our readers about the risks posed by being systematically hooked on the drug of quantitative easing (QE) and being seduced by the pernicious attractions for borrowers of what became essentially free money thanks to ultra-low interest rates and easy access to credit (depositors in the eurozone experienced the converse of Alice-in-Wonderland policy: negative deposit rates where you were guaranteed to lose a proportion of your nominal savings every year). We have used the analogy of the addict: when the liquidity methadone is withdrawn, unless managed carefully and sensitively, the risk is ‘cold turkey’. The events of this past week in the financial sector are the first jitters of the monetary tightening DTs.
In a global economic system already awash with debt and exacerbated by the significant monetary and fiscal measures taken to cope with Covid and Ukraine since 2020, last year’s abrupt reversal of monetary policy (exactly a year ago, the US Federal Reserve (Fed) was still to raise its interest rate from zero; today it is 4.75%) has created obvious tensions as liquidity is constrained (no more central bank printing; in fact, the opposite as central banks actively sell bonds rather than purchase them) and interest rates rise to cope with what was runaway inflation, significantly increasing the cost of capital.
We have said in the past that in the new trajectory of interest rates, the upper limit of travel would be the tipping point at which the elevated interest rate risked the whole edifice crumbling under the weight of servicing its own debt. The difficulty is that it is not a precise number with a marker attached. We may not yet have reached that limit but its boundaries are being tested.
Powell’s Senate testimony
The seeds of the past week’s turmoil were sown years ago, but unwittingly this most recent germination was triggered ironically by what we were writing about last week: the markets’ reaction to Federal Reserve Chairman Jay Powell’s testimony to the Senate finance committee that the US economy was in his view not responding in the way he would like, that the risk was inflation remaining at above the 2% target for longer than hoped. It fed the narrative that interest rates would be higher and for longer, probably peaking closer to 6% than 5%. Markets immediately priced short-term bonds lower (the corollary of which was a higher yield in sympathy with a higher prospective interest rate) to the point where the 2-Year Treasury Bond broke through 5%. It was at this point that the missing elements in some banks’ operating models became critical factors.
In many cases, the regulated reserves held by banks are not only made up of shareholders’ equity capital but also investments made by the bank itself, often comprising significant bond portfolios. In looser monetary conditions many of those bonds will have been bought at much lower yields (and higher prices) than those prevailing today. Seemingly underpinned by the backstop of QE, nevertheless it relies on the Law of the Greater Fool for the system to work (you buy a very expensive instrument; you know it is already most probably over-valued, but prices are rising, it seems too good an opportunity to miss but you know that in order not to lose money, you need someone to be prepared to pay at least the same and preferably an even higher price when you need to sell it; the fundamental flaw is that you do not control the price, and in periods of distress nor do you control when you might be forced to sell). As bond prices drop, so the value of reserves declines. Other interested parties sniff danger: equity shareholders begin to sell their shares, worsening the reserves problem, and depositors (in this case already underwhelmed at being taken for granted with miserly, negative real interest rates) withdraw their savings to protect them. The bank needs to raise cash to meet the withdrawals; it becomes a forced seller of its most liquid assets i.e. those bonds whose prices are already falling. In a financial high noon, a messy end is almost assured unless the authorities step in. If this sounds eerily familiar, it is: we witnessed something very similar in the insurance/pensions markets last October in the LDI bond crisis.
Bond yields have whip-sawed in response. The volatility has been extraordinary, even by recent yardsticks. If that US 2-Year Treasury referred to above was 5.0% a week ago, today it is 4.14% having dipped to 3.91%. All other major sovereign short duration yields have followed suit, tumbling like leaves as investors fly to the safest, most liquid assets they can find (in this case safety is defined as those bonds issued by countries which are the least likely to go bust and default on their loans). But while a flight to safety, it also sends a clear message to the policy makers that as far as interest rates are concerned, enough is enough.
Markets and the Fed: the mother of all Mexican Stand-offs
We have many times referred to the tensions between markets and the principal central banks as to who has the greater influence over monetary policy: investors as the providers of capital, or the central banks as those who determine the benchmark cost of money. What we have today, ahead of the Fed’s policy meeting next week, is an extreme test of the Fed’s credibility. Jay Powell’s job is (or should be) on the line.
Powell is in a cleft stick of his own making. Twice in his career as a central banker he has been forced to reverse policy. Having tried to raise interest rates throughout 2018 and spooked the equity markets in a turbulent fourth quarter over which period the S&P 500 Index fell 18%, he immediately reversed tack in January 2019 in what became known as ‘Powell’s Policy Pivot’. In 2021, alongside his international peers, he attempted to hold an indefensible line that inflation was transitory: he had it all under control, there was nothing about which to be concerned, he still expected US base rates to be zero at least until the end of 2023 and possibly in to 2024; they are now 4.75% and for several consecutive quarters in 2022 playing catch-up, he deployed three-quarter point increments. A week ago, at the Senate he implied that interest rates had possibly another point to a point-and-a-quarter to rise to their peak and would remain on a plateau for some while.
Markets are far from united themselves, but the increasing weight of opinion is for another reversal. Vocal opinions range on a spectrum from saying the Fed should begin cutting interest rates next week, through others saying a modest rise in March is justifiable but no more beyond mid-year and then they come down swiftly thereafter; finally, only a rapidly declining minority currently sees the Fed’s original “higher for longer” plan as a tenable strategy.
At its heart is that in the aftermath of the Global Financial Crisis, central banks collectively declared that they had learned lessons, in future they would provide solutions and not themselves be the problem. Today, there is a growing perception that they have become the problem again.
Amid all the turmoil and the speculation about interest rates and liquidity constraints, the chief elephant in the room remains inflation. Were the Fed to capitulate to market pressure and reverse policy, it would lose all authority. The message would be that inflation is only susceptible to so much intervention to control it; beyond that point it is in the lap of the Gods, time and comparative mathematics to resolve the problem. The sub-text would be that the Fed has no idea what it is doing. With politicians reluctant to grasp the fiscal nettle, the risk of embedded and enduring inflation would increase, the type of which both dominated and blighted economies and labour markets for two decades in the 1970s and 80s. Those who experienced it would not care to repeat it.
Despite the turmoil, and acknowledging the risks posed by higher rates, this week the European Central Bank still raised its deposit rate by a half point to 3%, citing the inflation enemy. In a week’s time we will know the decisions of both the Fed and the Bank of England.
Governments are hardly innocent bystanders. Hunt and a handful of ‘E’s
Central banks are there to facilitate the funding of their national governments’ fiscal programmes. While western governments might be politically sensitive to the immediate problems of inflation and the cost-of-living crisis, being cravenly wedded to Keynesian ideology has made many of them very slow to adjust to today’s realities. Egregious state spending funded by high taxes and borrowings with all its inherent inefficiencies and embedded fiscal drag largely remains the order of the day. We had a UK budget this week; behind all the political window-dressing of Jeremy Hunt’s Three ‘E’s (what were they? ‘Excitable’, ‘Eventually’ and ‘ ‘Eaven knows’?), he still ducked his ‘Eye-wateringly difficult challenges’ referred to in the Emergency (there we are: two more ‘E’s!) Autumn Statement last year about public spending. Preferring to kick that particular ball in to the long grass again until after the election, the OBR estimates national debt/GDP will remain above 94% until at least 2027 with absolutely no sign of a government budget surplus in the foreseeable future. In the US, the debt ceiling of $31 trillion was breached in January with no replacement yet agreed while the national debt is 137% of GDP. You get the picture.
Markets complicit too
But if the markets are exerting their influence, they themselves are not beyond censure and blame. They too have been complicit. Seared into our memory is the comment in the Financial Times made by a ‘trader’ at the end of March 2020 at the height of the Pandemic financial crisis. The Fed had been forced to take extreme measures and in addition to slashing interest rates and resuming QE in prodigious quantities, first with US government Treasuries, then Investment Grade corporate bonds, when even that was not enough it finally resorted to buying High Yield corporate bonds (what were formally officially known as ‘Junk Bonds’). The morning after, a comment was reported in the FT that in back-stopping High Yield, “the Fed has just created a riskless market”. It was such warped thinking as this which perpetuated the acceptability of negative yields on government bonds (where the borrower is actually paid by the lender to do so), also to the virtual evaporation of the principles of valuation being applied in equities, both in the listed and unlisted environments. It made the Greater Fool respectable while everyone increasingly kept their fingers crossed that the Fool’s bluff would not be called. As Jupiter Merlin Team member Algy Smith-Maxwell is fond of saying, “trees don’t grow to the moon”. Valuation matters, whatever the asset. As some bankers and many investors are finding out the painful way today.
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.