Assessment of the interest rate market in March by Avobis
March was an eventful month full of surprises. The inflation figures for February and the subsequent abrupt loss of confidence in the banking sector - with a particular focus on Credit Suisse - sent Swiss market interest rates on a turbulent ride. However, the SNB reacted stoically and separated the two issues by raising by 50 bps and sticking to its monetary policy stance.
Fears of inflationary dynamics getting out of hand seem to be confirmed. In February, almost all nine CPI segments recorded price increases compared to the previous month. This is due to increasing prices for services and goods regardless of their origin (Figure 1). An easing of inflation is currently not in sight and with the first adjustment of the mortgage reference rate expected in June, inflation is likely to move further away from the SNB target. The market then adjusted its interest rate and inflation expectations significantly upwards, as can be seen from the strongly inverted yield curve.
However, the problems at Silicon Valley Bank and later at Credit Suisse led to fears of a possible banking crisis, which pushed the inflation issue into the background. The concern that further interest rate steps by the central banks could cause a systemic collapse in the banking sector also led to a rethink in the Swiss interest rate market, causing market interest rates to correct sharply downwards. The takeover of Credit Suisse by UBS and the global injection of liquidity into the banking system subsequently partially alleviated fears. Ultimately, the SNB’s monetary policy decision on 23 March and its signal caused a certain disillusionment in the markets, whereupon the focus returned to the inflation problem and higher interest rate steps were thus again priced in.
Although the swap curve at the end of the month is roughly the same as at the beginning of the month, the initial situation has changed noticeably, which is particularly evident in the higher expected interest rate volatilities at the end of the month compared to the beginning of the month.
The impact of the banking turmoil on economic growth is uncertain. A decline in demand could dampen inflationary pressures. The impact on financing conditions is equally unclear, as banks may become more cautious and reluctant to lend. This would be similar to an interest rate hike in the fight against inflation. These effects now need to be monitored and assessed accordingly, which is why the swap curve implies only moderate interest rate steps for the next two meetings despite decoupled inflation.
Our expectations
Inflation in Switzerland has been decoupled from normal conditions. The Swiss franc as a monetary policy instrument to combat imported inflation is only effective to a limited extent in the fight against rising domestic inflation. Additional restrictive measures are therefore necessary. If the global financial system continues to prove robust, another 50 bps hike could be implemented at the next meeting. However, should further systemic risks emerge, a smaller rate hike or even a pause in interest rates could be considered. It is crucial to monitor the situation carefully and evaluate various scenarios comprehensively.
Abroad
Growing concerns about a possible banking crisis following the collapse of three regional banks in the US have prompted central banks to respond with liquidity injections. Nevertheless, a recent study suggests that the US banking system has unrealised losses of two trillion USD, which strongly questions the possibility of further interest rate hikes. Thus, while inflation remains unimpressed despite the unexpectedly rapid rise in interest rates, cracks are beginning to appear in the banking system.
The rise in interest rates since last year has led to considerable losses in the value of mortgage-backed bonds and other virtually risk-free bonds, which make up a large part of banks’ assets. One study shows that the market value of the assets of the US banking system is two trillion USD lower than the binancial value. Combined with a high proportion of uninsured deposits at some US banks, loss realisations could threaten their stability.
If half of the uninsured depositors were to withdraw funds, close to 190 banks would be potentially exposed to risk. This would also affect insured depositors, with potentially $300 billion of insured deposits at risk.
Although the banking system is currently sound, there could be a lack of liquidity in the event of a bank run, leading to a cascading effect in loss realisation and ultimately jeopardising solvency. This could expose both American and other banks to a looming liquidity crisis. Therefore, the Fed, the ECB and other central banks are taking coordinated measures to strengthen liquidity.
The market is already pricing in interest rate cuts for the Fed and only small interest rate steps for the ECB due to fears of possible systemic risks (Figures 5 and 6). The reasons for this are, on the one hand, the restrictive effect of the liquidity problem on lending and, on the other hand, the aggravation of the liquidity problem or even the emergence of systemic risks in other areas through a continued restrictive monetary policy. Both would lead to a decline in economic growth and thus a dampening effect on inflation. Thus, market-implied inflation expectations have not risen despite continued high inflation figures and falling interest rate expectations.
Our expectations
The current situation in the banking sector seems to have calmed down for the time being, but there is still a risk that the rapid rise in interest rates since last year could burden other areas of the financial system besides the banking sector. Therefore, we rule out further interest rate hikes for the time being. At the same time, however, we also consider interest rate cuts unlikely. Inflation is still too high and must be fought with a restrictive monetary policy. Moreover, besides the key interest rate, central banks have a wide range of instruments at their disposal to deal with problems such as liquidity difficulties. For these reasons, we expect the Fed to pause on interest rates at its next meeting and to keep a close eye on the situation surrounding the banks and the inflation trend in the coming months. For the ECB, on the other hand, we expect a rate hike of at least 25 bps due to the devastating inflation trend.