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These are the undesirable consequences of rapid rate rises.

  • Wednesday, May 24, 2023

The US Federal Reserve Open Markets Committee (FOMC) has raised interest rate by 0.25% to 5.25%. This was consistent with market expectations. The increase in the Fed Funds rate leaves it consistent with the year-end peak implied by the Fed’s March projections. 5.25% is the highest US interest rate since 2007. US markets initially took the news positively as the rise was expected but then reversed on the press conference comments of Fed Chair Jerome Powell who warned that the recent uncertainty in the banking sector would hit jobs and economic growth.

The decision to raise rates further comes after three US banks have failed in the past two months and others now are under stress due to the pressure of the US rapid interest rate rises. Mr Powell will be aware that failure of banks will lead to tighter credit conditions for both households and business on top of the increased cost of borrowing and living. Mr Powell was insistent that the broader US banking system remained ‘sound and resilient.’ Despite his reassurances, concerns remain about the solvency levels of some regional banks. Markets are now anticipating the Fed will pause its interest rate hiking cycle.

The rapid rise in interest rates over the past 12 months from 0.25% in March 2022 to 5.25% in May 2023 has had the impact of driving down inflation. Headline inflation in June 22 was 9.1% and has now fallen for ten consecutive months to 4.9% in April of 2023. Although there are still pockets of inflation in the economy such as food prices, the Fed Funds rate is now higher than Fed forecasts of underlying inflation for 2023 and 2024. This positive real interest rate indicates that policy is already restrictive, which should help to tame inflation further.

The risks of an overtightening monetary policy are becoming clear. The failure of Silicon Valley Bank and Signature Bank in March exposed fragilities in the US banking system. The collapse of First Republic further exacerbated these concerns. But these failures may also help the Fed. As lending standards tighten in response to these events this will reduce the availability of credit, which in turn lowers economic activity and inflation.

Some leading analysts are of the view that a pause may not be sufficient and that the Fed will have to reverse these rate rises as soon as the autumn to support the economy due to tightening credit conditions impacting the health of the economy. That would run opposite to the Feds current resolve to bear down on inflation.

Analysts feel that a time may come when the Fed will have to make a decision to either prioritise inflation control or economic growth and the avoidance of a banking crash.

US banks are having to use their reserve capital in order to cover higher interest rate payments to their depositors. This problem has developed as a result of near zero lending rates during the pandemic now insufficient to offset higher deposit payments. This is leading to concerns that with US interest rates at 5.25%, how long can this prevail until another bank fails. Potentially there could be large numbers of US banks that become technically insolvent. The Hoover Institute has reported that 2315 out of 4800 US banks have higher liabilities than their assets.

Deposits can leave banks quite quickly in these days of mobile banking and therefore the risk of a run on the bank is elevated. Depositors fled First Republic at a pace so rapid that the Federal Deposit Insurance Corporation (FDIC) had to seize the bank, wiping out the value of both shareholders and bond holders’ assets and then needing to pump US$13bn of capital into the bank as well as a US$50bn loan to JP Morgan for them to take over the failed bank.

The next bank on the taxi rank of concern is Pacific Western Bank (Pac West) who’s shares are down 40% before trading was suspended in the first week of May.

The Fed and Treasury are sticking to their position that the failed banks had weak lending criteria and poor management. First Republic lent to technology startups but was also exposed to falling real estate values particularly office blocks and industrial property. US interest rate rises has led to a tightening of financing. As a result, US commercial property prices have fallen 5% so far this year but Capital Economics expects a full peak to trough to hit 22%. This would create negative equity and default rates to rise.

Commercial Mortgage-Backed Securities (CMBS) have dropped in value to levels seen in the early days of Covid 19. This is problematic for banks as they hold 46% of CMBS debt. Small US regional banks are particularly exposed to these assets.

SVB’s failure was in the offset of lending and deposit rate imbalance and sought to bridge that imbalance by investing in safe US treasuries which fell in value as interest rates rose. This left a short-term hole in the balance sheet.

These are the results of aggressive interest rate rises over a short period of time and last weeks Fed rate rise to 5.25% will place more pressure on banks to cover higher deposit rates. Some analysts are suggesting that the technical insolvency of many US banks will continue until the Fed cuts interest rates by 1%. At present that does not look likely as rates have just risen and the Fed are all over this issue. The Fed is currently prioritising inflation control over allowing a banking crisis to develop.

If we are faced with further failures, then the Fed and Treasury Dept will be faced with a big decision. Should they intervene by further funding buy outs or seek to protect all deposits through a federal guarantee so that no run on any bank occurs. That would be a massive and last call. These are challenging times for the experienced Janet Yellen.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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