Investment thoughts from our Real Return team

The Illusion of wealth

With California being the locus of recent banking stresses, it is not without irony that the Federal Reserve Bank of San Francisco recently issued a paper titled Loose Monetary Policy and Financial Stability.¹ In its conclusion, the paper states:

This study provides the first evidence that the stance of monetary policy has implications for the stability of the financial system. A loose stance over an extended period of time leads to increased financial fragility several years down the line. The source of this fragility is associated with swings in those financial variables that have been identified by the literature as harbingers of financial turmoil.

Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences. Such policies increase the risk of financial crises and thus the risk of high social, political, and economic costs.

The Bank for International Settlements’ Bill White and Claudio Borio, both of whom have warned repeatedly of the deleterious consequences of loose monetary policy for financial stability, may take umbrage to the authors’ claim of being the “first” to unearth this relationship, never mind the likes of earlier eminent economists such as Friedrich Hayek and Ludwig von Mises.

Still, it is good to see that US Federal Reserve (Fed) staffers are starting to join the dots, however belatedly. The authors of the recent paper keenly observe that “When interest rates are relatively loose, financial intermediaries have incentives – or are even required – to search for yield and thus risk.” Even a cursory reading of financial history shows this to be a story as old as time.

What, then, is the modern-day result of pricing money too cheaply? We contend that it is the illusion of wealth brought about by the gargantuan stock of government debt held by institutions that need not mark those assets to market, thanks to regulatory and accounting practices.

In theory, losses on assets not subject to mark to market should not be a problem. In practice, as was made abundantly clear by the failure of Silicon Valley Bank (SVB), that is not always the case. SVB was not without a hand in its own demise: a concentrated depositor base highly exposed to the start-up ecosystem of Silicon Valley, alongside rapid asset growth, was part of the problem. So too was the regulatory requirement to hold a percentage of so-called riskless assets – government bonds – that meant the asset side of the bank’s balance sheet was vulnerable to a rapid rise in interest rates. Those securities held to meet capital requirements by the regulator were classified as ‘held-to-maturity’ securities and therefore beyond the purview of mark-to-market practices. When SVB found itself at the centre of one of the largest bank runs in US history and needed to sell those ‘held-to-maturity’ securities in order to meet deposit outflows, those unrealised losses all of a sudden became very real.

How large are these unrecognised losses in banks? As the Federal Reserve Bank of San Francisco paper noted, financial intermediaries are heavily incentivised to search for yield and risk when interest rates are relatively loose. How many banks across the world have followed these incentives – even requirements – to buy supposedly riskless assets in non-mark-to-market banking books? No wonder, therefore, that the Fed has agreed to allow commercial banks to pledge these ‘held-to-maturity’ securities as collateral in return for funds in an amount equal to the par value of the bonds.

At the system level, the unrecognised losses on supposedly riskless duration assets are likely to amount to a staggering number. The illusion of wealth runs right through the global financial architecture, from commercial banks through to pension funds, insurers, asset managers, endowments, sovereign wealth funds, and right to the core of the modern monetary system – the central banks. Researchers at the Mercatus Center, a US think tank, have shown that the Fed’s balance sheet saw just over US$1 trillion in unrealised market-value decline in just the nine months to September 2022² – the balance-sheet manifestation of inflationary policy.

The problem is that inflationary policy inevitably leads to higher interest rates and thus to the repricing of assets. The root cause of SVB’s problems was the repricing of assets in response to higher interest rates, and the same cause was at the heart of the UK liability driven investment (LDI) debacle in September 2022. Had it not been for the margin calls, would we have ever learned of the challenges facing the UK’s LDI pension schemes? The accounting and risk practices of the regulators would have allowed them to carry on indefinitely, masking the shortfall until the schemes could not meet their liabilities. For now, the pressure on LDI schemes has abated with the stabilisation of gilt yields, but the risk remains. Should rates resume their trend higher, the role that leveraging gilts can play in reducing risk is likely to be tested again.

With an end to the multi-decade decline in interest rates, the years ahead are likely to be defined by the clash of higher interest rates with what is still a highly leveraged system.

Policy pivot

The failure of SVB and other banks has introduced considerable uncertainty around the outlook for monetary policy. Having failed to anticipate the sustained acceleration of inflation to levels way above target, central banks have been strident in their commitment to bringing inflation back down to target. As recently as his testimony to US Congress in early March, Fed Chair Jay Powell reaffirmed the central bank’s commitment to bring inflation to heel, noting that “the ultimate level of interest rates is likely to be higher than previously expected”. The terminal rate (the peak that the market expected the Fed funds rate to reach) quickly moved up to a cycle high of 5.7%, at which point the banking-sector turmoil began to unfurl. The question now is whether the Fed prioritises financial stability over inflation.

The US$390bn increase in the Fed’s balance sheet over two weeks following the onset of the banking-sector stress prompted many to declare that the Fed has resumed quantitative easing. This was most certainly not the case. The increase in the Fed’s balance sheet was wholly a function of the Fed fulfilling its role as the lender of last resort, supplying liquidity to the banking sector through its various lending facilities. From this perspective, the Fed is focused on financial stability.

Yet central banks have continued to hike interest rates in the face of banking-system stress. The Fed hiked interest rates by 0.25% at its 22 March meeting. The European Central Bank had gone one better and raised rates by 0.50% on 16 March, despite the failure of Credit Suisse. The UK 0.25% rate rise on 23 March followed another hot inflation print. Despite a round of rate hikes at the March meetings, the bond market voted that the increases are nearly done; short rates collapsed, with the US 2-year Treasury yield declining by 1.09% in three days. Typically, central banks will follow the bond market, particularly at hawkish-to-dovish inflection points. The question in this cycle is whether it is possible that the market is wrong to doubt the Fed’s commitment to tighten policy. In our view, it is unlikely that the bond market is wrong.

Liquidity versus credit

While the collapse of California crypto and banking start-ups looks bullish for liquidity, it is bearish for bank credit growth. With respect to the very near term, the Fed has addressed the cause of the banking stress – the forced sale of assets by banks at potentially fire-sale prices in order to raise liquidity. But the increase in the Fed’s balance sheet is unlikely to translate into easier credit conditions in the real economy. Looking beyond the near term, the recent banking-system stress is likely to exacerbate what was already emerging risk aversion among commercial banks. The Fed’s senior loan officer survey showed two sequential quarters of tighter credit conditions prior to the shenanigans in the first quarter this year.

As we look ahead, commercial banks are likely to be even more parsimonious with their balance sheets. It appears extremely unlikely that at this difficult stage in the economic cycle, money balances created do anything other than replace lost deposits or end up at the Fed’s reverse repurchase facility or in a money-market fund. It will probably not be ‘lent back out’ and transmitted into the real economy through credit creation. Tighter bank credit looks to be coming, and this will serve as a headwind to both economic growth and inflationary pressures. A recession is not a foregone conclusion, but the risk has increased substantially.

Market implications

The key question is what all this means for the market outlook. There are interesting similarities between today and late 2018, when Jay Powell publicly stated that interest rates were “a long way from neutral”, after which US credit spreads increased substantially. Short-term interest rates reversed lower, but this was only the beginning; the US 2-year Treasury yield continued to fall from 2.5% to 1.5% by the end of 2019, with the Fed cutting rates in mid-2019. As in 2018, it seems very likely we have seen the cyclical peak in safe-haven government bond yields (and are headed lower from here).

While risk assets have risen following the banking turmoil, it is far from clear whether this is good for stocks. Following Powell’s Christmas Eve pivot of 2018, global equities (represented by the MSCI ACWI in US-dollar terms) advanced by over 25% in 2019.³

However, there are important differences between today and 2019. In 2019, the Fed was cutting interest rates as inflation decelerated and unemployment remained very low. Today, inflation is still high, and unemployment looks set to rise. In this cycle, employment looks much more vulnerable as the gross capital misallocations of 2021 come home to roost, banks tighten lending standards, households finish drawing down on their excess savings, and global growth is more subdued. While China’s reopening will help, global growth looks nothing like it was in 2018. Rising recession risk should challenge the fundamental case for risk assets.

There will, of course, be debate around what the expansion of the Fed’s balance sheet means for risk assets. In the era of market activism, market participants have been conditioned to see an increase in central-bank balance sheets as a buy signal, and there are those that are arguing that this is the case on this occasion. In combination with bearish sentiment, risk assets have indeed squeezed higher, but it is important to see the Fed’s balance sheet in the current economic and market context. This time, we think the expansion of the Fed’s balance sheet should rather be seen as surrogate liquidity for the weakest banks, while the vast majority will continue to tighten their lending standards at this phase in the cycle.

In our view, the real story of SVB is that it has crystallised the emerging credit downturn. The accelerating mess in commercial real estate is a testament to how banking stress has increased the probability of the downside scenario on those ecosystems that are most dependent on easy access to credit. While investors and policymakers have become fixated on the risk of inflation, the risk of credit deflation is back on the menu.

¹ Source: Loose Monetary Policy and Financial Instability, Federal Reserve Bank of San Francisco Working Paper 2023-06 (https://www.frbsf.org/wp-content/uploads/sites/4/wp2023-06.pdf).
² Source: The Federal Reserve’s Balance Sheet: Costs to Taxpayers of Quantitative Easing, Mercatus Center, 10 January 2023.
³ Source: FactSet, April 2023.