InvestMacro

By Alexander Kurov, West Virginia University 

The Federal Reserve faces a pivotal decision on March 22, 2023: whether to continue its aggressive fight against inflation or put it on hold.

Making another big interest rate hike would risk exacerbating the global banking turmoil sparked by Silicon Valley Bank’s failure on March 10. Raising rates too little, or not at all as some are calling for, could not only lead to a resurgence in inflation, but it could cause investors to worry that the Fed believes the situation is even worse than they thought – resulting in more panic.

What’s a central banker to do?

As a finance scholar, I have studied the close link between Fed policy and financial markets. Let me just say I would not want to be a Fed policymaker right now.

Break it, you bought it

When the Fed starts hiking rates, it typically keeps at it until something breaks.

The U.S. central bank began its rate-hiking campaign early last year as inflation began to surge. After initially mistakenly calling inflation “transitory,” the Fed kicked into high gear and raised rates eight times from just 0.25% in early 2022 to 4.75% in February 2023. This is the fastest pace of rate increases since the early 1980s – and the Fed is not done yet.

Consumer prices were up 6% in February from a year earlier. While that’s down from a peak annual rate of 9% in June 2022, it’s still significantly above the Fed’s 2% inflation target.

But then something broke. Seemingly out of nowhere, Silicon Valley Bank, followed by Signature Bank, collapsed virtually overnight. They had over US$300 billion in assets between them and became the second- and third-largest banks to fail in U.S. history.

Panic quickly spread to other regional lenders, such as First Republic, and upset markets globally, raising the prospect of even bigger and more widespread bank failures. Even a $30 billion rescue of First Republic by its much larger peers, including JPMorgan Chase and Bank of America, failed to stem the growing unease.

If the Fed lifts interest rates more than markets expect – currently a 0.25 percentage point increase – it could prompt further anxiety. My research shows that interest rate changes have a much bigger effect on the stock market in bear markets – when there’s a prolonged decline in stock prices, as the U.S. is experiencing now – than in good times.

Making the SVB problem worse

What’s more, the Fed could make the problem that led to Silicon Valley Bank’s troubles even worse for other banks. That’s because the Fed is at least indirectly responsible for what happened.

Banks finance themselves mainly by taking in deposits. They then use those essentially short-term deposits to lend or make investments for longer terms at higher rates. But investing short-term deposits in longer-term securities – even ultra-safe U.S. Treasurys – creates what is known as interest rate risk.

That is, when interest rates go up, as they did throughout 2022, the values of existing bonds drop. SVB was forced to sell $21 billion worth of securities that lost value because of the Fed’s rate hikes at a loss of $1.8 billion, sparking its crisis. When SVB’s depositors got the wind of it and tried to withdraw $42 billion on March 9 alone – a classic bank run – it was over. The bank simply couldn’t meet the demands.

But the entire banking sector is sitting on hundreds of billions of dollars’ worth of unrealized losses – $620 billion as of Dec. 31, 2022. And if rates continue to go up, the value of these bonds will keep going down, which fundamentally weakens banks’ financial situation.

Risks of slowing down

While that may suggest it’s a no-brainer to put the rate hikes on hold, it’s not so simple.

Inflation has been a major problem plaguing the U.S. economy since 2021 as prices for homes, cars, food, energy and so much else jump for consumers. The last time consumer prices soared this much, in the early 1980s, the Fed had to raise rates so high that it sent the U.S. economy into recession – twice.

High inflation quickly cuts into how much stuff your money can buy. It also makes saving money more difficult because it eats at the value of your savings. When high inflation sticks around for a long time, it gets entrenched in expectations, making it very hard to control.

This is why the Fed jacked up rates so fast. And it’s unlikely it’s done enough to bring rates down to its 2% target, so a pause in lifting rates would mean inflation may stay higher for longer.

Moreover, stepping back from its one-year-old inflation campaign may send the wrong signal to investors. If central bankers show they are really concerned about a possible banking crisis, the market may think the Fed knows the financial system is in serious trouble and things are more dire than previously thought.

So what’s a Fed to do

At the very least, the complex global financial system is showing some cracks.

Three U.S. banks collapsed in a matter of days. Credit Suisse, a 166-year-old storied Swiss lender, was teetering on the edge until the government orchestrated a bargain sale to rival USB. A $30 billion rescue of regional U.S. lender First Republic was unable to arrest the drop in its shares. U.S. banks are requesting loans from the Fed like it’s 2008, when the financial system all but collapsed. And liquidity in the Treasury market – basically the blood that keeps financial markets pumping – is drying up.

Before Silicon Valley Bank’s collapse, interest rate futures were putting the odds of an increase in rates – either 0.25 or 0.5 percentage point – on March 22 at 100%. The odds of no increase at all have shot up to as high as 45% on March 15 before falling to 30% early on March 20, with the balance of probability on a 0.25 percentage point hike.

Increasing rates at a moment like this would mean putting more pressure on a structure that’s already under a lot of stress. And if things take a turn for the worse, the Fed would likely have to do a quick U-turn, which would seriously damage the Fed’s credibility and ability to do its job.

Fed officials are right to worry about fighting inflation, but they also don’t want to light the fuse of a financial crisis, which could send the U.S. into a recession. And I doubt it would be a mild one, like the kind economists have been worried the Fed’s inflation fight could cause. Recessions sparked by financial crises tend to be deep and long – putting many millions out of work.

What would normally be a routine Fed meeting is shaping up to be a high-wire balancing act.

About the Author:

Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

By George Prior

The banking crisis that spooked investors and sent shockwaves around the world could ultimately be beneficial for global financial markets, says the CEO and founder of one of the world’s largest independent financial advisory, asset management and fintech organizations.

The comments from deVere Group’s Nigel Green come after UBS agreed to buy the embattled Credit Suisse for $3.2 billion on Sunday, with the Swiss National Bank also pledging a loan of up to $108 billion to back-up the takeover.

It came just days after the second and third biggest bank failures, Silicon Valley Bank and Signature respectively, in US history in recent days.

He says: “The events of the past week or so have sent global markets reeling as investors feared a credit crunch, and other issues, last seen during the 2008 financial crisis.

“Despite the shockwaves, we expect that the banking crisis could ultimately prove to be beneficial for global markets for several reasons.”

He continued: “The emergency lifelines being thrown to banks by regulators and governments, among others, appear to have now halted contagion within the sector, largely containing the crisis from hitting other firms and other sectors.

“Global investors’ nerves will be calmed after the US Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank in a coordinated statement, which came ahead of the opening of financial markets in Asia on Monday, all vowed to boost liquidity to ease pressures in the international financial system.

“It underscores the commitment to do whatever it takes to avert another wholesale crash. This brings the confidence and certainty that markets crave.”

A harsh spotlight has been focused on banks in the last week and while it has been for many of the wrong reasons, it has also “served to highlight to investors that the rules imposed in the wake of the 2008 financial crisis mean that most banks are in a strong position to withstand shocks,” says Nigel Green.

“It shows that most financial institutions have plenty of capital and more than enough liquidity to meet operational needs and withdrawals – and that what went wrong at Credit Suisse and SVB were decisions made by a handful of former senior execs.”

The deVere CEO goes on to add that the crunch in the banking sector and so-far avoided fallout for the wider global financial system strengthens the case that central banks will “ease up on interest rate hikes.”

He notes: “Central banks know that besides having to try and tame stubbornly high inflation, they also need to ensure financial stability.  The events of the last week which rocked confidence will certainly give them cause for pause.

“The stepping back from interest rate hikes will be welcomed by investors who are concerned that overtightening now – when monetary policy time lags are notoriously long – could steer the economy into a recession.”

Both the Federal Reserve and the Bank of England meet this week.

The deVere CEO concludes: “It’s been a bumpy ride over the past few days but successful contagion containment, the solid fundamentals of most banks, central banks rushing to inject liquidity, and the growing case for interest rate hikes to be paused will be cheered by global markets.

About:

deVere Group is one of the world’s largest independent advisors of specialist global financial solutions to international, local mass affluent, and high-net-worth clients.  It has a network of offices across the world, over 80,000 clients and $12bn under advisement.

By Dan Steinbock

Amid the worst global volatility since 1945, Philippines may to be aligning its future with secular erosion, political divisions, militarization and nuclear risks.

Only some six years ago, the Duterte administration was still recalibrating its foreign policy to balance between Chinese development and US military cooperation. The Philippines, finally, stood to benefit from both great powers, as many ASEAN nations had done for years.

But those days are fading fast. And the timing couldn’t be worse. Manila seems to be positioning in a way that could result in elevated economic and geopolitical collateral damage. If that’s the case, it’s unwarranted. Other options do exist.

Militarization with US, elevated nuclear risks in the region

Last week, the Philippines and the United States announced the two will hold their largest Balikatan [“shoulder-to-shoulder” military] exercise in history, with 17,600 expected participants. Starting in mid-April, it will feature live fire, 12,000 US troops, 5,000 Philippine soldiers, over 110 from Australia and Japanese observers.

Officially, the focus will be on “maritime defense, coast defense, and maritime domain awareness.” Yet, leading US observers say the aim is to increase interoperability among the allies, to contain China’s rise and to optimize US flexibility in its regional military bases.

That, however, is likely to pave the way to a premature military conflict, which will then be used to boost elusive unity and legitimize further mobilization.

Worse, last week also saw the nuclear risks increase drastically as the US nuclear alliance with the UK and Australia (AUKUS) revealed a plan to launch a fleet of nuclear-powered submarines in the region.

Australia’s defense minister Richard Marles said the deal to buy nuclear-powered attack submarines from the US was necessary to counter the biggest conventional military buildup in the region since World War II. The deal will cost up to $245 billion over the next three decades and create 20,000 jobs.

What Marles left unsaid was that the primary beneficiary of the deal, which will delegate geopolitical risks away from the US to Australia and Asia, is the US Big Defense. And let’s be real: those jobs, which will not benefit Australia’s civilian economy, represent only 0.14% of its total labor force. Far worse, the deal could drag 26 million Australians, along with hundreds of millions of Asians, into a nuclear holocaust.

Foreign policy reversal

In the process, the stated Philippine foreign policy of “friend to all, enemy to none” appears to be dissolving, while the parallel domestic objective of “unifying the nation” is likely to be derailed. As the march of militarization proceeds, associated economic, political, military and ethnic tensions will increase accordingly. The path from Afghanistan and Iraq to Syria and Ukraine has been a series of colossal devastations. Should the same fate fall to Taiwan or the Philippines, the outcome is not likely to prove that different.

Worse, while the new, more malleable foreign policy could drag the Philippines into hostilities that the wide majority of the Filipinos oppose, it would also split the ASEAN.

Instead of opposing the AUKUS, which violates Philippine constitution, Southeast Asia Nuclear Weapon-Free Zone (SEANWFZ Treaty) and the UN nuclear weapon ban treaty that the government has ratified, Manila seems to be aligning its future with the very countries driving the arms races and nuclear proliferation in the region.

Furthermore, this alignment takes place at a historical moment when the economies of these allies are struggling with the worst economic challenges since 1945. Perhaps that’s why they now resort to misguided military mobilization, which is exploited as a diversionary technique to distract the governed and pacify the markets.

Cost-of-living crises in the West, rising volatility

US annual inflation rate, which had soared close to 10 percent in summer 2022, slowed only to 6.0 percent in February. Although the interest rate has been hiked to almost 5 percent, the US remains three times above the Fed’s target of 2%.

In euro area, the situation was worse as inflation remained 8.5 percent in February 2023 after peaking at 11.1 percent in November. Last week, The ECB raised interest rates by 0.5%, further pushing borrowing costs to the highest level since late 2008. Due to persistent inflation, the hikes are expected to continue.

Even in Japan, where inflation was negative until the fall of 2021, it soared to 4.3 percent in January 2023, the highest since 1981, and continues to rise. As a result, Japanese central bank’s new chief Kazuo Ueda will have to raise the interest rate in the coming months, which will further penalize the ailing consumption.

Despite a decade of historical fiscal packages, past monetary easing and massive debt-taking, British living standards are crumbling, French workers are rioting, Italy remains under colossal debt burden, and even in Germany the recession fears are returning.

If the SVB risks and contagion spreads…

The Fed raised the interest rate to 4.5-4.75 percent in its February 2023 meeting, still pushing borrowing costs to the highest since 2007. Despite increasing financial instability, Fed Chairman Jerome Powell warned of more rate hikes and seems to be aiming at 5.25 to 5.5 percent, thus flirting with a recession, or worse.

Indeed, new data shows that the collapse of Silicon Valley Bank (SVB) wasn’t an anomaly, but reflects systemic pressures in the US financial sector. Some 200 American banks face SVB-like risks. They do not have enough assets to pay all customers, even if half of uninsured depositors tried to withdraw their money.

Last week, the ratings agency Moody’s downgraded its outlook for the US banking system from stable to negative, due to the “rapidly deteriorating operating environment.”

These are the economies Manila is now pivoting to, possibly for years to come.

The lessons of history

Last time, the Philippines served as a battleground of the Great Powers, Japanese troops butchered at least 100,000 Filipino civilians in Manila, while the Battle of Manila caused massive civilian devastation: 100,000 killed and 250,000 in total casualties, thanks to Japanese atrocities and US firepower. Like Berlin and Warsaw, the city became one of the most devastated capitals.

Lessons of history: destroyed walled city of Intramuros (May 1945)

Source: Wikimedia Commons

During World War II, total Filipino deaths amounted to 560,000-1 million; almost 4.9% of the then-population. In relative terms, that’s far higher than the losses of the US (0.3%) or even Japan (3.9%); and higher than in Burma, China, Korea, or Malaya/Singapore. In Southeast Asia, the devastation was worse only in Indochina.

Today the destructive power of Philippine allies’ conventional and nuclear weapons is far, far more lethal than in 1945.

Without a genuine “friend to all, enemy to none” foreign policy, the inclusive rise of the Philippines is not viable.

About the Author:

Dr. Dan Steinbock is an internationally recognized strategist of the multipolar world and the founder of Difference Group. He has served at the India, China and America Institute (USA), Shanghai Institutes for International Studies (China) and the EU Center (Singapore). For more, see https://www.differencegroup.net