How the SVB fallout may affect growth, inflation, monetary policy, and South Africa
- The situation remains fluid and it is too early to make a hard call
- Our base case is that this is not systemic, but will accelerate a US recession
- The US Federal Reserve’s (Fed’s) resolve on inflation will be tested
- The Fed is at or near the peak in its policy rate
- Tighter credit conditions in the US can do some of the Fed’s inflation-fighting work
- SA is still a price taker on monetary policy – the Fed hike will force the SA Reserve Bank’s (SARB’s) hand, but a Fed pause will give SARB room to stay pat
- Downside local growth risks are countered by upside potential from China and local energy investment
- The negative fiscal implications will mean persistent curve steepness, all else equal
- The positive carry versus weaker growth obscures the outlook for the rand, particularly given a renewed current account deficit
- There is limited read through to SA banks in substance, but selling off in sympathy with global financials
Fed’s monetary policy should focus on whole economy
A key issue is whether the Fed should separate financial stability issues from monetary policy. In theory we would argue that, yes, these are two separate issues: financial stability focuses on the financial sector, while monetary policy focuses on the aggregate economy. This does not mean that financial stability or instability does not have consequences for the real economy and, in turn, for monetary policy. However, financial stability should be managed using macro-prudential tools, not interest rates. The economic consequences of the crisis, rather than the crisis itself, would have implications for interest rates.
That said, monetary policy could have financial stability implications, as we have seen over the past 20 years. Excessively loose monetary policy could destabilise the financial system via bubbles that ultimately burst.
Given regulations that were put in place in the wake of the Global Financial Crisis (GFC), as well as the improvement in household and corporate balance sheets, the current crisis should not be systemic. The Fed’s Bank Term Funding Programme (BTFP) and additional government US$25bn backstop should further reduce the risk of systemic fall out.
Hence, the Fed should be able to address its monetary policy mandate as it would have before, but taking into account the growth and therefore inflation implications that this banking event may have. We do not believe the Fed needs to cut rates or implement QE to address the needs of the banking sector.
The ECB increased policy rates by 50 basis points (bp) yesterday, in keeping with its recent guidance. This reflects a focus on inflation risks and data-dependence. The ECB indicated that it would deal with financial stability and liquidity risks if needed and in such a way that it does not impede on monetary policy implementation. For now, the ECB has been able to distinguish between financial stability and inflation targeting. Granted, the Eurozone is not the epicentre of the current banking sector woes, which arguably made it easier for the ECB to hike in line with previous guidance.
Can financial stability and monetary policy be separated?
Some may argue that this crisis means the end of quantitative tightening (QT). This could well be the case but, importantly, the banking system in the US is not short of liquidity. Reserves are still ample. The constraint has been the distribution of the liquidity within the banking sector, as revealed by the smaller, niche, riskier banks struggling. If anything, large, safe banks will attract deposits away from the now-perceived riskier banks. Although money market funds and short-dated US treasuries have lured some investors/savers out of deposits, overall, retail deposits remain quite sticky.
One argument against the separation of financial stability from monetary policy is that the Fed (and Treasury and Federal Deposit Insurance Corporation (FDIC)) are effectively picking certain sectors over others. If the Fed carries on raising rates, but “bails out” tech sector banks, it is rationing credit to the rest of the economy in favour of the tech sector.
Implications for Fed monetary policy
This will test the Fed’s resolve in regaining its inflation-fighting credibility and whether the Fed has indeed changed. Will the Fed blink – slash rates and do quantitative easing (QE) – at the first sign of real trouble? We note that some research houses have shifted dramatically in their forecasts for the Fed funds rate, from forecasting a 50bp hike in March to now forecasting no change or even a cut.
If the Fed does separate financial stability from monetary policy with respect to current dynamics (still strong labour market and sticky inflation), then a 25bp hike still seems like a reasonable prospect next week. The latest labour market data in the US was firm, but the inflation picture is mixed with solid CPI but slightly softer PPI releases. The Fed could justify a pause that is clearly framed as an assessment of the evolution of the macro economic fallout rather than a pause to address the banking crisis directly. A cut and QE would erode what little credibility the Fed has left.
Assuming this is not systemic, even the medium to longer-term outlook for the Fed will depend on how financial conditions evolve. In this regard, we would focus more on the real economy and look at bank lending standards and credit conditions rather than the typical financial condition indices that focus on equities, bond yields, FX, and corporate bond credit spreads.
A recession was always our base case, but what recent events will very likely do is tighten credit conditions/lending standards further. Currently it is not obvious that this tightening will/should necessarily have to be broad-based. It could be that credit to riskier industries, such as tech, will be rationed, with limited implications for credit provision to households, for example. This would mitigate some of the impact on real growth. If credit tightening is more widespread, then there will be a sharper slowdown in growth and larger increase in the unemployment rate.
The easing in the labour market would put downward pressure in ex-rental services inflation, which would make the Fed comfortable that inflation is under control. This will enable the Fed to ease policy in a cyclical fashion.
So where the market could be wrong (but obviously things are very fluid and no one knows) is in the cuts being brought forward as aggressively as they have, but where it would be right is to say we are at or near the peak.
The evolution of inflation will determine how long the Fed stays at the terminal rate. What is clear is that the “no landing” scenario, that would seemingly have required the Fed funds rate going to 6%, should now have a notably lower probability of transpiring, so too a “soft landing” scenario.
Historically, a recession and rising unemployment rate have been followed by disinflation. If the crisis is an accelerant for the recession, then there is reduced risk of the Fed losing control of inflation assuming the Fed does not go full tilt and cuts rates aggressively and moves from QT to QE.
While the Bank Term Funding Program (BTFP) and FDIC support is not classified as a bailout, it is effectively a bailout in the form of ongoing moral hazard as risk takers are supported when things go wrong. Just because the taxpayer is not stepping in directly, does not mean this does not have the same effect and signalling as a bailout.
Look specifically for the tone of the Fed
The bond curve has bull-steepened in response to the market pricing out hikes and pricing in cuts. Continued curve steepening would depend on the signalling from the Fed. A “hawkish pause” or a 25bp hike would probably stall the steepening, whereas a “dovish pause” or a cut would accelerate the steepening. Equities usually sell off in the initial phase of the steepening, as the Fed lags the market pricing for cuts. Historically there is no fixed timeline between the bond market rally and the trough in equities, but the turn in equities usually comes halfway to two thirds through the steepening. If the Fed starts easing next week and throws in some QE for good measure, then risk-on/liquidity could offset the impact of the now near-guaranteed recession on earnings.
As an aside, the FDIC has effectively guaranteed all deposits with SVB and Signature Bank. If this were to be applied to the whole system (this is not yet the case), then there will be an additional cost on the whole US banking system, as the contribution towards the FDIC’s Deposit Insurance Fund will have to increase. There have already been calls for renewed regulatory scrutiny and tightening following some walk-back in post-GFC regulations under Trump in 2018.
Implications for SA rates
Our base case is that the SARB will follow the Fed, but domestic data continue to lend a hawkish bias to the Monetary Policy Committee (MPC). High food price inflation, rising inflation expectations, and the weak rand should keep the SARB cautious, which precludes easing in the short term. If the Fed pauses, then this paves the way for the SARB to stay put in March. If the Fed hikes by 25bp, then we think the SARB will deliver a final 25bp hike in this cycle.
A US recession and a tightening in global financial conditions would be negative for SA’s growth, exacerbating domestic energy and transport constraints. We had upgraded our growth expectations at the start of the year due to 1) China’s reopening and 2) upside to domestic fixed investment related to electricity generation. Yet our expectation is still for a muted 0.5% – 1.0% expansion. It is too early to adjust our growth expectations, as we (markets and investors) have no insight into what policy makers are pondering or how long it will take to contain the fallout.
Sentiment is key in SA
From a market perspective, sentiment will be a key driver in the short term. We have already witnessed the “contagion” for Credit Suisse, but would note that Credit Suisse is very different to SVB and had legacy problems that are again coming to the fore as policy has been tightened.
The SA yield curve has steepened as rate hikes locally have been priced out. This is also reflected in the FRA curve, where the market is pricing in 70% probability for a final 25bp hike and with easing commencing in 1Q24. This is notably less dovish than what is priced by the Fed Fund futures, and reflects the view that rand risks and sticky local inflation could keep the SARB on hold for longer, despite the persistently weak growth backdrop.
Longer-dated bond yields have been anchored by the rising credit risk premium despite the fall in US Treasury yields. SA’s 5-y credit default swap (CDS) spread has risen by 50bp to 290bp, while the sovereign spread (SA 10-y dollar bond yield less US 10-y bond yield) by around 60bp to almost 400bp. The rollover in SA’s terms of trade, load shedding, and higher funding costs already imply we are past the fiscal sweet spot. The banking crisis fallout poses downside risk to the fiscal position via weaker growth, with the additional pressures of a higher wage bill based on current negotiations.
Implications for SA banks
When banks get into trouble, it is more often than not concerns about their solvency that trigger the worries, but it is liquidity problems that ultimately result in their demise. That is very much the case here.
SVB was seemingly adequately capitalised, but too great a portion of their assets were deployed in long-dated “held to maturity” securities (treasury and agency) and too much of their funding was short duration. These securities were not marked to market and when yields spiked, they created large unrealised losses at the same time as their customer base (US private tech firms) starting suffering cash flow problems and therefore withdrawing cash from SVB.
SA banks have very little in common with this situation. While Basel III has imposed the requirement for larger holdings of High Quality Liquid Assets (HQLA) on our banks, HQLA form a notably smaller part of their overall balance sheets, are shorter duration in general, and are typically either hedged or matched with longer duration liabilities. In addition, while SA bond yields have moved higher, the scale of the relative move is much smaller than the US and any government bond holdings on SA bank balance sheets are likely in the money on a total return basis.
On balance, the read through is limited and the spill over to SA banks is mostly one of investment contagion as money flows out of financials on a global basis and they sell off in sympathy.