Dear Investors,
Monetary Policy: Global rates reassessment
Global markets are rapidly learning to live with the consequences of tighter monetary policy conditions.
One of these consequences has clearly materialized in the form of a more challenging environment for weaker institutional balance sheets.
In the past week with the demise of Silicon Valley Bank as well as Signature Bank and Silvergate.
The market is now pricing in a much lower (U.S.) rates complex for the remainder of this year and into 2024 than it was just a couple of weeks ago.
First Abu Dhabi Bank are less dovish.
Financial conditions are set to tighten further as the effects of previous rate increases gradually permeate the economy.
We do not subscribe to the view that we are facing the spectre of GFC 2.0 and a re-run of 2007/2008.
Looking ahead though, they are cognisant that the hawkish bias conveyed by Fed Chair Powell and his colleagues of late, if left unchecked, risks driving a deflationary wave across the U.S. financial sector.
More broadly in the coming months amid the intensifying pressures of tighter monetary conditions and the more challenging macro environment that this is creating.
Monetary policy authorities cannot afford to ignore the unintended consequences of their tightening actions.
Inverted curves are an accurate predictor of fate
The inverted nature of the U.S. yield curve has, over history, tended to be a pretty accurate lead indicator of looming recession risk.
Paradoxically perhaps, the curve has flattened a little in the risk averse rate rally following the SVB collapse.
But from extreme (triple digit) inversion earlier in March, even a 30bp flattening still leaves the curves deeply and ominously inverted.
As SVB is categorized formally as idiosyncratic risk – even though tighter monetary conditions will continue to erode credit metrics at other weak financial institutions – and the Fed resumes its tightening bias at the FOMC, First Abu Dhabi Bank would expect the curve inversion to resume, to reflect the deterioration in macro-economic conditions.
Financials sector takes it on the chin
The sector is diversified with less than 30% in banks, roughly 20% in insurance, and the rest in diversified financials.
The large banks represented in the S&P 500 Index Financials sector are well-capitalized and have passed rigorous stress tests administered by the Federal Reserve (Fed).
Given post-global-financial-crisis regulatory requirements and swift action by regulators to support the banking system this month, Wells Fargo Advisors thinks it is unlikely that a large U.S. bank would experience a similar liquidity event.
Most of these companies have been setting aside reserves to cover potential losses that may occur in a recession.
The Financials sector is highly cyclical and is likely to come under pressure as a recession nears.
Historically, the sector has been a market performer as the cycle ages, the Fed tightens monetary policy, and the yield curve flattens or inverts.
Lower-quality, smaller regional banks with greater sensitivity to the economy and interest rates have underperformed this year.
Monetary Policy: The Central Bank trade-off
The central bank trade-off between crushing activity or living with inflation is now impossible to ignore as economic damage and financial cracks emerge.
That was evident in the Federal Reserve’s forecast of recession this year and sticky inflation in years to come.
Central banks have clearly separated responses to the banking tumult and kept hiking rates.
BlackRock sees a new, more nuanced phase of curbing inflation ahead: less fighting but still no rate cuts.
US personal consumption expenditures
For BlackRock we have seen clear evidence over the past two weeks that central banks are separating financial stability and price stability goals.
This separation contrasts with the central bank response to the 2008 bank failures and to the pandemic when they used all their tools – including rate cuts – to stimulate the economy.
They think stubbornly high inflation means a similar response this time is unlikely. Measures of core services inflation excluding housing remain well above levels that the Fed can likely tolerate.
BlackRock expects the February personal consumption expenditures data – the Fed’s preferred inflation gauge – to confirm inflation’s stickiness due to strong wage growth and tight labor markets.
Against this backdrop, they think market expectations of rate cuts are optimistic – and underappreciate the severity of the longstanding trade-off facing central banks.
Their inflation fight means they are actively generating recessions this time, not trying to avoid one.
Economy monetary policy Update
Economy seems to be entering credit tightening with a head of steam.
According to S&P Global’s chief economist, the data were “broadly consistent with annualized gross domestic product (GDP) growth approaching 2%, painting a far more positive picture of economic resilience” than seen over the past several months.
Data regarding core capital goods orders, which exclude orders for aircraft and defense.
Such orders increased in February by 0.2%, beating a Bloomberg survey estimate for a decline of the same magnitude.
Monetary Policy BoE hikes interest rates after surprise surge in inflation
The Bank of England (BoE) raised interest rates to 4.25% from 4.00%, the 11th consecutive increase.
Minutes from the meeting showed that the Financial Policy Committee told policymakers before the vote that the “UK banking system maintains robust capital and strong liquidity positions,” and “that the UK banking system remains resilient.”
For T.Rowe Price financial markets appear to expect rates to increase again amid no signs of a letup in inflation.
On a year-over-year basis, consumer prices rose to 10.4% in February – well above the consensus expectation.
Japan’s inflation remains high, but price pressures ease
On the economic data front, the rate of consumer inflation slowed in Japan, with the core consumer price index rising 3.1% year on year in February, down from January’s 4.2%, an over four-decade high.
In accordance to T.Rowe Price the contribution from energy fell notably due to government electricity subsidies to cushion the impact of price pressures.
Amid calls for further stimulus, a government panel endorsed plans during the week to add more than JPY 2 trillion to existing inflation relief measures.
This will go toward responding to the rise in energy prices as well as support to low-income households.
March saw a continued divergence in the fortunes of Japan’s services and manufacturing sectors.
While Japanese service providers saw solid improvement, as government support and an uptick in Chinese tourism boosted demand.
The manufacturing sector contracted, with both output and new orders falling.