“There are decades where nothing happens; and there are weeks where decades happen”Vladimir Lenin
I was visiting relatives in Kuching, Sarawak when the multiple news reports of American bank failures hit the screens and home televisions the world over.
The speed and ferocity of the downfall of Silicon Valley Bank (SVB) and the subsequent response from bigger US institutions to rescue First Republic Bank all unfolded within a few days. To add on to the seemingly never-ending list of worries, investors were also hit with news of Credit Suisse’s rescue and the unexpected wipe-out of its AT1 debt holders last week.
There are weeks where decades happen. Admittedly, it feels reminiscent of the 2008 Global Financial Crisis (GFC) in some aspect…
Volatility Is An Instrument of Truth
About six months ago I wrote:
“because interest rates are a blunt tool, this sets the stage for a potential fallout that could be quite devastating. The single-minded focus to bring down inflation prints by raising unemployment and bringing down spending is incrementally painful, and it also threatens financial stability by raising the odds of disruption in the financial plumbing.“
In a typical Fed tightening cycle, the fringes or riskiest areas where excess speculation are rife often gets blown up first. We’ve seen that in the crypto / DeFi space last year and in certain emerging and frontier markets. From there, the ‘blow-ups’ proceed to the core (developed markets) if a tight policy stance remains.
I’ll opine that we are here now, that the regional bank crisis in America is the evidence that shows that the world cannot tolerate adjusting to this higher interest rate regime.
Regional banks are incredibly important to the domestic American economy as they serve thousands of towns and communities and small, medium-sized businesses. Consider also the fact that more than two-thirds of jobs created in the US are by these small, medium-sized businesses.
Policymakers understand this and hence have been quick to respond so far to avert a crisis. But the damage to confidence has been done, and we’ll likely see lending standards tighten, leading to less lending and credit growth, which leads to a deterioration in small business confidence. This has negative effects on domestic growth as investment and consumption gets curtailed.
As for G-SIBs (yes Deutsche Bank is one), they’re likely to be safer than what most fear. But over the near-term, fears can develop into self-reinforcing cascades in market prices so it may be wise to stay prudent for the time being. As seen in the chart below, the S&P 500 Financials index has fallen to it’s post-pandemic breakout level and currently hovering hanging around this crucial support zone:
The surge in bond market volatility is signaling a possible end of a trend higher in yields for this current cycle. We may be near or at the peak in interest rates. The BofA MOVE index, which measures US Treasury bond volatility, has made a new high recently with the plunge in yields in the front-end:
This has caused the US Treasury curve to steepen, which typically occurred when recessions are about to occur:
Additionally, my trader friend Alex Barrow pointed out that “the forward rate for 3-month bills in 18 months time is at an all-time low against the current 3-month rate. The last time this indicator was anywhere near this low was in early 01’ and was shortly followed by a recession.”
It is only after such moves that we can then derive meaningful signals. Volatility is an instrument of truth.
Policymakers always fight the last crisis
I don’t expect a repeat of 2008-2009, and if any analog in history is relevant, this feels closer to the early 90s S&L crisis. Policymakers do have the power and a playbook to prevent a collapse of the banking system: as long as banks’ bond holdings are not needed to be MTMed and central banks provide backstops, it’s unlikely to be a repeat of the GFC.
The American General William Westmoreland (a WWII veteran) wasn’t able to adapt to the evolving battlefield dynamics of the Vietnam War – using obsolete strategies to fight an enemy that seemingly fought anywhere and with disregard of casualties. Similarly, policymakers are fighting the last crisis and deploying the strategies they know best as the memories of the dark days of the GFC linger in their minds.
If any, this current ‘crisis’ will unfold unlike any others, and many of us wouldn’t be able to expect or anticipate how this ends. Perhaps the ‘gray swans’ are in the commercial real estate industry, given that its unlikely the players have adjusted sufficiently to the surge in interest rates after a long period of cheap financing. Perhaps the risks are in the technology sector, and that could be really frightening because of how digital and entrenched technology is in global business, trade, governance and defence.
Investors mustn’t forget that financial markets are complex adaptive systems. Assets are priced at the margin, and all participants operate with their biases and under limited information. Collectively as participants interact, the markets have emergent characteristics, and the system adapts on aggregate. Reductionist thinking processes don’t work for long, hence, it’s difficult to predict the next crisis (and seldom that they are identical).
Stay optimistic & be prepared
The high penetration of social media in today’s society allows fears to spread quickly, and sometimes, irrationally. So while there could be more adverse developments surfacing in the weeks ahead, financial markets are discounting them as quickly as things unfold.
As compared to improving investor sentiment in January, fear has crept back again and sentiment surveys are showing that investors are defensively positioned.
This sets the stage for a near-term rally in risk assets as policymakers continue to take measures to assure public fears and as investors look forward to lower interest rates that are increasingly likely. However, no bull market begins on ‘hope’. If any, they start after a collapse in confidence and with fear in the air and market participants panicking and feeling despondent. We may see chaos again before we start a new market cycle.
Bigger picture-wise, the fact that global central banks, led by the US Fed, responded with higher interest rates in 2022 to crush inflation even before an adequate supply response can develop as a function of natural forces of the marketplace, guarantees that we’ll see bouts and waves of inflationary and disinflationary cycles in the years ahead.
Stay optimistic, but be wise as a serpent and be prepared. As market dislocations occur, I’m excited for the future as the opportunities I see are increasingly abundant…
BTW: Kuching’s Laksa is absolutely delicious. It’s closer to what Singaporeans know as Mee Siam, where the sauce is curry-based but both chicken and prawns are used. It’s my favourite Laksa compared to the Singaporean or Penang versions. I recommend Choon Hui Cafe – do try it when you’re in Kuching
If you’re looking for great dessert in Rome, I had the Semifreddo al Pistacchio at Culinaria in December last year- guarantied to send your tastebuds to Nirvana