The US bank Silicon Valley Bank (SVB) is a high-profile casualty of central banks’ battle against inflation. Its demise is a reminder that interest rate hikes have a nasty habit of operating with a lag.
Yet SVB's collapse does not represent a systemic risk. The bank was in a uniquely precarious position. It was vulnerable on two fronts in particular. First, it was far less diversified than many of its global peers. SVB was a specialist lender whose deposit base was almost entirely composed of early-stage technology companies – firms that had enjoyed substantial capital infusions in 2021 but whose inflows later dried up.
Second, its risk management controls were weak. Because it was unable to grow its loan book as quickly as it was taking in deposits, SVB chose to park its clients’ funds in longer-maturity US treasuries and mortgage-backed securities but, crucially, without hedging the duration risk of those assets. In other words, it made such investments while failing to insure itself against any losses it might incur in the event of interest rate hikes.
This led to a mismatch in the duration of its liabilities – deposits – and its assets. Therefore, when the Federal Reserve raised interest rates and SVB’s clients began withdrawing money, the bank was forced to sell its bonds at a heavy loss. Those losses eventually equalled the bank’s equity, triggering its demise.
None of this suggests the world is about to witness a credit squeeze. SVB’s lack of diversification and weak risk management are not characteristic of the banking industry as a whole. In the US, large, systemically important banks are subject to much tougher regulations governing risk management and the reporting of portfolio losses. In Europe, meanwhile, all banks are required to carry out regular mark-to-market adjustments to their investment portfolios. What is more, the backstops put in place by US regulators – including measures to protect SVB deposits in full – materially reduce the risk of further bank runs.
SVB's demise will pressure central banks into slowing interest rate hikes. Central banks will now have to consider the impact of any further interest rate hikes on the stability of the financial system. We now expect an earlier end to quantitative tightening in the US than previously anticipated – not least because QT disproportionately impacts smaller banks. At the same time, a 50-basis point interest rate hike by the Fed at its next meeting now looks out of the question. We expect a 25bp rise but do not rule out the US central bank keeping rates on hold in March.
SVB’s demise is a standing reminder of the lagged economic effects of rate hikes and signals that a recession is more likely than investors previously thought. The excess savings consumers had built up and the lines of credit businesses had easy access to during the COVID-19 pandemic acted to delay the negative impact that higher interest rates have on economic activity. But SVB’s demise shows that rising borrowing costs are now beginning to feed through to the economy, albeit punitively and in specific sectors. A recession is now more likely than many investors had thought.
Many areas of the financial market have yet to fully price in the risk of recession. We have argued that the market – rightly for the most part – continues to view this cycle as an ‘inflation cycle’ and not a ‘growth cycle’. But this has meant that the risks of a recession have not been sufficiently baked into asset valuations.
Growth-sensitive asset classes across the board – cyclical equities, small cap stocks and high yield bonds – appear vulnerable. We remain cautious and underweight equities. As markets begin to price in growing risks to the economy, we anticipate a transition in stock market dynamics. Quality stocks, which have struggled through the cycle so far (again, because markets considered inflation as the primary risk rather than a decline in growth), should begin to outperform. As disinflation resumes, we expect the equity-to-bond correlation over the medium-term to turn negative, taking pressure off balanced funds. The attraction of gold also increases as real rates stabilise and grind lower alongside a weakening US dollar.
Arun Sai is senior multi-asset strategist at Pictet Asset Management
