On the third anniversary of the global outbreak of the pandemic, the doubts sweeping through the current markets feel familiar. In those early days of lockdown, it was hard to know if you could still shake hands with a friend or trust your milk carton wasn’t infected. Now the concern is that your bank may not be safe or your bank’s bank may be taking risks they don’t understand. When confidence wanes, signs of trouble are suddenly everywhere.
There is still reason to believe that confidence will return, as calmer heads confirm that the vulnerabilities at Silicon Valley Bank and, say, Credit Suisse are idiosyncratic and unlikely to spread. But while the Federal Reserve’s efforts to restore order to markets require further action, its core task of controlling inflation looks a little easier as tighter financial conditions dampen demand.
The biggest surprise of the past week was not the collapse of some middle-market lenders, but that an impressive government response did so little to restore market confidence. In hindsight, maybe that shouldn’t have been so unexpected.
Investors are still licking their wounds from the worst year of simultaneous stock and bond losses in decades. The recent rebound since January has only made them more wary of taking risks on valuations that have been less than compelling.
Second, with all the conflicting data on the likelihood of a recession and the heat of inflation, market bulls and bears agreed that the US banking system was rock solid. News that the country’s 20th largest bank is qualifying for the looser regional bank standards came as an unwelcome shock.
This then sparked an additional search for innocent bystanders who could be the next victims of the turmoil. If large deposits have been protected at Silicon Valley Bank and Signature Bank, how safe is cash stored elsewhere, even if a new Fed lending facility is put in place? Even the longest banking relationships come under renewed scrutiny as counterparties assess the financial risks (and clients the career risks) of holding money with a smaller bank that may not weather the turmoil.
Finally, there are concerns about the financial installation. The crypto world took another blow when USDC, one of the most solid stablecoin models, traded below par as its manager feared the loss of a $3 billion deposit. That’s hardly the same as a money market fund breaking the buck, but it does raise the question of where else trouble might lie outside the tightly regulated world of systemically important banks.
It’s possible that over time, without new money or guarantees from the Fed, the Treasury Department, or the Federal Deposit Insurance Corporation, all of those frayed nerves will settle down on their own. Regulators and politicians alike are suspicious of what looks more like a taxpayer-funded bailout. But they will certainly take those steps if they need to restore order, and they know what to do. Whatever banking turmoil lies ahead, it’s certainly less challenging than a global pandemic and lockdown.
However, greater uncertainty about how this immediate crisis will play out is offset by rising confidence in the Fed’s ability to get inflation under control more quickly. Already last week’s market action further tightened financial conditions outside of the Lehman and COVID-19 crises through a few actions in a single day.
The market chances that the Federal Open Markets Committee will hike rates next week are falling fast, but skipping a much-anticipated 25 basis-point hike could fuel fears more than calm them. In any case, the hiking cycle is as good as over. The latest inflation data continues to be hotter than anyone would like, but it should cool down on its own given poor market sentiment and financing that has become more expensive and harder to find. Barring further supply shocks, demand will subside on its own.
When uncertainty and jitters look like they’re engulfing everything, everywhere, all at once, investors need perspective more than ever. The US economy is slowing, but consumer savings and government spending should still help ensure any recession is short and shallow. Bank news is worrying, but US largest institutions remain solid. Inflation will not go away overnight, but it is now more likely to ease faster than recent expectations. The next few days and weeks promise more drama, but the broad course of the economy this year still looks little changed.
Christopher Smart is Barings’ Chief Global Strategist and Head of the Barings Investment Institute, based in Boston.