On the third anniversary of the pandemic's global outbreak, the doubts spreading in 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 that your milk carton wasn’t infected. Now, the concern is that your bank may not be safe or that your bank’s bank may be running risks it doesn’t understand. When trust unravels, signs of trouble are suddenly all around.
There's still every reason to believe that confidence will return as calmer heads confirm that the vulnerabilities of Silicon Valley Bank and, say, Credit Suisse are idiosyncratic and unlikely to spread. But if the U.S. Federal Reserve’s efforts to restore order to markets may require further measures, its central mission to control inflation looks a little easier as tighter financial conditions cool demand.
The biggest surprise of the past week was not the collapse of a few midtier lenders, but that an impressive government response did so little to restore market confidence. In retrospect, however, perhaps this shouldn’t have been so unexpected.
Investors are still licking their wounds from the worst year of simultaneous losses in stocks and bonds in decades. The recent bounce since January only made them more leery of taking on risks at valuations that were hardly compelling.
Second, amid all the contradictory data about the odds of recession and the heat from inflation, the one thing market bulls and bears agreed on was that America’s banking system was rock solid. The news that the country’s 20th-largest bank qualified for the looser standards of regional banks came as an unwelcome shock.
This then triggered an additional search for innocent bystanders that might be the next victims of the turmoil. If large deposits at Silicon Valley Bank and Signature Bank were protected, just how safe is cash stored elsewhere even with the deployment of a new Fed lending facility? Even the longest banking relationships are getting fresh scrutiny as counterparties assess financial risks (and clients assess career risks) of keeping money at a smaller bank that may not withstand the turmoil.
Finally, there are concerns about financial plumbing. The crypto world suffered another blow when USDC, one of the most solid stable coin models, traded below par when 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 triggers questions about where else troubles might arise outside the tightly regulated world of systemically important banks.
It’s possible that all these frazzled nerves settle on their own over time without new money or fresh guarantees from the Fed, the Treasury or the Federal Deposit Insurance Corporation. Regulators and politicians alike are wary of something that looks more like a taxpayer-funded bailout. But they will surely take those steps if they must to restore order and they know what to do. Whatever banking turmoil lies ahead, it’s surely less challenging than a global pandemic and lockdown.
Higher uncertainty around just how this immediate crisis plays out, however, contrasts with rising confidence in the Fed’s ability to bring inflation to heel faster. Already the market moves over the last week have tightened financial conditions more in a single day outside the Lehman and COVID-19 crises by some measures.
Market odds that the Federal Open Market Committee will still raise rates next week are falling fast, but skipping a highly anticipated 25-basis-point hike may fuel fears more than it calms them. In any case, the hiking cycle is all but over. Recent inflation data continues hotter than anyone would like, but it should cool on its own amid sour market sentiment and financing that has turned more expensive and harder to find. Barring more shocks to supplies, demand will ease on its own.
When uncertainty and nervousness look like they’re engulfing everything, everywhere and all at once, investors need perspective more than ever. The U.S. economy is slowing, but consumer savings and government spending should still help make any recession short and shallow. The banking news is unsettling, but the largest U.S. institutions remain sound. Inflation won’t disappear overnight, but it’s more likely now to fade faster than recent expectations. The next days and weeks promise more drama, but the broad trajectory 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.