Economic update – April 2023

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:
– What impact has the banking crisis had on interest rates and markets?
– Who/what caused some of the failures in the US regional banks?
– Economy showing resilience – key employment data still strong in US and Australia
– Inflation still above objectives but growing evidence that the high point is in the past

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

There is a lot going on in the world of finance and to make some sense of it, we will do our best to walk you through it in a calm and rational manner.
Cutting to our conclusion, we do not think we are in a crisis – like in 2008 – or anything like it. Yes – some did/will get hurt but the problem is well-contained – at least until the next ‘crisis’ emerges.

Going back to our previous Economic Update of March 1st, no one was talking about banking crises. Indeed, the month started calmly with our growth data release and the RBA decision to increase the cash rate seemingly just as we all expected.

Indeed, the first nine days of March were largely ‘business as usual’. Then, unbeknown to us at the time, a moderately-sized bank in California, called Silicon Valley Bank (SVB) had a $42bn run on its deposits in only one day – a record of sorts. Still unbeknown to us at the time, the next morning, SVB contacted the regulator that it had about $100 bn more of requests to withdraw deposits and it couldn’t make them good. The bank was shut down and events escalated quickly.

Before we get into the details, it is important to refresh our understanding of how banks work. Around the 1960s, life was a lot simpler in terms of financial products and technology. Depending on the jurisdiction, a bank would accept deposits and establish customer accounts then allow customers to transact on them to facilitate their lives and businesses. The bank would only hold about 10% of those deposits in cash (when cash really was cash – i.e. notes and coins) and lend out, or invest, the other 90% often in the form of loans to businesses, home loans and personal loans.

Cash could usually be withdrawn at call (i.e. immediately, when the bank was open – no 24 hour internet banking!) but the loans usually had fixed, much longer investment terms. If depositors suddenly demanded their money back, the first 10% of assets could be offset against the cash holding. 10% then was thought to be a reasonable buffer to withstand the whims and needs of depositors. If more funds were to be withdrawn, there was a problem as the longer-term loans could not usually be reversed at will.

Banks exist for many important reasons. We couldn’t have an efficient society without them. They make their profits on the difference between the interest paid out on deposits and that received on longer term loans. Banks compete with one another on both deposit rates and loan rates to make the system work efficiently.

As we all know, depositors don’t get much interest on simple deposits but they pay quite a bit on home loans and the like. The bank pockets the difference and this is called the ‘net interest rate margin’ (NIM). What happens to fresh deposits that have not yet been lent out in the traditional way? They would usually be parked in safe assets such as long-term government bonds and the like until prudent loans could be made to clients.

Under normal conditions, long-term bonds have a higher yield than short-term bonds and deposits. All is then good for the banks. However, from time to time, particularly when a central bank is trying to slow down its economy, a central bank might force up short-term rates such that there is a so-called ‘inverted yield curve’. That is, short-term yields are higher than long term ones. When this happens, part of the traditional banking model doesn’t work. Such inversions are usually short-lived and there are complex financial products that allow banks to deal with the inverted situations.

Because a bank exists on this model that does not keep 100% of deposits on call, if a situation arises where depositors lose confidence in the bank and are concerned for the safety of their money, they collectively and actively withdraw their capital. This results in a ‘run on the bank’. In the ’old days’ this might have amounted to a queue at a cashier’s counter to take out bundles of notes and coins. Runs do not require logic or fact. Older readers might recall John Laws, the one-time famed Sydney radio announcer, started a run on a bank from some slack comments he made on his show and he got into trouble for it.

Dialling forward many decades and deposits can be removed electronically and moved directly to another financial institution – within seconds or less. No queues; no notes; and no coins!

Let’s return to the SVB case in particular. It has been reported in mainstream media that SVB was ultra successful in attracting new customers. Indeed, they specialised in ‘tech start-ups’ and the like, and some of the venture capitalists who funded these start-ups located around Silicon Valley, even insisted that they use SVB as their bank. As a result, the SVB client base was not diversified in any reasonable sense and the clients were largely very well educated and very well connected (including via social media and other rapid contact methods). Some have suggested SVB was more of a hedge fund than a bank in this regard.
That SVB was particularly successful in attracting deposits was arguably its downfall. It attracted deposits so rapidly that it couldn’t match those assets quickly enough with sound loans so they parked these large amounts of excess assets in seemingly safe long-term US Treasuries – often thought of as the safest assets on the planet.

Let’s now introduce the US Federal Reserve (The Fed). Whether rightly or wrongly, the Fed has been on a mission since March 2022 to raise the Fed Funds rate (short-term interest rate) to bring down price inflation which has undoubtedly been above its policy objective of 2% – 3%.
For many years before, the Fed rate was low and often close to zero. The rapid rise in its rate from just above zero to nearly 5% in less than a year caused the yield curve to ‘invert’. That is, the yield on short bonds became substantially higher than those of long-term bonds. That was a deliberate action to (hopefully) control inflation.

Let’s get back to SVB. It had a rapid run on its deposits for whatever reason. It was rapid because the depositors were sophisticated and well-connected. We saw analysis from reputable experts on CNBC saying that the deposits withdrawn did not go to cash or anything like it. The deposits largely went to the bigger well-known banks or the money market to earn higher returns on savings. This was not a run on ‘the banks’ as a whole, but simply reflected clients making a choice of which bank or institution to deal with.

We have noted evidence to suggest that SVB was not squeaky clean in a number of regards but it also got caught out on the presumption that US Treasuries are all but riskless. If a Treasury is held to maturity (like holding a 10-year bond for 10 years), the holder will reasonably expect to get all of their money back and all of the yield payments along the way. Corporate bonds might well have quite different probabilities of default. However, if a Treasury is not held to maturity, its (mark-to-market) price fluctuates on a daily basis responding intraday to changes in interest rate expectations.

SVB, when faced with a run on its deposits, would have needed to sell its long-term Treasuries at an unexpected loss (on a mark-to-market basis) because the price of a Treasury is inversely related to its yield and yields were being forced sharply upward. As the Fed forced up yields, they forced down the value of SVB’s (and others) Treasuries and the gap was enormous because of the aggression of the Fed policy. Selling a Treasury early can always result in a profit or a loss on capital.

To start a run, it wasn’t necessary for SVB to actually crystalise a loss through selling the long- dated bonds it owned at a loss. Any qualified financial analysts could view the SVB portfolio and realise the increased risk that SVB was facing.

Some have suggested that SVB should have been subjected to the same stress tests that bigger banks faced after the GFC – and that would have prevented the problem. Seemingly expert analysts on CNBC suggested that SVB would have passed such stress tests because the existing stress test was about how a bank could deal with falling rates. There was no stress test for rising rates. Whose fault is that?

So where does this leave us? Several smaller banks have been subjected to runs. That is no different in substance in Australia from people and businesses moving deposits from small banks to the big four or five. We may not like it, but that is business.

Contrast that to 2008 or so when there were complex financial products that no one seemingly fully understood and who owed how much to whom. In the panic most financial institutions then stopped lending to each other – called a credit freeze. Central banks freed up liquidity from the end of 2008 and commercial banks then got back on track. This time around, government agencies merely ‘insured’ the deposits over the traditional $250,000 limit. Problem solved!

This run on SVB and a few regional banks was not nice but it will not knock the global economy off track – or at least that is what we think.

Having hopefully dealt with the ‘banking crisis’ let us focus on analysing market behaviour and possible projections – including any ongoing implications from the ‘crisis’.

At the start of March, Australian GDP growth came in at a respectable, but not stellar, 0.5% for the quarter or 2.7% for the year. The RBA hiked its rate by 25 bps to 3.6% and foreshadowed more hikes to come. This action was largely anticipated.

China surprised a little with some strong economic data and policy objectives.

The US then reported its very strong labour market data which followed an even stronger prior month.

Even the UK dodged the recession bullet with positive growth in Q4, 2022 rather than the expected pull-back and the start of a recession.

Before the SVB collapse, Fed chair, Jerome Powell, was talking about maybe returning to a 50-bps hike at the March 22nd meeting following the smaller 25- bps hike in February. The market started pricing in an e o y 2023 Fed rate even higher than the Fed’s projection of 5.1%. Back in January, the market thought 4.4% was the level. Expectations were swirling; then the story about SVB broke!