The Collapse Of A Tech-Heavy U.S. Regional Bank Roiled Markets

The rapid collapse of Silicon Valley Bank (SVB) last week sent tremors through the financial markets. Within a span of a few days, the combination of the realization of significant losses on its investment portfolio, a surge in deposit withdrawals, and an unsuccessful capital raise contributed to the collapse of the 16th-largest bank in the U.S. It is too early to assess the full macro impact of the SVB collapse. But for now, we think the macro effects will be limited.

Markets faced turbulence from the suddenness of the largest bank failure since 2008. From March 8-9, U.S. 10-year bond yields fell by 40 basis points, equities fell by 4%, and the CBOE volatility index spiked to 30 from 20. A flight to quality was also seen in European markets, where German 10-year bond yields fell by 40 basis points and the Swiss Franc appreciated by 3 cents against the U.S. dollar. All have since recovered somewhat following a swift policy response by U.S. authorities. But conditions remain in flux, as evidenced by concerns in Europe around Credit Suisse.

The U.S. government moved quickly to stem the damage from SVB's collapse. On March 12, the Treasury, Federal Reserve, and Federal Deposit Insurance Corp. (FDIC) jointly announced they were taking steps to guarantee all deposits--not just those insured up to the FDIC limit of $250,000--of SBV and Signature Bank (which was closed by the New York chartering authority). This protection did not extend to shareholders and bondholders. In addition, the Fed launched a new facility--the Bank Term Funding Program (BTFP)--allowing eligible banks and savings institutions to borrow against high quality collateral at par. As of this writing, these extraordinary measures seem to have calmed the markets somewhat, and contagion to other banks has been mostly limited so far (see "The Fed's Plan For U.S. Banks Should Reduce Contagion Risk," March 13, 2023).

Market expectations of U.S. policy rates have swung wildly. The fed funds futures curve as of March 16 shows the Fed raising rates by 25 basis points (bps) at its March 22 meeting (it was split between zero and 25 bps on March 15), a sharp reversal from last week (see chart). By end-2023 the market expects the fed funds rate to drop to around 4% (up from 3.25%-3.5% on March 15). On March 16, the European Central Bank (ECB) raised its policy rates by 50 bps as we expected, and the euro short-term rate forward curve has flattened.

At This Juncture, The Fallout SBV Will Not Move The Macro Needle

We generally see the macro effects from the collapse of SVB to be limited. The most likely macro contagion channel is consumer confidence, where uncertainty about the way current events might play out and their duration could dampen spending and demand. If widespread enough, the effects on consumption--particularly in services, which has remained strong--would hamper employment growth.

We also think that macro spillovers to the rest of the world from the U.S. will be limited. Direct links from Europe to SVB are low, and cross-border bank exposures to the U.S. are much smaller than at the time of the Global Financial Crisis. This is particularly true for the German and British banking systems, which have fewer net claims on U.S. residents compared with 2007, according to Bank for International Settlements (BIS) data. Switzerland and the Netherlands, which report having more net claims on the U.S. economy than in 2007, are two notable exceptions. Moving to Asia-Pacific, the links are even weaker (with some potential effects in Japan) and will likely pale compared with the ongoing positive growth impulse from a faster-than-expected recovery in China. Emerging markets will be affected by U.S. rates and general funding conditions.

Turning to policy, fears that central banks now have their hands tied as a result of supporting financial stability are misguided, in our view. To put it colloquially, central banks are able to walk and chew gum at the same time. This argument boils down to central banks having a sufficient number of instruments to achieve their policy objectives. Specifically, central banks can use their balance sheet through various facilities to provide financing and liquidity to help banks shore up their balance sheets. (And these can be extended beyond the announced one-year time frame of the BTFP if needed). Banks can independently continue to adjust their short-term policy rates to influence financial conditions and guide inflation back to target. The risk of inflation becoming more entrenched remains significant for both the Fed and the ECB, given the continued high pace of core inflation.

Therefore, we think the fight to contain inflation will continue. Supporting financial stability does not materially compromise fighting inflation. Indeed, until material evidence emerges that any spillovers from SVB have a sustained negative impact on demand, central banks will continue raising policy rates to rein in inflation. The pace may be somewhat more moderate until we get an "all clear" on the banking sector, but pausing the rate hike cycle now runs the risk of again falling behind the inflation-fighting curve, an outcome that central banks clearly wish to avoid.

Our overall macro focus continues to be on the pace of the much-anticipated slowdown. We see ongoing resilience in macro outcomes in both the U.S. and Europe. Resilience is most prominent in the services sector, where demand and employment remain robust. But it is also present in the European manufacturing sector where the production of backlogged orders from the effects of COVID-19 still has some months to go before it runs out. Partial data from the first quarter of the year suggests that GDP could again surprise on the upside, lending support to the view that the downturn may be shallower than previously thought and that policy rates will need to stay higher for longer.

Our Baseline Looks Unchanged, Though Risks Are Higher

The SVB collapse has jolted markets, but we are not convinced that it will move the macro needle. The downside risks to our forecasts have risen, but we see no material change to our baseline as of now. We plan to publish our updated macro and credit views later this month at the end of our current Credit Conditions forecasting round and will continue to assess the macro ramifications and monitor contagion risk in the broader financial system (see "Global Banking Risk Monitor").