News in Charts: Entry to ‘Zombieland’

The second-fastest Federal Reserve (Fed) hiking cycle of recent times claimed its first casualty in the US banking sector on 10 March when Silicon Valley Bank (SVB) collapsed, in turn reawakening fears about European banks, as the dramatic change in the fortunes of Credit Suisse (CS) showed. Against this backdrop, in a move that many may regard as ‘bold’, the European Central Bank (ECB), Fed and Bank of England (BoE) have all raised rates. First was the ECB, hiking by the full 50 basis points it had promised, at a time when market fears were at their peak in between the failure of SVB and the UBS-CS merger. Next up, by 25 basis points, was the Federal Reserve, which indicated however that while additional policy tightening was possible it was no longer planned. Last came the BoE, raising Bank Rate by 25 basis points to 4.25%. These hikes, amidst serious concerns about the health of the global banking system, left investors highly unclear about what happens next for short and long rates, with implied volatility on US Treasury options currently at its highest since the Global Financial Crisis (GFC).

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Although market volatility helps in the fight against inflation by tightening financial conditions, as Fed Governor Jerome Powell acknowledged, it by no means facilitates financial stability. The Fed functions as the main provider of liquidity; and if it withdraws the ‘liquidity blanket’ to counteract inflation it may create unintended accidents, such as the SVB failure, which may escalate to disasters if not contained. To avoid such an escalation, the Fed’s total assets are growing again, despite its ongoing, $95 billion-per-month programme of quantitative tightening. This increase can be partly attributed to the new Term Funding Program (TFP), which offers liquidity to banks on more favourable terms and for longer periods than the typical Federal Reserve lending facilities.[1] With the TFP, the Fed is seeking to restore faith in banks after the dramatic fall in their valuations post-SVB, as reflected in their book equity multiples.

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The SVB accident appears to have been contained, however, so at present the Fed has no sufficient reason to prioritise financial stability over economic fundamentals in setting the path for rates. Fathom’s Global Outlook, Spring 2023 foresees recessions in the euro area and the UK starting in the first half of this year, with the US following later in the year. March’s downgrade in the Federal Open Market Committee (FOMC) growth forecasts suggests that its perception of recession risks has also increased. The FOMC’s elevated recession probability prompted the futures market to expect easing this year. The market expects the cuts to come fast and large by the end of summer, delivering by year-end a rate around 50 basis points lower than at the last year-end.

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Policymakers are likely to wait for concrete evidence of the economy contracting and slack opening in the labour market before starting to ease. Higher rates are expected to contribute to slowing economic fundamentals particularly through the credit channel. Fathom has long argued that easy monetary and fiscal policy since the Global Financial Crisis allowed low-profitability and loss-making firms (‘zombies’) to remain on life support and become more levered, without addressing their ailing business models. More expensive credit may trigger some widespread zombie-slaying. The most vulnerable companies are in sectors where profitability is low due to large costs to maintain competitiveness (e.g., R&D-intensive pharmaceuticals), or where revenue generation and investment are regulated (e.g., oil) or where recovery from the pandemic is incomplete (e.g., recreation). We have already seen the destructive impact of higher rates in the financial sector, where around 7% per cent of all US zombie firms reside.

A sharp turn in the credit cycle could make the downturn deeper than expected, but the zombie-slaying that would ensue would be good for the long-term productivity of western economies. In any case, do not be surprised if rates head south sooner and probably go lower than many expect.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1] Under the TFP, banks can swap assets for to cash to recapitalise, but they swap at face value instead of selling them at a discount.

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