Back in March 2022 when the Fed embarked on its second most aggressive hiking cycle ever, we warned that it would not be the first hike that created risk, but that the risks would probably surface after the Fed had delivered its final hike. That last hike appears to have happened: so where are we now?
With inflation down and economic activity re-accelerating, the Fed seems set on maintaining rates at current cyclical highs for longer than the market had expected and hoped just a few weeks ago. Despite the abrupt departure from years of zero rate policy, the economy has so far defied the odds of a recession.
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This resilience in economic activity despite an aggressive tightening cycle has gone hand in hand with a recovery in consumer confidence and an overall bullish sentiment in markets. The share of bullish investors surveyed by the American Association of Institutional Investors is above the historical average and cash allocations are significantly below average.
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But amid the upbeat mood, complacency remains a risk. Take the banking sector as an example. The troubles that engulfed Signature Bank and Silicon Valley Bank (SVB) only a year ago feel like a distant memory, but it might be worth recalling them: especially as the Fed announced that it would allow the emergency Bank Term Funding Program (BTFP), a measure set in place after the SVB collapse, to expire as planned on 11 March 2024. The support mechanism being removed is not small, standing at $164 billion at the beginning of March. Withdrawing it risks exposing all over again the cracks that appeared in the US banking sector under the new, higher, interest-rate regime.
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US banks have generally lower levels of capital buffers in the latest fiscal year than banks in Europe or Japan, even after adjusting to reflect their market valuations, and as a result their health is more sensitive to market gyrations. The BTFP program has been very effective at allowing banks to avoid realising losses on their government bond assets, while injecting liquidity and boosting investors’ and depositors’ confidence in the process. There are already signs that risks may resurface with the removal of the BTFP program.
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One bank that has started making disturbing headlines even before the expiry of the BTFP program is New York Community Bancorp (NYCB). The troubles at NYCB are different in nature from those at Signature or SVB. They began at the end of January, when the share price slumped as the bank cut dividends and reported an unexpected loss during the fourth quarter, citing stresses in its commercial real estate portfolio. Rating agencies slashed NYCB’s ratings to junk status in mid-February and, at the end of the month, the newly appointed CEO revised the fourth quarter loss to $2.7bn, 10 times the amount originally reported. This week NYCB announced another new CEO, and revealed that it had raised $1bn from investors, including the former treasury secretary Steven Mnuchin, in a move reminiscent of some of the deals that were happening during the 2008 banking crisis to shore up liquidity and confidence.
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While we do not foresee a full-blown banking crisis or a repeat of the 2008 financial crisis, it is important to remain vigilant for potential risks. In this respect, banks continue to be a source of direct vulnerability; but they also perform the valuable role of canary in the coal mine, as economic malaise tends to manifest itself in their balance sheets and asset prices. It is likely that the expiry of the BTFP program will increase the vulnerability of the banking sector. However, it might also prompt a more transparent scrutiny of how corporates and households are dealing with higher interest rates, and better price discovery of risks.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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