News of the week summary - 26/03/2023

Central Banks’ fight against inflation challenged by growing financial instability

Central bankers are currently walking a tight rope: they must tame down inflation while containing financial instability, which has grown as officials have raised interest rates in their fight against surging consumer prices.

This week, the Federal Reserve and the Bank of England have raised interest rates by 0.25 percentage points, and 11 days ago the European Central Bank lifted its rate by 0.5 percentage points. A sharp U-turn in Central Banks’ policies could have prompted markets to believe officials know something they don’t, and engendered further instability.

However, Jerome Powell (head of the FED) has opened the door to the possibility that this could be the last increase (or at least the penultimate). Just after the Credit Suisse crisis, another systemic bank, Deutsche Bank, has seen the price of Credit Default Swaps (insurance against default on debt) on its bonds surge, a sign that markets believe the German lender could be in trouble. Because more bank failures and financial uncertainty could seriously damage the real economy, central banks may have to ease up on their combat against inflation.

Global economic activity remains stable, real estate prices fall

According to business surveys, economic activity grew at a modest pace in Europe and the US, thanks to strong demand for the services industry. The reopening of the Chinese economy after the country eased its Covid policies, and a decline in energy prices have stimulated global activity.

This will fuel inflationary pressures everywhere, and it shows that monetary policy has not impacted the real economy yet as demand remains high and labor markets strong. Nevertheless, its effects on assets prices have been important already, as bonds prices fell, and home prices declined in February for the first time in 11 years in the US.

 

Growing concerns in the 8B$ MBS market

Banks, insurers, and other institutional money managers have invested vast sums of money into agency mortgage-backed securities (bonds issued by US government-sponsored lenders Fannie Mae and Freddie Mac and backed by mortgages) because the risk of default is considered very low, and they are easy to sell. They represent a gigantic 8B$ market.

However, the value of these bonds has fallen as interest rates have risen, thus pushing up unrealized losses for banks which bought lots of them (like SVB). Regulators have taken over SVB and will sell its assets, which will add volatility to the market. The main concern is that a larger institution will fall after SVB, like Charles Schwab which owns 237B$ worth of mortgage backed securities, and could fail if withdrawals grow too much. It is likely that in order to prevent such a nightmare scenario, regulators would provide banks with important loans to meet withdrawals without having to sell assets.