Interest rates may ease due to tensions in the banking sector.

The European Central Bank met on Thursday and raised rates by 50bps, in line with market expectations and their previous guidance. This takes the deposit rate to 3%. The bank lowered its headline inflation forecast for this year to 5.3% from 6.3% previously but noted that ‘Inflation is projected to remain too high for too long.” Core inflation was expected to be higher than previously for this year, but lower thereafter. Growth estimates for this year were revised up to 1% from 0.5%. Notably absent from the statement was any guidance on next steps, and market expectations for terminal rates were little changed by the announcement.

The ECB was the first of the big three central banks from our perspective to meet this month, with the Federal Reserve meeting on the 22nd and the Bank of England on the following day. Until recently it looked as if expectations for the policy outcome of these meetings were fairly certain. However, last Friday bought the unwelcome news of the failure of Silicon Valley Bank in the US, which experienced a funding crunch, leading investors to ask themselves if other banks were likely to face similar issues. This led to significant declines in equity prices in the banking sector around the world, most notably for European major Credit Suisse, which has long been troubled by numerous controversies. The Swiss National Bank stepped in to provide support, causing the Bank’s share price to rise, but its CDS spread (the cost ensuring its bonds) still indicates significant stress.

The ECB’s statement today recognised these recent market tensions, and committed to “respond as necessary to preserve price stability and financial stability in the euro area”. They also reassured markets by commenting that “the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy.”

These market developments change the calculus for central banks, reminding them that problems for individual banks can quickly spread. Most concerningly, if the commercial banking sector becomes less able to lend money, there is a knock-on effect of reduced growth in the real economy. This upset has led investors to reprice the chances of central banks continuing to increase interest rates significantly, particularly in the US. Contagion from a smaller US bank to a big European one will be the primary concern of the ECB, which will have made them think twice about their previous market guidance toward a 0.5% increase at this meeting.

The ECB had been criticised for being behind the curve in the global fight against inflation, being the last of the three central banks to begin its hiking cycle. Indeed, hawks on the committee will point at European core inflation, at 5.6% year on year in February and yet to peak, as being the most serious concern and reason to forge ahead. However, these latest developments could turn this lagging position into an advantage. Rates in the eurozone are some way from being as restrictive as in the US, and given the lagged effect of increasing rates, this could leave Europe in a better position if the global economy were to soften from here. The ECB could adopt a more dovish approach, with less tightening in the economy from previous hikes already baked in.

There are concerns about the US regional banking sector. Unlike the larger banks, which have been subject to significant regulation in the wake of the global financial crisis, these banks have less diversified deposit bases. Cash assets for smaller banks are at much lower levels. Depositors have been withdrawing cash and putting it into money market funds, where they receive better interest rates. This has dented liquidity.

The interconnectedness of the banking sector means that the weakness of one bank can create disruption and markets may be febrile for a while as they digest the impact of this fragility. Nevertheless, the majority of major banks – particularly those in the UK and Europe – are extremely well-capitalised and liquid, with diverse depositor bases. They also have smaller investment banking and financial markets divisions.

The main consideration is whether it moves the Federal Reserve to change its position on further interest rate rises. Higher interest rates are the catalyst of the current problem in the banking sector. The Fed Chair, Jerome Powell, recently implied that interest rates might rise higher than the market expected, which contributed to the current crisis. The Fed will not want to be blamed for another financial crisis and they may turn less aggressive. This possible change in tone from the Fed may help calm things down, leading to lower bond yields, which could improve the value of the banks’ bond holdings. The Fed futures markets are now indicating a 0.25% rise later this month, rather than the 0.5% suggested by Jerome Powell.

In the meantime, it is important to remember that volatility in markets is something investors should expect, and the recovery from the current downturn is unlikely to be smooth. There are signs that confidence is improving in the wake of Switzerland’s central bank loan to Credit Suisse. It is also worth noting that banks are generally far better capitalised and have less bad debts than in the run up to the global financial crisis and measures of financial market risk – such as the spreads on credit default swaps – are nowhere near their level in 2008. However, concerns within the banking sector are always likely to be temporarily destabilising. As always with these periods of volatility, investors need to sit tight and think long-term.

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