Silicon Valley Bank collapse: What does it mean for interest rates, inflation and banks?

The collapse of Silicon Valley Bank (SVB) has reverberated across markets, with concerns emerging over the impact on the broader financial sector and global monetary policy.

Higher borrowing costs contributed to the collapse on 10 March. The worry now is what impact continued rate hikes could have on the sector.

It’s most likely this collapse won’t have a contagion effect though. For a start, European banks don’t face the same sort of problems as US banks. In the US, authorities have been shoring up confidence and have guaranteed all deposits at SVB, while HSBC acquired the bank’s UK operations.

But even if the worst-case scenario is avoided, the SVB saga does highlight certain risks within the monetary and financial systems.

Containing contagion

“Policymakers responded quickly to avert contagion,” said Kristina Hooper, Chief Global Market Strategist at Invesco. “However, it does suggest the kind of pressure other banks could come under if the US Federal Reserve (Fed) continues to raise interest rates.”

Even though the probability of a recession has increased as banks temper lending, strong labour and inflation data mean the Fed is unlikely to be diverted from its hiking path yet, according to Benjamin Jones - Director of Macro Research, Multi-Asset at Invesco.

“Financial markets are fragile, and these events make investors and the Fed’s job harder,” he said.

The latest US consumer price index coming in at 6% on 14 March underscores the dilemma that central banks face, with inflation proving stickier than expected despite a series of interest rate hikes.

“The SVB story proves that financial institutions are not immune to the rapid pace of interest rate increases,” said Charles Moussier, Invesco's Head of Insurance Client Solutions for EMEA.

The insurance industry is in some ways unusually vulnerable to inflation, which has fuelled a rise in fixed income yields, creating sizeable unrealised losses in insurers’ balance sheets. However, unlike banks like SVB, insurers have a far more stable deposit base and typically use large hedging programmes.

This story also comes shortly after October’s gilt market crisis in the UK, which spooked markets and hit pension schemes hard.

"The problems within the US banking sector serve as a reminder of the need for liquidity resilience in a world of more volatile interest rates,” according to Derek Steeden, Portfolio Manager at Invesco Investment Solutions.

“While rapidly rising interest rates were behind both the UK liability-driven investmentⁱ crisis and current banking concerns, this time it has brought about a sharp fall in government bond yields as investors reassess the number of future rate hikes central banks need, or can afford, to make,” said Mary Cahani, Director, UK Pensions at Invesco.

What does SVB’s collapse mean for asset allocation?

Fixed income: we could see a preference for government bonds and high-quality credit

Within fixed income, government bonds have rallied aggressively with yield curves steepening while credit spreads have widened. “This is a typical risk-off, flight-to-quality reaction,” said Paul Syms, Invesco’s Head of Fixed Income ETFs.  

This is an interesting turnaround from early last week, when Fed Chairman Jerome Powell indicated a stricter stance to bring inflation under control. It has now been over a year since central banks began taking an aggressive approach to rate hikes to curb inflation. The consequences of that have started to become clear.

“The Fed will now be thinking as much about financial stability as inflation,” said Lewis Aubrey-Johnson, Head of Fixed Income Products at Invesco. Indeed, markets are now anticipating a more tempered approach from policymakers. They have started pricing in an earlier, lower peak than was previously forecast. US interest rate futures, for example, are suggesting that the Fed will cut rates within the next six months.

When it comes to the upcoming meeting on 22 March, Syms thinks the focus will be on slowing or pausing hikes rather than cutting them.

But what does all this mean for fixed income investors? Does the SVB event indicate an increased risk of recession, for example? In short, it’s a little too early to say. Rather than drawing conclusions from this event in isolation, investors will be watching policymakers closely to see how they react.

That said, the event is likely to lead to more risk-off positioning. In other words, less equity, more fixed income. And, within fixed income, less high yield and emerging market debt and more government bonds and high-quality credit.

European banks: AT1ⁱⁱ performance is down, but looser monetary policy could be supportive

European banks have been hit by this event, with the European bank equity index down several percentage points. AT1s initially fell several points. However, it is important to remember that European banks do not face the same pressures as US regional banks.

“They are very different animals,” said Aubrey-Johnson. “Overall in Europe, there’s less interest rate risk; deposits are still growing; loan growth has been far more modest; and there are only minimal unrealised losses on banks’ ‘Held to Maturity’ portfolios”.

In terms of what this means for AT1 valuations, “it’s a bit too early to make a big call”, said Syms. “Undoubtedly the selloff has driven yields and spreads back to attractive entry levels, but markets could remain volatile for a while”. That said, if central banks do reduce the pace of rate hikes, or even pause them, “it could be a very supportive environment for AT1s”, he added.

Multi-asset thinking: relative value preferred

With some fragility in the market and inflation proving sticky, central banks face a challenging period.

“It’s not clear the US dollar is the ultimate haven now, if the yield gap between US and European yields narrows. The Japanese yen might be better,” Jones said.

“European equities are better priced to weather this storm and relative value positions should be preferred to outright equity views.”

UK and European equities: valuation opportunities can be found

After a particularly strong start to the year for equities, the market was already looking nervously for any sign of weakness or uncertainty to trigger a correction. News flow over recent days from California seems to have provided such a catalyst.

“While we understand that, in some minds, the words ‘banking collapse’ trigger a series of emotions and memories of Northern Rock and Lehman, the failure of SVB is very different,” said Neville Pike, UK Equities Product Director at Invesco.

“The failure is not a result of systemic over-exuberance in lending”, he added. “Rather, it is a failure on the part of SVB to manage maturities on either side of its balance sheet.”

No doubt the regulatory environment around US banks will come under increased scrutiny in the coming weeks and months. It’s a process that may well be deeper and more prolonged than some might think. However, the risk of contagion to tightly regulated and well-capitalised UK banks – and indeed UK equities – is low, in Pike’s view.

Lower interest rate expectations may now put some pressure on UK banks’ net interest margins. However, Pike draws attention to the fact that this is a sector where valuations are abnormally low.

James Rutland, European Equities Fund Manager at Invesco, echoed Pike’s comments. “European banks are far more tightly regulated, and the liquidity coverage ratio is monitored far more closely than with non-GSIBⁱⁱⁱ banks like SVB.”

Regulators under the microscope

“On the regulatory side, US policymakers are facing questions about how such a situation could arise in a post-GFC regulatory and supervisory environment”, said Michael O’Shea, Senior Public Policy Manager at Invesco.

Part of the problem is that “complex regulations are forcing a focus on the largest and most diversified institutions,” said Moussier.

Indeed, policymakers outside of the US are reassessing the resilience of their own banking systems and rulebooks in the event that any market contagion spreads.

It’s likely that central banks will reassess any forthcoming rate decisions in this new context, given the impact of the Fed’s interest rate hikes on this latest liquidity event. All eyes will be on the European Central Bank (ECB) this Thursday 16 March as it considers raising interest rates further to manage inflation in line with its baseline objective.