Bonds (not banks)
The small banks crisis in the US is rolling on. Deposit flight remains a key risk and there are negative macroeconomic implications if credit growth slows. It is all very supportive for fixed income markets. We have seen the ‘bonds up and equities down’ relationship working well recently. Central banks are even closer to their peak rate levels and next year will potentially see monetary easing. There is a scenario where weak risk sentiment pushes government bond yields even lower. A yield of 3% is in sight for US Treasuries while, for anyone with appetite for even more duration, 30-year gilts trade well below par. I said it months ago, but 2023 really is turning out to be the year of the bond.
This week I celebrated 18 years at AXA Investment Managers. There are people in the market today, doing research, trading, or sales who would have still been at primary school the day I first walked into 7 Newgate Street (our offices at the time in May 2005). A lot has happened since, including the collapse of Northern Rock, Bear Stearns and Lehman Brothers, the euro sovereign crisis, Brexit and the Trump Presidency, COVID-19 and the most aggressive monetary tightening cycle since the 1980s. Even with all the volatility that these events generated, the period has delivered 3% annualised returns from UK government bonds, 5.4% (in GBP) from global credit, 6.2% from US high yield and 9.3% from world equities (MSCI World in GBP). I cannot tell you how many Cassandra calls there have been over the last 18 years, but staying invested and taking a long-term view has worked so far.
Today’s crisis is focused on US banks. The S&P 500 bank index is down 17% year to date (according to Bloomberg data at the time of writing) and a significant amount of investor equity capital has been wiped out in recent weeks by bank failures. Higher rates, duration mismatches, increased mobility of deposits and declining confidence are all factors contributing to the crisis amongst regional banks in the US. Data from the Federal Reserve (Fed) show that deposits in the US commercial banking sector have fallen by more than $600bn so far in 2023 with about half of that coming from declines in deposits at small banks. Higher rates available in money market funds have attracted funds away from bank deposits and this continues, with money market funds attracting a further $47bn in the week ending 3 May (data from the Investment Company Institute).
High rates are a problem
There could be more bank failures. The Fed raised its overnight interest rate again this week to 5.25%. There is a good chance that this will be the last move – although this is data dependent – but, for now, Fed Chair Jerome Powell and his colleagues are not very amenable to the idea of cutting interest rates soon. That means short-term rates will remain higher than most of the deposit rates available at regional banks. Money could continue to leave bank accounts for money market funds as a result. Given that these funds are mostly invested in the Fed’s overnight reverse repo facility means that they kind of act as a drain on overall macro liquidity (hence the need for the Fed’s new bank-focused loan facilities). Furthermore, regional banks facing pressure on their deposit funding will have their lending capacity curtailed. The Fed’s data on banks suggests small bank credit is down around 3% year to date and there is a good chance that this gets worse, with implications for the commercial real estate sector and residential mortgage origination in many parts of the country.
Big is good…
The trend of big banks taking over the assets and the deposits of failed small banks is likely to continue. So far, the large commercial banks are doing well, reporting better numbers in the current earnings season with many showing growth in earnings over the same quarter last year. There is little evidence in the trends in assets and liabilities that credit is being tightened among the large banks and recent activity in the corporate bond market suggests that there are no funding issues – as well as suggesting that fees from bond origination and trading will remain healthy. Moreover, they will have been making money from the better price performance of US Treasury securities in recent weeks – in total, large commercial banks hold around $3trn in Treasury and agency bonds.
Looking forward I would not be surprised if there was some political concern about the biggest of the US banks just getting bigger. There have already been suggestions that additional fees will be levied on the banks to replenish the coffers of the Federal Deposit Insurance Corporation. Further into the future there may also be a threat from central bank digital currencies (CBDCs) if they are ever introduced as a retail product. Simply put, CBDCs would be an alternative to bank deposits and could, in theory, lead to a permanent reduction in bank deposit funding. This in turn would have implications for bank credit and, potentially, broader macro-funding. More securitisation of loans and mortgages and a further rise in the role of private credit provision could be some of the future implications. Large banks may be doing all right now and are certainly generating a lot of profit for shareholders, but there are potential future challenges to sustain that earnings growth. For now, CBDCs seem only to be favoured by technocrats in central banks and the kind of politician or economist that has a bias against banks (although the argument that they could contribute to a more stable financial system has some merit).
Still like credit
The present problems in the banking system do not yet constitute a credit crisis. It has been mostly about higher interest rates and duration gaps (banks are short-funded leveraged institutions at risk when short-term rates go up and asset valuations go down). The corporate bond market is not suggesting any significant credit issues. Investment-grade and high-yield credit spreads have risen a little in the last couple of weeks, in response to the banking problems, but are well within their recent ranges. Performance has been a bit soft since the end of the first quarter but is quite positive year to date. Issuance has also been strong and if the Fed has peaked, buying credit with investment grade spreads in the 150-200 basis point (bp) range continues to look attractive.
ECB remains hawkish for now
The European Central Bank (ECB) also raised rates this week, pushing the deposit rate up by another 25bp to 3.25%. A couple more hikes at least are on the cards this spring/summer. But even with this outlook, I still like fixed income in Europe. Economic data is becoming more mixed – for example, German factory orders fell 10.7% in March, French industrial output was down 1.1% and manufacturing Purchasing Managers’ surveys for April were soft. It seems just a matter of time before we see weakness creeping into the services sectors and more meaningful declines in core inflation. Now the ECB is hawkish, Europe has avoided banking issues – with one large exception – and there is little stress in peripheral spreads. So, yield curves are likely to remain inverted but, as in the US, credit in Europe may offer a favourable return potential over the course of 2023.
Long-end gilts at 4% yield
The Bank of England (BoE) is likely to follow suit next Thursday. The market has the UK benchmark interest rate peaking at between 4.75% and 5.0% by September, suggesting one or two more hikes after the expected move next week. I am inclined to think that lower headline inflation data and weakness in growth numbers might persuade the BoE to call a peak before then. Long-term UK government bond (gilt) yields are lower than the levels they reached last September but remain much higher than where they traded in 2022. For institutional investors or even for retail investors looking for a safe bet, long-end gilts look attractive if there is going to be a near-term peak in BoE interest rates and the UK economy further downshifts over the next year. The price of the benchmark 30-year gilt remains around 93 pence with a 3.75% coupon.
A few words
I doubt I will do another 18 years in my current role. The good thing is I still love what I do so hopefully I can remain gainfully employed for a while yet. The markets are a wonderful place to work for people with inquisitive minds and an interest in global economics, politics, and human behaviour. I have been fortunate to work with great people and very professional teams here at AXA IM and to have had the opportunity to engage with many interesting and clever people on the sell side and, most importantly perhaps, with clients. Thanks to everyone that continues to read my weekly update and engages with me in this crazy world we call the financial markets. And thanks for indulging my frequent ramblings about Manchester United. However, it seems every time I write something about them recently, they lose the next match. So, a moratorium until this season is over.