Bottom Line:
- While fears of a global financial crisis have prompted a significant reset lower in interest rate expectations, the SARB and Fed are expected to both deliver 25bps rate hikes this month. The outlook beyond March remains cloudy, given all the uncertainty surrounding the collapse of two US banks and the woes surrounding several other banks, which have extended to Europe amid concerns over the liquidity position of Credit Suisse.
- That said, central banks and authorities have responded promptly to the cracks emerging in the banking sector, which has helped ease fears of a widespread financial crisis such as the one seen in 2008. The strong response from central banks reiterates that policymakers will do whatever it takes to prevent a financial collapse, even if it means allowing inflation to remain above target for longer. Financial markets and economists alike have slashed bets for further tightening beyond March and have brought forward their expectations for a pivot in monetary policy.
Baseline View:
March is likely to be the final rate hike in the current tightening cycle amid the mounting turmoil across financial markets and expectations for a global downturn. While there are several factors that could justify the SARB leaving rates on hold this month, these are outweighed by those that warrant a hike. One of the main factors is the sustained weakness in the ZAR. The SARB will be reluctant to fall behind the Fed, with US policymakers expected to deliver a 25bps hike next week. A further widening in the monetary differential between SA and the US would add to the headwinds facing the ZAR.
Broad expectations:
There has been a marked shift in the outlook for interest rates since the previous report. The US banking crisis that unfolded triggered a massive reset in the outlook for interest rates, with the US futures market trimming rate hike bets by as much as 100bps over the past few days.
FRA markets are now pricing in around a 50% probability of a 25bps rate hike in March compared to almost a 100% probability of two 25bps rate hikes, one in March and one in May, at the start of last week. While the need to hike rates further has moderated following the collapse in oil prices and sharp drop in international rate hike bets, ETM is still of the view that the SARB could still deliver a 25bps rate hike at its March meeting. Had the ZAR been stronger, less fragile, and not amongst the worst-performing EM currencies, and had sentiment towards SA been better, the situation might have been different. However, the SARB may still feel that it needs some added insurance to quell any extreme speculation against the ZAR given that inflation remains elevated.
Risk to the Outlook:
It is worth highlighting that the monetary policy differential between SA and the US has narrowed considerably in recent months, which has detracted from the ZAR’s resilience. Therefore, the SARB will be very mindful of the ramifications of a further narrowing in the spread as it will want to avoid further depreciation in the currency. Since the January meeting, the ZAR has depreciated by more than 6% against the USD and is some 22% weaker than this time last year. This, to a large degree, will be offsetting the impact of the drop in international commodity prices. The risk heading into the March MPC meeting is that the contagion in the US banking sector deepens, and central banks are forced to step in and act as a backstop for banks. Should we see the banking crisis worsen, prompting a meaningful shift in guidance from the Fed next week and a sustained decline in international commodity prices, the SARB may opt to hold off hiking rates later this month. As it is, the Fed has already increased its balance sheet by $300bn in just the past week. That is a stronger intervention than the early stages of QE1 when the GFC unfolded.
Fears of a global banking crisis prompts a reset in global interest rate expectations
Fears of a global banking crisis have intensified following the tremors in the US banking sector which followed the demise of SVB, Signature and First Republic banks, and more recently, the woes surrounding Credit Suisse. The financial turmoil is overshadowing recent economic data, prompting a significant repricing in market-implied interest rate expectations across developed markets.
The risk of a domino effect across financial markets has forced the FDIC, the Federal Reserve and the Swiss National Bank to intervene to aid banks. While the actions from the Fed and SNB, together with measures such as Basel III, have provided some level of surety that the global banking sector won’t spiral into a full-scale crisis as seen in 2009, markets are fearing the worst, prompting a rotation into haven assets and a massive adjustment lower in the implied path for interest rates.
Whether the Fed is happy to continue hiking when it knows that it’s hiking is part of the reason behind the crisis is debatable. Investors will find out on Wednesday when the FOMC decides monetary policy.
It does however seem counter-intuitive to be bailing out banks, conducting a closet form of QE which builds the Fed’s balance sheet and lifting interest rates at the same time.
Will the pivot in global monetary policy come sooner than expected?
Although it is unlikely that problems relating to medium size banks like SBV and Signature will degenerate into a fully-fledged banking crisis, the contagion is spreading across the globe. Credit Suisse’s shares plunged last Wednesday after its largest shareholder announced that it would not inject any more funds into the failing bank. Since then, the SNB has stepped in and provided a liquidity injection, while in the US some tier-one banks recapitalized First Republic Bank by $30bn to ensure its continuity.
Although there are many more measures in place than in 2008 following the implementation of Basel III, markets still fear that a large-scale banking crisis could unfold as more cracks emerge across the global banking sector.
Fear of a banking crisis has resulted in a significant shift in the implied policy rate in the US Fed Funds Futures market. The magnitude of the repricing is evident in the chart above. The red line represents the market’s implied policy path before the SVB saga, while the blue line reflects the market’s pricing after SVB’s collapse. Over the past weeks, the implied terminal rate has been lowered by around 80bps, from 5.60% to 4.80% this week. Furthermore, the futures market is now pricing in 100bps worth of rate cuts by the end of the year from the expected peak.
Concerns over the current state of play
The government has not issued a temporary guarantee on deposits leaving many of the smaller banks exposed. They are not as systemically important as the large banks, while some of them (like SVB), have a unique set of depositors that are large and not fully covered by the FDIC guarantee limit on deposits of $250k. In other words, there are real losses that could be sustained by large depositors who will prefer to move their funds to larger, systemically important banks that could attract a full-blown government bailouts as they would classify as “too big to fail”. With more than 50% of depositors housed in these smaller banks across the US, this is an important time, and the FDIC’s limited bailout capacity may not be enough.
So how do we know that the authorities are perhaps a little more concerned about developments than they let on? Well, the Fed started building its balance sheet again last week in what can only be described as a form of stealth QE.
The Fed didn’t announce it publicly, but it is evident in the data, which shows how the balance sheet rose $300bn in just one week. The build of its balance sheet was faster than the very first iteration of QE during Lehman Brothers’ collapse, highlighting the degree of concern currently doing the rounds. There is more to come from this that is almost guaranteed, which makes last week’s rate hike announcement by the ECB an interesting one. After all, Credit Suisse, a substantially larger bank than any of those failing in the US, is in serious trouble and requires SNB assistance.
ECB Chief Lagarde pointed out that EZ banks are well-capitalized, that systemic risk is under control and that the situation in Europe is quite different to that of the US. However, the decision to hike by a full 50bp smacks more of desperation to play catch up in monetary policy terms to tackle inflation than it reflected concern of the scale of the potential fallout. While building stress in the banking system is unfolding, the ECB might’ve considered holding off until the dust around all of this had settled.
Nonetheless, it completed its move and showed confidence in the EZ banking system. Between the SNB offering Credit Suisse some $54bn in liquidity assistance and large US banks injecting $30bn into First Republic Bank, over and above the Fed’s new round of QE and the FDIC’s assistance with the smaller banks, contagion fears have eased.
Fuel price inflationary pressures set to dissipate
In another development that may soften the SARB’s stance, the price of Brent crude oil has dropped more than 14% since the start of the year, and in ZAR terms, it is down more than 7% year-to-date and 20% y/y. Unless we get another significant blowout for the ZAR, this will translate into lower fuel prices and a notable reduction in headline CPI given the base effects from the elevated prices seen through Q2 last year.
The outlook for oil going forward, meanwhile, is turning more bearish as cracks form in the global economy and the possibility of the current banking crisis deepening, grows. Entities such as OPEC and the International Energy Agency have already forecast the oil market shifting into a structural supply surplus in the second quarter of the year, and risks to their outlook are skewed even more to the upside in terms of crude inventories expanding due to weakening demand and resilient supply from Russia. With oil prices likely to remain well below the SARB’s recent estimates for the quarters ahead, it will alleviate some of the pressure on the central bank to keep hiking rates in order to contain inflation.