Views are my own. Not investment advice, just my thoughts on macro developments.
There is a lot of discussion as to whether the recent financial instability is at an end or just beginning. As detailed in my previous notes I believe this is just the beginning. Given that markets are now rallying back and discounting any SVB led instability it is worth me detailing my reasoning behind this.
The problems at SVB are now well understood. It was really a liquidity issue. As deposits fled they were forced to sell Treasuries held in their “hold to maturity” account and therefore realise the losses on those treasury holdings. Now that the Fed is offering repo of Treasuries at par value in their BTFP scheme this shouldn’t be an immediate problem for other banks. Meanwhile any other funding issues are being eased by the Fed’s now daily swap line. Deposits have continued to flow out of regional banks and into money market funds but the immediate risks seem to have been reduced.
The reason I do not see this as being over is because I see the collapse of SVB and Signature Bank as inevitable symptoms of the end of the credit cycle. Interest rates stayed near zero and even negative for longer than anyone expected. It was always well known that the eventual rise in interest rates would cause losses in long duration assets but the market became so used to low rates that it became difficult to imagine their end. This is clear in the balance sheet of SVB where there were no interest rate hedges on their treasury holdings. The credit cycle is a cycle because it repeats. Interest rates go lower, participants search for yield and become complacent to risks, interest rates then go higher and lead to a sharp deleveraging, and repeat. Although the cycle repeats it is always slightly different as regulators prevent the risky behaviour of the previous crisis the leverage tends to build in a new place each time. Since the financial crisis banks have been heavily regulated. As a result they have been risk averse and have tended to lend less. It has been a big question for some time why banks haven’t been lending more despite Central Banks slashing interest rates and conducting QE. Instead banks chose to park their reserves with their respective central banks. The problem with this is that it is the more opaque corners of the market that have stepped in in place of banks, unconstrained by the burdens of regulation or the volatility of marking to market. This is the Private Debt sector.
The BIS notes that the Private non-financial sector debt increased to an all-time high of around 170% of world GDP during the Covid-19 pandemic. You can read their report here: Private sector debt and financial stability (bis.org)
You can also read similar reports from Bloomberg and The Economist about the booming Private Credit markets and the potential financial stability risks that they pose here:
What Is Private Credit? Industry Poses Regulatory Risks – Bloomberg
More borrowers turn to private markets for credit | The Economist
The counter argument to any calls for financial instability due to sharply higher interest rates is often that Banks are well capitalised and that therefore a repeat of 2008 is unlikely. I do not expect a repeat of 2008. Every crisis is different and the fragilities emerge in different places. It is just the drivers of these cycles that seem to stay the same. A period of low rates forces excessive leverage that is then unwound as rates go higher. Ray Dalio’s principles of navigating big debt crisis is a great resource for understanding these cycles Principles by Ray Dalio – Principles for Navigating Big Debt Crises
With the recent instability at Banks the one positive is the transparency. Balance sheets are public and regulators generally keep tight tabs on financial stability risks, although they clearly dropped the ball with SVB and smaller regional banks in general. The problem with the private credit market is that it is opaque. Moody’s describes the risks of this growing, opaque and less regulated market in this report: Private Credit: A growing market with growing risks | Moody’s (moodys.com)
Timing the end of a credit cycle is difficult. It has felt like the current one was approaching an end in 2019 before Covid hit and forced an extreme easing in financial conditions by global Central Banks which arguably supercharged this current debt cycle. Inflation has now forced central banks to tighten financial conditions and the recent turmoil is just the first signs of the cracks beginning to show. This is why I do not think this is the end of the financial instability. Instead I see these events as a signal that the current debt cycle is coming to an end.
The next question is how to trade this. The range of outcomes going forward is extremely large as central bankers have left their forward guidance more open to the incoming data as it is difficult to gauge what effects the recent instability will have on inflation. This will leave the markets at the mercy of every data print and Central Bank comment going forward. Medium term, after cutting through the noise I expect a recession by H2 of this year. This is really a global problem, not just a US one and G7 seems tightly linked in the current cycle. I therefore continue to trade defensive. I still like long XAUUSD as a stagflation hedge. I am short growth currencies like NZD and MXN and long havens CHF, USD and XAU. JPY is a difficult one as Japan fiscal year end currently appears to be bring JPY selling that is hurting a market that is long JPY. Medium term I expect crossJPY to trend lower with global rates but inflation is still there to make that path difficult. NZD stands out to me as the best short. Q4 GDP for last year has already shown to have been in contraction in New Zealand. Despite this the market is still pricing another 50bps of hike from the RBNZ. The overleveraged and frothy housing markets of New Zealand, Australia and Canada are likely to come under increasing pressure in this environment. NZD tends to underperform in a crisis and has a large current account deficit so I feel it is particularly. vulnerable in this backdrop.
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