by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an overview of our thoughts on the Congressional hearings for both TikTok and Treasury Security Janet Yellen. Next, we discuss why central banks have decided to raise interest rates in the face of an ongoing banking crisis. Lastly, we explore the reasoning behind China and Russia’s new interest in the Middle East.

Congressional Attention: Lawmakers are looking to bolster their reputation of being tough on big banks and China during hearings on the Hill.

• TikTok CEO Shou Chew testified before a hostile Congress on Thursday, as officials weigh a potential ban of the social media app. During the hearing, politicians did not shy away from confrontation. Chew, who tried to walk a tight line between being vague and honest, was challenged on his company’s ability to remain independent of Beijing. In one exchange a politician implied that Chew was committing perjury when he refused to say that the social media site does not disseminate material that would upset Beijing. The row over TikTok is likely the first of many fights over whether Chinese firms pose threats to U.S. national security.
  • Chinese authorities have raided the Beijing office of Mintz Group, a U.S. due diligence firm. The raid may signal that Beijing is willing to crack down on U.S. firms and comes just a week before the country hosts Tim Cook of Apple (AAPL, $158.93) and Noel Quinn of HSBC (HSBC, $33.48) for its annual investor conference.
• Meanwhile, Treasury Secretary Janet Yellen’s flip-flop regarding efforts to insure U.S. bank deposits without the approval of Congress has added to concerns that the government may need to rescue the banking system. While speaking to Congress, Yellen walked back remarks that suggested that the Treasury Department was not prepared to expand deposit insurance. Any rescue plan without congressional consent will likely meet pushback as politicians would view unilateral executive action as evidence that banking officials are not being forthright about the severity of the banking crisis. Investors have been paying close attention to Yellen’s remarks for signs of a possible bailout for regional banks.
• The two separate hearings on banks and Chinese companies reflect a trend away from the Bork rule that defined the period between 1970-2010. Named after former Federal Judge Robert Bork, the rule stipulates that regulations should not be used to interfere with economic efficiency or consumer welfare. This sentiment has been the bedrock of elitist thinking regarding the government’s approach to business but is showing signs of eroding. As the congressional hearings demonstrate, lawmakers would like to prioritize policies that favor state objectives such as national security and bank stability over economic efficiency. If we are correct, this will likely lead to a higher inflationary environment as firms look to push the cost of burdensome regulations onto the consumer.

 Interest Rate Fallout: Major central banks still decided to raise rates despite the ongoing banking crisis.

• The decision to raise rates indicates that monetary policymakers are hesitant to stop tightening without solid evidence that the banking system’s health has no other fix. Recent liquidity injections by the Federal Reserve and Swiss National Bank have given officials confidence that the worst of the crisis has peaked. In individual statements, the Bank of England, Federal Reserve, and European Central Bank all offered reassurances that the banking system remains resilient amidst the turmoil. Additionally, each bank maintained that they remain committed to bringing down inflation and preserving financial stability.
• Although central bankers signaled that they are not considering rate cuts, the market seems to believe otherwise. The CME FedWatch tool shows an 80% chance that the Fed will cut rates by its July meeting. Meanwhile, the overnight index swap rates for the GBP and EUR suggest that the BOE and ECB will look to stop hiking around June or September of this year. Movements within the bond market also suggest that investors believe that policy will begin to normalize. As of Thursday, the inversion spread between the 10- and two-year Treasury narrowed by 42 bps since the start of the month.
• Monetary policymakers want to raise rates but do not want to destabilize the financial system. The usage of the backstops has offered banks some relief from deposit outflows. The latest figures from the Fed show that U.S. banks borrowed $53.7 billion from the Fed’s new Bank Term Funding Facility. However, there is still no guarantee that the turmoil in banking will end anytime soon. The sudden spike in Deutsche Bank’s (DB, $9.65) default insurance costs will likely add worries that the financial system remains fragile. As a result, it is still reasonable to assume that central banks could consider easing monetary policy this year if the banking issues persist.

Middle East Problems: The China-Russia pivot toward the Middle East complicates the efforts of the U.S. to exit the region.

• Russia and China are working to mediate tensions between Arab countries to help reduce the region’s dependence on U.S. security. On Wednesday, Moscow had announced it was close to restoring diplomatic ties between Saudi Arabia and Syria. The move comes on the heels of several recent successes of China and Russia to calm violence in the region, highlighting the U.S.’s declining importance. Last week, China assisted in restoring diplomatic ties between Saudi Arabia and Iran. Moscow and Beijing may be looking to build their influence in the Middle East to disrupt efforts by the West to isolate them.
• U.S. foreign policy within the Middle East continues to show signs of disarray. Despite efforts to reduce the U.S. forces within the region, the Pentagon carried out airstrikes in Syria against an Iranian rebel group. The U.S. has about 900 troops in Syria to help with Syrian fighters’ efforts against Islamic State militants. Meanwhile, Israeli Prime Minister Benjamin Netanyahu’s efforts to undermine the country’s Supreme Court and other democratic institutions have frustrated Washington. The Biden administration expressed concerns about the changes to Israeli law earlier this week. The ongoing friction will complicate cooperation efforts between the two countries as they look to take on Iran and expand the Abraham Accords.
• As the U.S. looks to focus its attention on expanding its influence in the Indo-Pacific, it appears that Russia and China are looking to deepen their ties with Middle Eastern countries. The China-Russia pivot toward the region will aid efforts to reduce their respective reliance on the West. It will also ensure that China can maintain its access to commodities even as its relationship with the U.S. deteriorates, while Russia can use its relationship with Arab countries to undermine the West’s efforts to slow its petro sales through price ceilings.
  • The biggest loser in this scenario may be the European Union, as it is stuck between kowtowing to authoritarian governments that challenge its value or being forced to accept U.S. foreign policy that often challenges its strategic interests.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the Federal Reserve’s rate decision. Next, we discuss the Fed’s economic outlook and why it may not be representative of future policy. Lastly, the report examines China’s battle to avoid isolation by the U.S.

Proceed with Caution: The Fed insists it believes that the U.S. banking system is “sound and resilient,” but its guidance suggests otherwise.

• The banking crisis has shifted Fed sentiment regarding future policy. On Wednesday, the Federal Open Market Committee decided to raise its benchmark policy rate by 25 bps to a target range of 4.75% – 5.00%, its highest level since 2007. The hike was in line with market expectations but comments in the Fed statement indicated that policymakers may be less committed to hikes going forward. This view is reinforced by the FOMC’s decision to replace the phrase “ongoing increases in its target rate” with “additional policy firming” in its official statement. In another sign the Fed has become less committed to imminent hikes, Fed Chair Jerome Powell implied that the FOMC may view stricter lending standards as a substitute for policy tightening.
  • On a related note, the Bank of England also raised rates by 25 bps.
• Despite hints that the Fed may be close to ending its hiking cycle, Powell also insisted that the central bank does not plan to cut rates this year. The lack of commitment to either raise or lower interest rates confused the market as the ongoing banking turmoil and elevated inflation suggests that the Fed should be taking some sort of action. This indecisiveness led to concerns that the Fed fears a recession may be near. As a result, the S&P 500 seesawed by rising to a session high of +0.8% at the beginning of the press conference but closing down 1.7% on the day. Additionally, gold was up 1.3% around market close, and the U.S. Dollar index dipped 0.62% in the same period.
• Policymakers are still worried about the ongoing banking crisis. After all, deposit flight remains a major issue for regional banks, as demonstrated by the recent disclosure from PacWest Bank (PACW, $10.12). The possible guarantee of bank deposits do little to allay those fears since rising interest rates incentivize depositors to put their savings into higher yielding mutual funds and U.S. Treasuries. If deposit outflows persist, the Fed may be left with no choice but to cut rates in order to protect small banks, which make up nearly 40% of all loans and 70% of commercial real estate loans, and their failure could lead to a broader economic crisis.

Not Adding Up: The Summary of Economic Projections (SEP) highlights the inconsistencies regarding the Federal Reserve’s narrative.

• Although the Fed dot plot from 2023 appears to be unchanged from the previous meeting, a direct comparison shows that policymakers were less inclined to reduce interest rates. The latest median forecast policy rate of the dot plots remained relatively unchanged from the December meeting, with the 2024 forecast revised slightly higher from 4.1% to 4.3%. That said, a direct comparison shows that members are more hawkish than the statement implied. As the following chart indicates, several fed officials revised up their policy rate projections. The upward revision signals that policymakers are not comfortable with lowering rates even with the ongoing banking turmoil.

• GDP and employment predictions also failed to articulate a consistent story about the Fed’s view regarding the economy. Policymakers’ median forecast showed economic output expanding by 0.4% in 2023 and the unemployment rate increasing from 3.6% to 4.5% in the same year. These projections are confusing as it implies that the Fed expects that over 1.4 million workers could be displaced over a 10-month period and that would translate to merely an economic slowdown and not a recession. There is no historical precedent of this ever happening, with the closest being a period between 2002 and 2003, when household unemployment climbed to 962,000 while the annualized GDP growth ranged from 0.5-3.6% within the same time frame.
• The SEP reinforces our view that the Federal Reserve may believe that the window for raising rates may be closing fast. Its modest upward revision in dot plots reflects members’ belief that the economy is too hot to bring inflation back to its 2.0% mandate. Meanwhile, the year-end forecast of the unemployment rate implies that they are not confident that the labor market will be able to remain tight throughout the year. The lack of clarity suggests that interest rate expectations could become very volatile over the next few weeks as the market weighs the release of economic data and Fed speeches. This may lead to sideways movement in the S&P 500 as investors battle over the direction of the economy and monetary policy.

China Related News: Beijing’s fear of being isolated by the U.S. and its allies appears to be edging closer to reality.

• Apprehension over China’s growing influence has made it easier for the U.S. to strengthen its ties with its Indo-Pacific allies. Chinese officials expressed fury over the U.S. and U.K.’s attempts to supply Australia with nuclear-powered submarines. Beijing’s ambassador to the International Atomic Energy Agency, Li Song, warned that such a move could lead other countries to follow suit. Meanwhile, a growingly assertive China has forced some former foes to warm their ties. On Wednesday Japan ended trade restrictions on exports to South Korea, paving the way for a normalization of trade relations which had been weakened due to a dispute involving Japan’s treatment of Koreans during World War II.
• Intelligence sharing by the U.S. allowed New Delhi to repel an attempted Chinese military incursion along the contested China-India border late last year. The U.S. provided satellite imagery and other real-time intelligence showing the Chinese forces gathering and preparing for the operation, which then allowed India to position sufficient forces to thwart the incursion with only minor casualties. The intelligence assistance was reminiscent of the aid provided to Ukraine last year that helped it fight back against the Russian invasion.
• As China and the members of its evolving geopolitical bloc continue to probe for weak spots in the territorial defenses of their rivals, it appears that the U.S. has decided to use increased intelligence sharing to help strengthen and secure the cooperation of countries within the Indo-Pacific region such as India, Japan, Australia, and South Korea. The move to isolate China from the rest of the world risks retaliation from Beijing, who may look to offer its military weapons expertise to countries opposed by the U.S. If this assumption is correct, it would suggest that we may be headed toward a more hostile and less trade-friendly world.
• As we have mentioned in previous reports, this situation generally bodes well for commodities as the hoarding of essential raw materials are likely to drive up prices.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. and European banking crises and what they mean for monetary policy going forward (we also note that the Federal Reserve will release its latest interest-rate decision this afternoon at 2:00 PM EDT).  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an encouraging rapprochement between Japan and South Korea and the latest on the China-Russia summit in Moscow.

U.S. Banking Crisis:  In a speech to the American Bankers Association yesterday, Treasury Secretary Yellen signaled that she and other federal officials stand ready to intervene in the banking system again if more banks suffer deposit runs that threaten to spark contagion to other banks.  That appeared to mark a reversal for Yellen, since she had previously said the federal government would guarantee banks’ uninsured deposits only if the officials again invoked emergency powers to protect them.  In any case, the crisis continues to show signs of dissipating, with bank stocks and other equities having strong price gains yesterday.  All the same, we remain worried that additional stresses are building in the bank sector, especially among smaller banks which have substantial exposure to the possibility of mass defaults in commercial real estate.  The concerns about issues in commercial real estate have recently been rising sharply.

• Yellen’s statement is part of a burgeoning debate on whether the government should fully insure all bank deposits, or at least raise the insured amount above the current cap of $250,000 per depositor, per bank.
• The maximum FDIC-insured amount hasn’t changed since 2008. However, even if that cap were raised substantially, it still might not cover much of a large company’s deposits.  Large corporate deposits can run well into the millions of dollars, or even hundreds of millions of dollars, as shown by the collapse of Silicon Valley Bank (SIVB, $106.04).  Companies withdrawing their deposits en masse can destabilize a bank just as surely as individuals can.
• That helps explain why much of the current reform talk centers on the possibility of insuring all bank deposits. However, many Republicans in Congress are pushing back strongly against the idea, largely on moral hazard grounds.  While we do expect the crisis will eventually lead to new regulatory reforms, it’s still tough to predict exactly what will happen with the insured amount.

U.S. Monetary Policy:  The Federal Reserve wraps up its latest policymaking meeting today, with its decision due out at 2:00 PM EDT.  Despite the strong economic data for January and February, we suspect the banking crises in the U.S. and Europe will discourage the policymakers from hiking their benchmark fed funds rate by anything more than a modest 25 basis points.  Many investors and observers are even expecting them to hold rates steady.

U.S. Stock Market:  With the banking crisis encouraging hopes for lower interest rates, many technology stocks and other “long duration” equities have gotten a boost in recent days.  Nevertheless, new data shows that the combined weighting of Apple (AAPL, $159.28) and Microsoft (MSFT, $273.78) in the S&P 500 has now reached a record high of 13.3%.  Other big technology stocks have recently somewhat recovered from the beating they took from the Fed’s interest-rate hikes over the last year, but the new data underscores how Apple and Microsoft are now in a class by themselves in terms of market dominance.

European Banking Crisis:  Debate continues to rage about Swiss regulators’ decision to zero out the additional Tier 1(AT1) capital bonds of Credit Suisse (CS, $0.9681) as part of its rescue over the weekend.  Although AT1 bonds are designed to absorb losses in a bank failure, essentially making them junior to the bank’s equities, some of Credit Suisse’s AT1 holders are reportedly considering legal action against the regulators’ move.  In any case, the write-down of the bonds is expected to undermine their value throughout Europe, boosting funding costs for banks.

• As noted above, many investors continue to hope the current banking crises will prompt the main central banks to stop, slow, or even reverse their campaigns to hike interest rates in order to fight inflation. However, they were disappointed by the European Central Bank’s decision last week to hike its benchmark short-term interest rate by an aggressive 50 basis points.
• In a sign that the ECB could continue to hike rates aggressively, German central bank Governor Joachim Nagel discounted any fears that the banking crises would have broad effects on the European banking system and called for the monetary policymakers to be “stubborn” in their rate hikes to fight inflation.
• Nagel also showed no sympathy for the holders of Credit Suisse’s AT1 bonds, saying those who profited from their opportunity should be prepared to shoulder the risk they took. However, he did confirm that the ECB would not follow the Swiss decision to bail in AT1s before a bank’s equity was wiped out.

United Kingdom:  The February consumer price index was up a full 10.4% year-over-year, an acceleration from the 10.1% rise in the year to January and far above the expected annual increase of 9.9%.  Much of the unexpected acceleration reflected a jump in service prices.  While investors before the report had been evenly split on whether the Bank of England would keep hiking its benchmark interest rate at its meeting on Thursday, they are now pricing in a likely hike of 25 bps.

Japan-South Korea:  President Yoon Suk-yeol of South Korea yesterday said that he would order his government to return Japan to its “white list” of countries with fast-track trade status after a summit with Japanese Prime Minister Kishida last week.  Yoon also expressed his confidence that Japan would soon reciprocate the gesture.  The countries have black-listed each other since 2019 because of a dispute over Japan’s treatment of Koreans during World War II.

• The diplomatic thaw and improved trade ties between Japan and South Korea reflect their realization that they need to stand together, along with the U.S. and other allies, to resist China’s increasing geopolitical aggressiveness.
• The upside for investors is that increased trade between Japan and South Korea should be good for both countries’ economies, and for their stocks.

Sri Lanka:  The International Monetary Fund (IMF) gave final approval for a $3-billion bailout loan for the country this week, after the government instituted a number of fiscal reforms and convinced key bilateral lenders, including China, to sign onto a debt restructuring program.  The IMF deal unlocks $4 billion in other emergency lending and will help alleviate Sri Lanka’s lack of foreign currency reserves and deep recession, although it doesn’t necessarily allow the country to tap global financial markets again.

China-Russia:  During their summit meeting in Moscow yesterday, Chinese President Xi and Russian President Putin agreed to “significantly increase” trade between their two countries by 2030, and Putin threw his weight behind the greater use of CNY in trade.  Putin noted that about two-thirds of China-Russia trade is now in the Chinese currency, although much of that reflects the fact that Russian exports to the West have been severely crimped by sanctions.

• Separately, the Russian government said it will start using new benchmark oil prices to calculate the taxes its oil firms pay on their exports. Although the G7 countries have imposed a price ceiling of $60 per barrel on Russian oil, recent statistics suggest Russian firms are often getting more than that.
• The tax revamp is reportedly geared to increase the Russian government’s oil revenue by about $8 billion annually.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. banking crisis and how investors’ concerns appear to be dissipating, at least so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a few words on Chinese President Xi’s continuing visit with Russian President Putin as well as some items touching on U.S. labor tensions.

U.S. Banking Crisis:  Now that investors’ attentions has shifted toward ailing regional lender First Republic Bank (FRC, $12.18), reports indicate that Jamie Dimon, CEO of JPMorgan Chase (JPM, $127.14) is leading an effort to convince a number of major banks to invest in the firm beyond the parking of some $30 billion in deposits there last week.  Coupled with the moves by government officials to stem the crisis, the effort by Dimon appears to be helping to quiet investor concerns.  Although First Republic’s stock price fell 47% yesterday, it has rebounded approximately 15% so far this morning, while bigger banks and the overall market continue to rise.

• The market action may look like the crisis is passing, but we would urge caution, as other stressors in the financial markets could still come to light. In addition, since much of the nation’s bank lending is done by mid- and small-sized banks, any pullback in lending by those banks in response to the crisis could have a noticeably negative impact on U.S. economic growth.
• Investors are particularly worried about big, new headwinds for agency mortgage-backed securities (MBS). Those securities are widely held by mid-sized banks such as the one that touched off the crisis, Silicon Valley Bank (SIVB, $106.04).  Now that the government owns the bank, it is expected to sell off the roughly $78 billion of MBS on Silicon Valley’s books.  To the extent that other banks fail and are taken over by the government, similar sales could add to the supply of MBS and drive down their value.

Germany:  Responding to the banking crises in the U.S. and Switzerland, the ZEW Institute’s index of investor sentiment fell to 13.0 in March, coming in short of both the expected reading of 16.4 and the February reading of 28.1.  The index, which is considered a leading indicator of German economic activity, now stands at its lowest level since January.  The index is designed so that readings over zero indicate greater optimism than pessimism.

France:  Despite the continuing mass protests against President Macron’s decree last week to boost the pension system’s retirement age, opponents in parliament yesterday narrowly failed to win a no-confidence vote against his government.  As a result, the reform of the pension system will stand, lessening the strains on the French budget over time and potentially giving a boost to the economy.  However, as Macron faces even more no-confidence votes, his political position is weakening.

Russia-Ukraine War:  As the Russian invasion continues to disrupt Ukrainian agriculture, Kyiv said the country’s grain harvest this year will likely fall by another 15% from 2022.  On top of that, Russia warned it could pull out early from the UN-sponsored agreement under which Russia is allowing Ukraine to export food products from its Black Sea ports, despite the fact that Moscow agreed to renew the deal last Friday.  The news highlights how the war continues to threaten global commodity supplies and could keep global food prices and inflation high.

Russia-China:  Russian President Putin continues to host Chinese President Xi in Moscow, with much of the discussion today reportedly focused on the China-Russia economic relationship.  One key topic is likely to be the planned Power of Siberia 2 natural gas pipeline, which will help Russia shift its gas exports to China now that it has largely been cut off from Europe.

• As we wrote in our Bi-Weekly Geopolitical Report on January 9 and March 6, China is likely to manage its evolving geopolitical and economic bloc in a largely neo-colonial fashion, where it uses the other members of its bloc, such as Russia, as sources of cheap natural resources and basic commodities, and in return China sends them its higher-value manufactured goods.
• One Financial Times report on today’s China-Russia meetings contains a quote from an unidentified Russian official that drives home our point: ‘“The logic of events dictates that we fully become a Chinese resource colony,” the person said. “Our servers will be from Huawei. We will be China’s major suppliers of everything. They will get gas from Power of Siberia. By the end of 2023, the yuan [renminbi] will be our main trade currency.”’

Venezuela:  Oil Minister Tareck El Aissami announced that he is resigning his position amid a government corruption probe that has already led to the arrest of multiple officials.  Reports suggest El Aissami was pushed out in a political purge, perhaps related to massive graft in the country’s oil sales.  However, we would also note that El Aissami oversaw the negotiations that led to U.S. energy giant Chevron (CVX, $154.58) receiving a license last year to restart its operations in Venezuela.  El Aissami has also been under U.S. sanctions for drug trafficking.  It therefore would not be a surprise if his resignation also involved his relationship with the U.S.

U.S. Monetary Policy:  The Federal Reserve begins its latest policymaking meeting today, with its decision due out on Wednesday afternoon.  Despite the strong economic data for January and February, we suspect the recent banking crises in the U.S. and Europe will discourage the policymakers from hiking their benchmark fed funds rate by anything more than a modest 25 basis points.  Many investors and observers are even expecting them to hold rates steady.

U.S. Labor Market – West Coast Ports:  According to the Pacific Maritime Association (PMA), which represents shippers and port operators, West Coast dockworkers have begun to slow port operations to protest the lack of progress in negotiations for a new contract to replace the one that expired last July.  The workers have reportedly stopped staggering work shifts during mealtimes, forcing terminals to shut down every day for an hour in the afternoon and another hour at night.

• Federal officials have been pressuring the PMA and the dockworkers to come to an agreement, but talks have recently stalled.
• The rising labor tensions are a reminder that the economy could still face disruptive supply chain issues at the West Coast ports.

U.S. Labor Market – LA Schools:  Some 30,000 bus drivers, custodians, special education aides, and other school staff in Los Angeles are beginning a three-day strike today in search of a 30% increase in wages and better working conditions.  In addition, a union representing some 35,000 teachers will also go out on strike in support.  The strike illustrates how low unemployment and high inflation continue to prompt workers to agitate for better pay and conditions, despite growing layoffs in technology and some other sectors.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Happy St. Patrick’s Day! Today’s Comment begins with a discussion about the European Central Bank’s rate decision and how it could impact monetary policy around the world. Next, we review the latest developments in the ongoing banking crisis. Lastly, we give an update on the rivalry between the U.S. and China.

What Now? The European Central Bank raised rates by 50 bps but the reluctance with which they made this move highlights monetary policymakers’ hesitancy to maintain aggressive policy in light of elevated financial strain.

• Some European policymakers were uncomfortable with the central bank’s decision to increase its benchmark policy rate by half a percentage point. ECB President Christine Lagarde noted that some of the members of the governing council wanted to halt rate hikes until the bank situation unfolded. The decision to ditch their written commitment to keep lifting rates further supports the idea that members are not sure about the future path of monetary policy. The indecisiveness among the ECB governing council was interpreted as a dovish shift by the central bank as investors now believe that it is less committed to fighting inflation.
• The ECB’s decision to raise rates now puts pressure on the Federal Reserve to lift its policy rate. Fed officials are dealing with similar circumstances as their European counterparts, but their reaction is far from certain. The Fed is already facing scrutiny for its failure to prevent the collapse of Silicon Valley Bank (SIVB, $106.05) and Signature Bank (SBNY, $70.0). As a result, it may be subject to increased political backlash if it overdoes it next week in its rate decision. The Organization for Economic Cooperation and Development (OECD) has weighed in on the matter by requesting central banks (most likely the Fed) to resume rate hikes. That said, continued tightening by the Fed raises the odds of a recession.
• In the United Kingdom, the decision to tighten monetary policy is even more complicated. The Bank of England and the U.K. Treasury have very different outlooks for the economy over the next few years. While the central bank predicts that output growth will be relatively unchanged by 2025, the Office for Budget Responsibility projects GDP to expand by 5% within that same period. The differing forecasts from monetary and fiscal policymakers suggests the two institutions might impose contradictory policies. In other words, the BOE is likely to become dovish, which may lead to an end to tightening, while the Treasury department may lean more hawkish thus paving the way for possible budget cuts or tax increases.
  • The recent deceleration in U.K. inflation expectations further reaffirms our belief that the Bank of England may lean toward not tightening in its next meeting.

New Developments: Financial contagion may be fading but it is still too early to tell whether the central bank’s job is done.

• Banks have taken full advantage of the Fed’s facilities to shore up their cash positions as they borrowed $165 billion from the discount window and the Bank Term Funding Program in the week ending March 15. The unusually high usage of the discount window shows the level of panic triggered by the collapse of Silicon Valley Bank. The discount window lent $153 billion, a new record. Meanwhile, the BTFP lent $12 billion. J.P. Morgan (JPM, $130.75) estimates that the Fed could administer up to $2 trillion into the U.S. financial system. The new bank funding facilities should prevent a liquidity crunch; however, its usage suggests that the financial system is still on edge.

• In other related news, J.P. Morgan has teamed up with other banks to rescue First Republic Bank (FRC, $34.27). A group of 11 lenders, which include Bank of America (BAC, $28.97), Citigroup (C, $45.62), and Wells Fargo (WFC, $39.30), have offered $30 billion in deposits to prop up the struggling California lender. The large transfer comes as fears of bank runs have led depositors to move their money from small and mid-sized banks to ones with large holdings. The group of banks agreed to park their deposits at First Republic Bank for at least 120 days.
• Fears of a potential financial crisis are fading, but it is not clear where the Fed will go from here. The Fed backstops have reassured markets that the central bank was willing to provide liquidity to stabilize the banking system. However, there are still concerns about whether the financial system is capable of dealing with further tightening. Hawkish Fed policy has made deposits less attractive as investors are now able to get more money using money market funds and purchasing Treasuries. That said, inflation is too high for the Fed to pivot now. The market seems to believe that the Fed will raise rates by 25 bps at its March 22 meeting, which is lower than the prediction of 50 bps made after Powell spoke to Congress last week.

Major Power Rivalry: As the West attempts to isolate China, Beijing looks to bolster its ties with Moscow.

• Russia and China continue to build closer ties, while the U.S. tries to find ways to thwart the two countries’ global ambitions. Chinese President Xi Jinping is set to visit Moscow on Monday to reaffirm the countries’ strong ties. Meanwhile, Republicans are pressuring the Biden administration to deter nuclear cooperation between Russia and China. It was reported that a Moscow state-owned nuclear energy company was providing Beijing with highly enriched uranium. China claims to be acting as a mediator between Russia and Ukraine, but China’s actions show that it does not want Putin to lose the war. China and Russia have used their partnership to reduce American influence around the world.
• Accordingly, the Western alliance is becoming less enchanted with Beijing due to its growing relationship with Russia. In a move that will certainly ruffle feathers in Beijing, a German finance minister is set to visit Taiwan for the first time in 26 years. The trip highlights the precarious relationship between Beijing and Berlin. Although Germany is dependent on trade, it wants to pressure China to distance itself from Russia. Meanwhile, more countries are joining the U.S. in its push to ban TikTok on government devices. The U.K. was the latest country to restrict the social media app. The West believes that the app poses serious security risks, and, as a result, the EU, Canada, and the U.S. have all restricted its usage in government settings.
• We have discussed our belief that the world is breaking up into two major economic and geopolitical blocs as countries move away from globalization, one led by the U.S. and the other by China. The rivalry between the two blocs will lead to proxy conflicts and trade battles. The war in Ukraine and the banning of TikTok are examples of how this has started to play out. As tensions begin to rise, the potential for a direct conflict will increase. At this time, neither the U.S. nor China favor outright war, but that could change if Putin’s failure in Ukraine triggers China to make a Hail Mary run for Taiwan. A conflict between the major powers would be very bullish for commodities as supplies will likely be constrained.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about the latest development in the ongoing banking turmoil. Next, we give our thoughts about the path for future central bank policy. Lastly, we review other market movement news.

On the Horizon: If Silicon Valley Bank (SIVB, $106.08) was the opening shot, then Credit Suisse (CS, $2.25) is the bazooka igniting concern about the global banking system.

• America’s six largest banks have lost a total of $183 billion in market value since February 1. The market rout started when Silicon Valley Bank was forced to offload its bond holdings at a loss of $1.9 billion and worsened after Credit Suisse’s largest shareholder, Saudi National Bank (1180, SAR, 41.50), refused to offer more capital. These events are not inter-related, but their timing has led investors to reevaluate their exposure to financial services companies. Although the Fed’s backstops helped alleviate the problems associated with SVB, the Treasury Department is actively reviewing the U.S. financial sector’s exposure to Credit Suisse.

• Credit Suisse remains the biggest problem for markets currently. The bank’s funding costs have become so high that some analysts believe that it will either need a capital injection or a breakup. Unlike Silicon Valley Bank, Credit Suisse has the liquidity to handle a significant outflow of deposits and has access to central bank facilities in multiple countries. Its problem lies with its profitability. Morningstar analyst Johann Scholtz estimates that the bank will lose $2.2 billion in 2023 and could maintain those losses going into 2024. Despite the bank’s bond being rated as investment-grade, on Wednesday it was trading at distress levels due to concerns that the bank could fail without outside financial support.
• While the bank may be too big to fail, it is unclear who will save it. The potential collapse of Credit Suisse has been known since October 2022. Economist Nouriel Roubini went as far as to claim that the bank is “too big to be saved.” Additionally, merger and acquisition options remain limited as major banks debate the price that they would be willing to pay for the struggling institution. Wednesday’s announcement that Credit Suisse will borrow up to 50 billion CHF ($54 billion) to purchase shares has calmed markets, but the bank is far from being out of the woods.
  • In more unwanted news, First Republic Bank (FRC, $31.16) is expected to make a sale after S&P Global Ratings and Fitch Ratings cut its debt to junk status.

Other Central Banks: The backstops provided by the Federal Reserve and Swiss National Bank have alleviated concerns but have also complicated the central banks’ efforts to combat inflation.

• The European Central Bank reluctantly raised rates by 50 bps in its policy meeting today and signaled that it would be paying closer attention to the market going forward. In their statement, policymakers emphasized that they will be monitoring inflation pressures and financial stability. The move suggests that the bank may feel confident that the Credit Suisse issue will not have significant spillover effects. Its lack of guidance indicates that the central bank does not want to lock itself into a decision currently.
• Despite the ECB rate move, the Federal Reserve’s decision to raise rates is still very complicated. Federal Reserve Chair Jerome Powell has put himself in a bind. During his testimony before Congress, Powell emphasized that the cost of failing to restore price stability will exceed the cost of success. Now that we have had two bank scares in less than a week, his words may come back to bite him. Over the last few weeks, Fed officials have assured markets that they were determined to bring down inflation at all costs, but the market now believes their fight is close to an end. Fed futures contracts, at the time of this writing, are signaling that the Fed will likely raise rates by 25 bps at next week’s meeting, and may be more cautious moving forward.
• That said, talk of “disinflationary shock” may be enough for central banks to be less aggressive going forward. The belief is that the ongoing banking crisis could encourage banks to pull back on lending. If true, it would be mean that a recession is much closer than policymakers realize. We have noticed that recent events have made trading government securities’ more difficult as banks look to shore up their cash positions for emergency situations. The Bloomberg Government Liquidity Index, which increases as bonds become less tradable, shows that government securities illiquidity from Japan (gray), the U.K. (orange), and the U.S. (blue) have risen to levels not seen since the start of the pandemic.

U.S. – International Relations: While the market is focused on banks, it is missing other important stories abroad.

• TikTok is under increased pressure to distance itself from China. The Biden administration has threatened to ban the Beijing-based social media site from the United States if Chinese owners don’t sell their stake in the company. The warning comes amidst rising tensions and growing distrust between the world’s two largest economies. The move helped support Snap Inc. (SNAP, $10.48) and Meta (META, $197.50) shares, but is likely to signal further decoupling between the two major powers.
• Meanwhile, tensions between Russia and the U.S. continue to escalate. The Pentagon released footage of the surveillance drone that crashed into the Black Sea. The video showed that a Russian fighter jet had dumped fuel on it and the U.S. military claimed that another jet collided with the drone. Both sides have blamed the other for the downed drone and accused the other of taking more aggressive behavior over the Black Sea. At this time, there do not appear to be calls for retaliation from the U.S., but the incident suggests that there is a heightened risk of direct confrontation between the two countries.
• Iran agreed to stop sending military weapons to the Houthis in Yemen as part of its pact with Saudi Arabia. The two countries had taken opposite sides of the conflict in Yemen. As a result, the Chinese-brokered deal may pave the way for the Houthi rebels to come to the negotiating table for peace talks. The arrangement reinforces the view that China is pivoting its foreign policy toward the Middle East as it looks to prevent being ever dependent on the U.S. for resources.
  • Although China has relied heavily on Russia for its oil needs, there is a concern that Russian crude production will fall in the coming years due to a lack of investment related to Western sanctions.

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