What did that lead to?
It helped fuel a period of extraordinary growth in US financial markets, save for the short, sharp pandemic drop in 2020. The US stock market rose more than 580% after the financial crisis, accounting for price gains and dividend payments. It also led to a massive increase in debt taken on by companies and countries. From 2007 to 2020, government debt as a share of gross domestic product globally jumped to 98% from 58%, and non-financial corporate debt as a share of GDP surged to 97% from 77%, according to data compiled by Ed Altman, professor emeritus of finance at New York University’s Stern School of Business. In a hunt for better returns than safe debt assets like short-term Treasuries offered, investors flooded companies with cash, buying bonds from risky ventures that paid higher yields while overlooking their lower credit quality. Yet despite the ballooning debt, inflation remained subdued in most developed economies — in the US, it rarely reached the Fed’s target of 2%.
What changed?
Inflation arrived with a roar in 2021 as pandemic restrictions waned while supply chains remained disrupted. In 2022, exacerbated by energy shortages and Russia’s invasion of Ukraine, inflation reached over 9% in the US and 10% in the European region. Led by the Fed, central banks began raising interest rates at the fastest pace in over four decades. They’re aiming to slow growth by reducing consumer demand, hoping in turn that prices will cool, too. Between March and November, the Fed increased the ceiling of the rate it uses to manage the economy, known as the federal funds rate, to 4% from 0.25%. Before the bank crisis, economists were expecting the central bank to hike the rate above 5% and hold it there for most of the year.
What has this meant for investors and markets?
After the rate hikes began, the US equity market plunged as much as 25% from its peak, as investors braced for the slowdown the interest rate hikes would likely bring. The pain was especially concentrated in the the tech sector, where stock prices and employee headcount had both ballooned during the pandemic. Bond prices fell by the most in decades, as the prospect of new issuances paying higher rates made existing low-yield bonds worth less. Both investment-grade and high-yield companies cut back on borrowing. One of the most rate-sensitive areas of the US economy, the housing market, saw sales slow significantly.
How did this trigger financial distress?
In September, a hedging strategy routinely used by UK pension funds backfired when yields on government bonds jumped faster than the models the funds used had allowed for. Intervention by the Bank of England was needed to calm market turmoil. Then in March the collapse of Silicon Valley Bank (SVB) was also linked to interest rate increases, but in a different way. It had put over half of its investment portfolio in longterm Treasuries and other so-called agency bonds, far more than other large banks. Those longterm bonds paid a higher return than shorter durations. But like other longterm bonds, their value had fallen sharply. That might not have mattered in better times, when the bank could have held the bonds to maturity. But when its tech-heavy clientele began to withdraw funds to make up for the slowdown in venture capital investments hitting the sector, SVB was forced to sell a big chunk of its portfolio at a loss of $1.8 billion. News of that triggered an exodus of deposits, almost all of which were uninsured, leading to its closure on March 10.
Can this lead to a financial crisis?
Lending rules were tightened after the collapse of credit markets in 2008, especially for the largest banks, leading to bolstered confidence in the financial system’s resilience. But no banks were unaffected by the interest-rate changes: At the end of 2022, according to the FDIC, banks had suffered $620 billion in losses on their holdings. SVB’s failure came days after the collapse of Silvergate Capital Corp., a bank that had specialized in services for crypto clients. Two days after SVB’s fall, regulators in New York State were worried enough about accelerating deposit outflows to shut down another midsized institution, Signature Bank. Federal regulators were worried enough to invoke emergency powers to say that federal deposit insurance would cover all deposits at both banks and to announce changes to the Fed’s lending programs meant to support banks whose portfolios had lost value. Bank stocks sank globally as Credit Suisse’s share price plunged until the Swiss National Bank said it would make up to $54 billion available.
What other damage can it cause?
The risk is that the turmoil in the banking sector can tighten the credit squeeze already set in motion by interest-rate increases. Lenders were expected to become more concerned with shoring up their own finances than providing the loans that enable economies to grow — even without a system-threatening bank collapse. JPMorgan Chase & Co. estimated the US economy faced a potential hit to gross domestic product of a half to a full percentage point from diminished credit growth in the aftermath of the latest banking-sector troubles. The worst outcome would be a giant bank failure that would dry up the flow of credit and almost guarantee a recession.
What does it mean for the Fed’s plans?
It certainly complicates them, as was reflected by market activity. Government debt yields plunged globally as mounting financial-stability concerns prompted bond traders to abandon bets on additional central-bank rate hikes and begin pricing in cuts by the Federal Reserve. The thinking is that stress in the global banking system will test the Fed’s resolve to raise rates further to get inflation under control. At the same time, a string of economic data showing that inflation and growth both remained strong showed that pressure to continue rate hikes will likely persist.
What does tighter credit mean for consumers and companies?
The effects of the rate hikes that began in early 2022 were felt by the year’s end. For US businesses, average yields for newly issued investment-grade debt jumped to around 6% and high-yield debt jumped to nearly 10% by November. That came on top of higher labor costs, especially in sectors like health care. Home buyers faced sharply steeper monthly payments, as the 30-year fixed mortgage rate topped 7%, the highest level in two decades. And despite significant wage gains for US workers over the last two years, record inflation began to eat into incomes. Outside the US, the Fed’s rate increases also strengthened the dollar relative to other currencies, which meant that dollar-denominated sovereign and corporate debt in emerging markets became a lot more expensive to repay. The questions raised by the recent financial turmoil are whether the community and regional banks that do much of the nation’s small-business and consumer lending pull back in a way that slows growth — and whether the economy as a whole is more likely to fall into recession.
What are the risks of business defaults?
Easy access to money in the US has led to higher and higher levels of debt among the riskiest corporate borrowers, especially those owned by private equity firms. A commonly cited measure of debt to earnings has ticked up in the leveraged loan market over the last 10 years. That means portfolios of collateralized loan obligations, which are loans bundled into bonds, grew more exposed to risks as well. Globally, zombie firms — companies that don’t earn enough to cover their interest expenses — have become more common. Companies that relied on venture debt from Silicon Valley Bank may also face a crunch in the absence of the specialized lending that the bank extended. Higher costs across the board — for capital, labor and goods — has created expectations that the default rate will rise, especially among highly indebted companies.
Bloomberg
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