GVA Bulletin – Credit Suisse

So what has happened on the SVB Financial front since markets reopened on Monday morning?

We already had Long-Term Capital Management and Lehman Brothers among others, and now we have SVB Financial.  Awesome.  Thing looked precarious at first when the markets first reopened on Monday.  It was mentioned that three stocks should be watched most closely for any signs of further trouble – PacWest Bancorp (PACW), Western Alliance Bancorp (WAL), and First Republic Bank (FRC).  And trouble they quickly found once markets opened for trading on Monday morning in falling -60%, -85%, and -79%, respectively in early morning trading.  As the trading day wore on, however, these stocks gradually stabilized and started finding their way back higher, providing the earliest signals that while the weekend solution from the Treasury, Fed, and FDIC was far from perfect, it was likely to be enough to alleviate the initial panic.  Depositors did not line up to drain their accounts, and the broader market found its footing through a volatile session, with the S&P 500 ending effectively flat for the day.

Does this mean the bank crisis problem is now behind us?

As evidenced by ongoing developments, the answer to this question is almost definitively no.  Although the risk of a U.S. regional bank spontaneously combusting SVB style has been meaningfully reduced, many banks still have serious balance sheet challenges that have come as a result of the Fed’s aggressive monetary policy tightening campaign, and their bank specific credit risk management challenges.  These banks may not be going into FDIC receivership, but it doesn’t mean that investors are all that enthused to own the equity or debt of these potentially at-risk banking institutions either.  Moreover, if a bank is dealing with these types of balance sheet issues, they are not likely to be eager to lend out money to individuals and institutions that may be interested in borrowing.  This, of course, is a drag on economic activity that may impact various regional economies across the U.S. to varying degrees if not the entire U.S. economy as a whole in the weeks and months ahead.  For example, if you’re running a tech startup out in Silicon Valley, running the day-to-day operations of your business not to mention managing your personal finances has almost certainly become vastly more complicated now that the “innovative” financial institution that created special banking solutions to support you running your business most efficiently is now no more.

So what is going on with Credit Suisse?

It’s worth noting that Credit Suisse (CS) has been coping with problems on numerous fronts for a long time now.  This has included scandals related to Greensill Capital and Archegos Capital, and Bulgarian drug money laundering among others.  Credit Suisse has also been dealing with significant deposit withdrawal activity and net asset outflows that have measurably increased liquidity risks for the bank and strained its financial condition.  All of these forces contributed to driving the Credit Suisse stock price lower by roughly -75% since the start of 2022.  Fast forward to this Tuesday, the bank revealed along with the delayed release of its 2022 annual report that it had identified ‘material weaknesses’ in their financial reporting.  Moving on to today in the very early morning hours here in the U.S., when asked during a Bloomberg interview whether the Saudi National Bank, which owns nearly 10% of Credit Suisse, would be open to assisting further if there was another call for additional liquidity from Credit Suisse, the Chairman replied, and I quote “The answer is absolutely not, for many reasons”.  My one-word analysis to this response: Ouch!!  Don’t mince words, what do you really think?  Rarely do we hear such direct candor, particularly in relation to financial markets, particularly from a shareholder talking about a company that they hold a nearly 10% stake, particularly related to a financial institution that is struggling in its own right in the immediate wake of a bank failure event, particularly not followed a few hours later by a clarifying statement trying to walk back the initial statement (I’ve got more “particulary”s here, but I’ll spare you).  In a word: Wow!  In the hours that have followed during today’s trading, Credit Suisse shares have fallen by more than -20%.

Should we be more worried about Credit Suisse than SVB?

This is a bigger deal than SVB Financial.  Credit Suisse is a systemically important financial institution (SIFI), which means that their failure could trigger a financial crisis (i.e. too big to fail).  This is a risk that must be monitored closely in the days and weeks ahead.  But now that this has been said, this does not at all mean at all that Credit Suisse is going to fail.  Nor does it mean that a financial crisis is going to be triggered even if Credit Suisse were to fail.  The memories of the Great Financial Crisis are still fresh in all of our minds, and a lot of public and private parties all around the world have very strong incentives to come together to figure out a cogent solution to Credit Suisse or any other sudden bout of financial contagion prevent another such outcome from happening again.  It is important to remember that while the collapse of Lehman Brothers gets the bad rap in our 15-year memories, this was not the only failure during the 2007-2009 period that got things going down the drain at the time.  We had New Century, two Bear Stearns hedge funds, American Home Mortgage, Northern Rock, Bear Stearns, IndyMac, the nationalization of Fannie Mae and Freddie Mac leading up to the collapse of Lehman, and we had AIG, Washington Mutual, and Wachovia in the weeks after just to name the headline grabbers at the time before the fiscal and monetary policy firehoses were finally turned on full blast.  Today, the global financial system is on much sounder footing, problems in the financial system remain primarily bank specific issues due to poor operational and credit risk management, and policy makers now have the propensity to jump to quickly, not too slowly, at any signs of trouble.  It’s the reason, after all, we remain awash in moral hazard so many years after the calming of the financial crisis.

So what’s next for Credit Suisse?

This is what I’m waiting on as I write this bulletin.  Another factor that makes the Credit Suisse trickier than SVB Financial (and both Signature Bank and Silvergate Bank, lest I forget already) is that Credit Suisse is not a U.S. based financial institution.  Indeed, they have a variety of U.S. based financial operations, but they are based in Switzerland.  As a result, it is primarily up to the Swiss National Bank and the Switzerland government to decide what action, if any, to take in response to Credit Suisse.  U.S. leaders can nudge the Swiss to take action, and the U.S. Treasury can review U.S. bank exposure to Credit Suisse, but at the end of the day its up to the Swiss.  Literally as I am typing  – I kid you not – the headline broke that the Switzerland government is in talks to stabilize Credit Suisse with an announcement with the Swiss Financial Market Supervisory Authority (FINMA) to make a statement soon, either today or tomorrow.  This brings us to the latest reasonable conclusion: just like with SVB Financial over the weekend, we are likely to get some sort of solution to the Credit Suisse situation soon.  It may not be great, but it will likely be good enough to calm the Wednesday bout of financial jitters.  It will be interesting to see how the rest of the week goes.

What should we expect more broadly from here?

Heading into Monday, I mentioned the bigger issue now confronting policy makers both in the U.S. and around the world.  This is the two major problems that require diametrically opposed policy responses.  And both problems have become materially more challenging as this week has progressed.  On one hand, policy makers including the U.S. Federal Reserve still have a raging inflation problem that requires further monetary tightening.  The latest reading on inflation from the release of the Consumer Price Index (CPI) on Tuesday made matters all the more complicated.  While the headline CPI cooled to an annualized 6%, which was positive, the situation looked far less promising once under the hood.  Just to name a few, the Core CPI (excluding food and energy) came in hotter than expected, core services inflation continues to accelerate, owner equivalent rent and primary rents are still streaking higher year-over-year, and the median CPI continues to hover at its highs on an annual rate basis.  In short, the Fed is still embroiled in an inflation battle and still needs to raise interest rates.  On the other hand, we likely have only scratched the surface in reading headlines about banks under stress.  When central banks raise interest rates from effectively a 0% floor that was in place for more than a decade, pockets of financial stress are likely to be revealed.  When the central bank goes from 0% to nearly 5% in less than a year, stuff in the financial system is bound to break.  In short, the Fed is seeing increased financial system stress that would find relief from lower interest rates.  Two big problems in requiring exactly opposite responses.  Calling all game theorists.

What is the Fed likely to do?

Instead of speculating, let’s check what the market is currently pricing in.  According to the CME FedWatch Tool, the Target Rate Probabilities for the March Fed meeting coming up next Wednesday is implying a 55% probability that the Fed will raise interest rates by a quarter point versus a 45% probability that the Fed will keep rates unchanged.  Before going any further, it should be noted that this reading has been as volatile as the 2-year U.S. Treasury yield since the start of the week, so expect these probabilities to repeatedly shift over the next week.  But here are the clearer takeaways.  The idea of a half point hike from the Fed floated this time last week by Fed Chair Jay Powell just before the collapse of SVB Financial appears fully off the table.  At the same time, markets have virtually no expectation that the Fed will be cutting interest rates anytime between now and next Wednesday.  The debate is moving back and forth between a quarter point hike and keeping rates unchanged next Wednesday.  What about the next meeting in May?  The market is currently pricing in a two-thirds probability that the Fed will be one and done – a quarter point hike in March and that’s it.  But it’s a looong time between now and May 3, so take this reading with a block of salt.  How about the rest of the year?  CME Fed funds futures are currently pricing in a 98% probability that the Fed will be cutting interest rates by December with the majority view expecting at least 75 bps in cuts by the end of the year.  December is a really looooong time away, so take this reading with a salt mine.  Nonetheless, this is what the market is currently projecting.

How should we expect the broader market to respond to these ongoing developments?

The following is my evolving base case: I now expect the Fed to raise interest rates by a quarter point next Wednesday.  Heading into Monday, I thought the Fed was most likely to keep rates unchanged next Wednesday, and this may very well end up being the case.  We’ll see how many more banks come under pressure over the next week.  But the Fed really wants to raise interest rates to flex their inflation fighting bona fides to the broader economy, even if it’s a quarter point.  And frankly, they probably need to continue to show their focus on fighting inflation from a credibility maintenance standpoint, particularly since they waited so long to finally start taking action this time last year and know the 1970s era consequences of backing off on monetary tightening too soon in an inflation fight (much like quitting antibiotics too soon where the infection can come back even worse, the same goes for interest rates and inflation).  Moreover, given that the Fed is already in for 450 bps to date since last March, moving interest rates by another 25 bps is a marginal difference at this point.  In other words, if an individual banking institution is already way out over their skis due to their poor credit risk management over the past 15 months, keeping rates unchanged or raising by another 25 basis points is not likely to make much of a difference at this point.  Finally, we should not overlook the fact that in the midst of the whack-a-mole style banking issues that have popped up over the last several trading days, both long-term U.S. Treasuries and mortgage-backed securities have meaningfully appreciated, providing a measure of incremental relief to many of these still fundamentally challenged banks.  As a result, the market would likely respect and reasonably digest a well forecasted quarter point move (once again, with the caveat that if a fresh new stream of banks come under pressure between now and Wednesday, the Fed is increasingly likely to stand down).

Putting this all together, it is reasonable to expect continued capital market volatility and daily headline event risk as we continue to navigate this challenging environment in the coming days and weeks.  Strong rallies in stocks or any other major asset class should reasonably be expected to be followed by comparably swift pullbacks as new events unfold, with safe haven securities like Treasuries and defensive stocks outperforming their riskier counterparts along the way.  Looking out a bit further, if current Fed interest rate forecasts hold if and when concerns about bank stability finally subsides, anticipate that capital markets may become increasingly enthusiastic (read – higher prices) at the prospects that the rate hiking cycle may not only be over but that rate cuts may soon follow.  Eventually, such easier than previously planned monetary policy may come back to bite with a renewed surge in inflation (read – followed by lower prices), but only time will tell on these possible outcomes further out the forecast horizon.

With all of this being said, the current situation remains fluid and dynamic, so any outlook expressed here is subject to change.  As a result, it remains important to watch the situation in the economy and financial markets closely as daily events continue to unfold.  I will continue to keep you updated as needed depending on how events play out from here.

Eric Parnell, CFA | Chief Market Strategist, Great Valley Advisor Group

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice.

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