Echoes of 2008 as SVB collapse sparks large falls in rates
Summary
- Silicon Valley Bank collapse was down to mismanagement of interest rate risk
- Term rates have fallen sharply as risk aversion rises
Silicon Valley Bank collapse a canary in the coalmine?
Unlike the Financial Crash in 2008, Silicon Valley Bank (SVB) didn’t collapse due to poor lending decisions. Instead, it was simply a conscious decision not to hedge the interest rate risk on its balance sheet which led to the demise of the bank. American regulators estimate that U.S banks still have $620 billion worth of unrealised losses in their books due to the drop in value of fixed rate bonds following the rapid rise in floating interest rates over the past year. So despite protestations that SVB is an isolated incident posing no broader systemic risk, markets are concerned there may be some follow through, should the Federal Reserve fail to reassure financial markets as well as deposit holders arising from the events of last week.
Similar to 2008, the first fault line may have appeared in the US but similar concerns may arise around the world. September’s dramatic LDI crisis in the UK, which triggered the collapse of the Truss government is an example of local vulnerabilities exposed by the rapid change in the interest rates environment and a loss of confidence in the system. Although not currently in the line of fire, the Euro-zone may not be immune either given the extended period of time that interest rates spent in negative territory. Given that there was at one point over $18 trillion of negative yielding bonds globally, the scale of unrealised losses on investments being held-not just by banks- could be massive.
Central banks are now in an invidious position. As recently as last Tuesday, the US Federal Reserve Chairman, Jay Powell, testified that a 0.50% rate hike was possible at its upcoming monetary policy meeting next week. Goldman Sachs is now forecasting that the Fed will leave rates unchanged at this upcoming meeting. This week, we get an early opportunity to gauge how concerned central banks are about financial stability when the ECB meets. Back in February, the ECB pre-committed to deliver a 0.50% rate hike at its policy meeting taking place this Thursday and the markets will be closely watching to see if they waiver from this commitment. Even if they do hold firm on the 0.50% move, the accompanying statement and subsequent press conference will also be keenly awaited for clues as to the ECB’s thinking on the path for rates in the Euro-zone specifically but also as a bellwether for current sentiment amongst rate-setters globally in the wake of new concerns about bank solvency.
The cost to hedge has fallen sharply
The market response to the news of SVB’s collapse was as expected- when risk sentiment sours, there is an immediate rotation from equities to bonds, pushing yields lower. The extent of the move lower, especially in US rates has been violent (yellow column in the chart above). US 2 year fixed rates have dropped by over 1% since Wednesday while 2-year swap rates in the Euro-zone and UK have both fallen by more than 0.30%. For both US and Euro-zone rates, these falls over the past week represent the largest drop in term rates since the Crash in 2008. The drop in term rates has also seen Cap pricing fall too- please contact the team directly at hedging@vucatreasury.com for updated pricing.
SVB’s situation serves as a cautionary tale for corporate borrowers- firms in interest rate sensitive sectors like banking and real estate or those carrying significant debt on their balance sheet need to have a board approved policy around managing interest rate risk and take steps to mitigate risk when it moves outside of an acceptable tolerance level. The failure to mitigate interest rate risk was fatal for Silicon Valley Bank but could easily have been avoided had they used techniques widely available to, and used by, corporate borrowers.
Martin Mulligan
Since 1994, Martin has structured and sold foreign currency, interest rate and commodity hedges for corporate and financial institutional clients at a number of major banks in Ireland, Australia and the UK.
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