Source: China Merchants Macro Meditation

1. The European and American banking turmoil is fermenting: the asset size of failed banks is close to 2008

Beginning on March 8, the turmoil of overseas banks due to the Silicon Valley bank incident continued. Looking at it now, the current round of banking turmoil has had a great impact. Among the three banks of America that have gone out of business (Silicon Valley Bank, Signature Bank (Signature Bank), and Silvergate Bank (Silvergate Bank)), two can rank among the top ten in the history of the scale of bankruptcy.

According to data from the US Federal Deposit Insurance Corporation (FDIC), since 2023, the asset size of failed banks has been close to the level of 2008. A crisis of confidence in the banking system is unfolding, and the confidence of overseas investors has suffered a setback.

The impact of the current bank rush on financial stability continues to ferment due to lack of investor confidence. After PricewaterhouseCoopers gave a negative opinion on the “effectiveness of financial internal control” of Credit Suisse Group, the Credit Suisse Group was sold off by investors despite being one of the world's systemically important banks. The 5-year CDS, which measures its credit risk, soared and reached an all-time high.

In the banking system, systemically important banks mean large amounts of their own assets and complex relationships with other financial institutions. As a result, the Credit Suisse Group crisis triggered a quick response from the regulatory authorities. Previously, the Swiss central bank had provided 50 billion Swiss francs of liquidity support to the Credit Suisse Group through mortgage loans and other short-term liquidity support methods.

In order to maintain market confidence, the Swiss government's Ministry of Finance, the Financial Markets Supervisory Authority, and the Swiss Central Bank have been facilitating the acquisition of Credit Suisse Group. According to the latest announcement, UBS Group completed the acquisition of Credit Suisse Group, with a transaction consideration of 3 billion Swiss francs. According to information disclosed by UBS Group, the Swiss government provided a guarantee of 9 billion Swiss francs for the potential loss of Credit Suisse's assets. Additionally, the Swiss Central Bank provided 100 billion Swiss francs in liquidity support for the acquisition.

2. Risk is likely to continue to be transmitted

The most obvious change in the current round of banking turmoil was the rapid response of the regulatory authorities. Taking the Silicon Valley Bank incident as an example, it only took 5 days from being overrun by depositors to transferring all of Silicon Valley Bank's deposits to Transition Bank. Similarly, in the midst of the Credit Suisse Group turmoil, it was less than a week from March 14, when the auditor gave a negative opinion on the financial report, which triggered a sell-off, until UBS Group announced the completion of the acquisition.

In our review in October last year, we anticipated that the Fed would raise interest rates or end in the first half of the year. The logic behind it is mainly based on historical laws that a liquidity crisis will occur within 4-20 months of US debt reversal. Liquidity crises, on the other hand, tend to reverse the Federal Reserve's monetary policy.

Currently, common liquidity indicators, such as “FRA-OIS spreads” and “LIBOR-OIS spreads”, have recently widened sharply, and signs of a liquidity crisis have already been shown.

In this context, on March 19, the Federal Reserve issued a joint statement with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss Bank: Starting March 20 (continuing at least until the end of April), the central bank's liquidity swap frequency, which originally operated weekly, will increase to every day.

A central bank liquidity swap is essentially a way for the Federal Reserve to provide dollar liquidity to financial institutions through other major central banks. Historically, surges in usage can be observed during the financial crisis, the European debt crisis, and the financial market turmoil caused by the pandemic in March 2020. The use of this tool can relieve the pressure on overseas financial institutions to sell dollar assets due to tight liquidity to a certain extent. Looking at it now, this is a precautionary plan by the regulatory authorities based on previous liquidity crisis relief experiences.

Well then,The central question to be concerned about becomes will risk continue to be transmitted when regulators act so quickly?We believe that the current round of European and American bank crowding is not over, and that risk events may still occur in the future. Looking back at previous liquidity crises, it can be seen that rating agencies often act as catalysts for risk events.

For example, in the European debt crisis, things began to change in treasury bond yields of Italy and other countries after their ratings were downgraded. Their 10-year treasury bond yields began to soar, and interest spreads on treasury bonds limited to the same period with Germany also widened markedly. Behind the relevant incident is the reason why rating agencies downgraded their ratings, triggering some institutions to sell off their assets.

In this round of banking turmoil, we have also seen the impact of rating agencies. Moody's first downgraded its rating of the entire US banking system from stable to negative on March 13, and added banks such as First Republic Bank to the downgrade watch list.

In this round of banking turmoil,Some investors are focusing on the indicator that unsecured savings account for total deposits.As can be seen, with the exception of the bankrupt Silicon Valley Bank and signature banks, regional banks that do not have a high share of deposits have all been included by Moody's on Moody's downgraded ratings watch list. If rating agencies drastically downgrade the ratings of financial institutions in the future, it may trigger a wide range of counterparty restrictions, which will undoubtedly weaken the stability of the entire financial system.

For example, in the case of Credit Suisse Group, several banks, including Société Générale and Deutsche Bank, have restricted their transactions involving the Credit Suisse Group after their risks were exposed.

Currently, after the acquisition of Credit Suisse Group, the market is once again focusing on First Republic Bank. As a large regional bank, its stock price has dropped around 80% this month. The bank has been downgraded by each of the three major rating companies, and investor confidence continues to suffer.

Although on March 16, banks such as Goldman Sachs, Morgan Stanley, Citi, J.P. Morgan Chase, Bank of America, Wells Fargo, and Bank of New York Mellon jointly deposited 30 billion US dollars in deposits into First Republic Bank to stabilize the financial market, this move still did not stabilize confidence.

We believe that any sign of crowding out will cause savers to face a “prisoner's dilemma”. The rational decision is to switch to big banks or offer cash. Since then, some banks will face pressure to shrink their balance sheets. For commercial banks, deposits are a relatively cheap type of debt. Although it is possible to receive liquidity support from the Federal Reserve, outflow banks will still face the problem of asset returns and debt costs being inverted, and equity values will shrink rapidly. Judging from the current situation, the above logical chain has not been broken, and it is expected that the turmoil will continue.

3. After the final decline in US stocks, the Federal Reserve is expected to change

Judging from the financial markets these days, the market is already pricing the end of the Fed's monetary policy tightening cycle. After the crisis broke out, the market quickly repriced the Fed's interest rate hike: on March 9, the market Price-in raised interest rates by 50 BP in March, suspended interest rate increases after adding 25 BP each in May and June, and interest rate cuts in December are expected. Expectations of interest rate hikes declined rapidly after the Silicon Valley bank incident, and financial markets even priced interest rate cuts in the first half of the year.

We expect that, with reference to the decision of the ECB's interest rate meeting in March,The Federal Reserve will still choose to raise interest rates this month.Inflation is still high and the unemployment rate is still low. The Federal Reserve will not cut interest rates immediately at the beginning of risk exposure; otherwise, there will be moral risk. For example, judging from current market support operations, the Federal Reserve is only providing one-on-one liquidity support to financial institutions in need.

According to the latest data, the Federal Reserve's balance sheet showed a trend of re-expansion, triggering investors' discussions on QE. The size of the Federal Reserve's assets and liabilities grew close to 300 billion US dollars in a single week, accounting for almost half of the reduction since the downsizing plan.

However, judging from the structure of asset expansion, last week's increase mainly came from the discount window, other loans (FDIC loans), and the newly established Bank Term Funding Program (BTFP). In other words, the Fed's asset expansion last week was mainly comprised of borrowing instruments, while bond assets held by the Federal Reserve continued to shrink according to plan.

Expansion through lending instruments is different from QE, mainly because lending instruments are initiated by financial institutions on the initiative of financial institutions, and the cost of borrowing is not low. Therefore, after a liquidity shock, financial institutions often take the initiative to repay loans, and the Fed's balance sheet shrinks as a result. Taking last week's expansion as an example, it can be seen that among the 12 regional federal banks, the San Francisco Federal Reserve and the New York Federal Reserve are the main implementers of the expansion. The reason behind this is a reflection of the support given to local banks by the two regional federal banks (Silicon Valley Bank and Signature Bank after being taken over by the FDIC, First Republic Bank, etc.).

So, where is the end of the Federal Reserve's final monetary policy shift or this round of interest rate hikes? We believe that only a drastic adjustment in US stocks can lead to a policy shift.

Once there is a drastic adjustment in US stocks, there will be two main logical deductive clues: one isThe recession in the US economy (indicating that interest rate hikes have suppressed aggregate demand, or that financial risks have been transmitted to entities) triggered a decline in profit expectations or a rapid decline in actual corporate profits;The second isFinancial institutions continue to be exposed to risk frequently, and investors' risk appetite has declined rapidly.

This round of overseas risk outbreaks will undoubtedly affect financial institutions' own asset and liability expansion activities. Judging from the history of nearly 40 years, there is a clear negative correlation between the scale of bank bankruptcy and the expansion of credit in the private sector. Currently, the share of assets of bankrupt banks in the US has risen to 1.5%, which will drag down bank credit investment and credit bond allocation.

Under these circumstances, it can be expected that credit spreads will widen somewhat, compounded by the fact that many banks will raise their lending standards, making corporate financing more difficult, and the real economy will weaken as a result. According to the above logic, the probability of a recession in the US economy will increase dramatically, and the unemployment rate will also rise from a low level.

However, since the main area of high leverage over the past ten years was the financial system, which did not involve real sectors such as real estate, etc., even if a liquidity crisis broke out, it would not create a systemic risk; it could be resolved as long as the monetary policies of central banks such as the Federal Reserve changed.

Under such circumstances, after the final decline in US stocks, if the Federal Reserve begins to shift, there will be an “opportunity” for global assets. The same is true domestically.

Risk warning:US fundamentals have exceeded expectations, and the Federal Reserve's policy has exceeded expectations.

Editor/Somer