Market View
Banks. Following the mismanagement of duration risk at Silicon Valley Bank (SVB), the decisive actions taken by the US government on March 12 halted a potential system-wide bank run among mid-tier banks. (The risk of contagion has meanwhile been limited, particularly after First Republic Bank received US$30B in support on March 16.) An important part of the resolution was the Federal Reserve’s Bank Term Funding Program (BTFP), offering banks the ability to value their bond holdings at cost rather than marked-to-market. The terms offered by BTFP are a fixed rate loan to banks of 1y OIS+10bps (overnight index swap) on any eligible collateral, namely bonds (US Treasuries, mortgage bonds etc) purchased by these US banks prior to March 12. Max usage according to JP Morgan could be somewhere close to US$2T outside of the five largest banks.
Liquidity conditions. Assuming US banks take advantage of this lending facility, BTFP could potentially inject more liquidity into the US banking system, bringing operations back to business as usual, for the most part. More broadly, however, liquidity conditions for markets (i.e. outside the banks) could be affected in other ways. For example, the fallout from the SVB situation could make banks more hesitant to make new loans or accumulate debt for fear of exacerbating their asset-liability mismatches. Or bank customers could move more cash from deposits to money market funds reducing bank reserves (as more is parked at the Fed via reverse repos) and tightening lending. Or depositors could move their capital from smaller to larger banks, increasing concentration risk within the financial system. If any of that materializes, it would suggest implicit tightening pressure from US banks.
Monetary policy. That gives the Fed a much more complicated job next week. We believe there are three plausible paths for the upcoming FOMC meeting. The first path is that the board chooses to pause – which is a view held by Goldman Sachs economists – though we believe this could send a signal that the Fed is worried about financial instability, potentially disrupting markets. The second is they hike 25bps on March 22 and then pause, which would implicitly recognize the potential for tighter financial conditions that we enumerated above. The third is that they hike 25bps and remain committed to further hikes as a way to maintain their credibility on taming inflation. This path could suggest that the Fed believes they have resolved the potential risks to the banking system. (Incidentally, we believe the odds of a rate cut or a 50bps hike are effectively zero.)
Outcomes. The distribution of possible outcomes for the Fed is rather wide and comes down to how they perceive recent developments. We believe they view what happened at SVB as sector-specific rather than systemic, though that view may yet change as exhibited by the heightened anxiety around Credit Suisse and First Republic Bank (albeit both situations appear to be managed at this point). Core inflation still looks sticky and the economic data otherwise shows strength, so we view the third path as most likely, although the expected terminal rate is lower now – perhaps in the 5.25-5.50% range. Indeed, the European Central Bank hiked rates by 50bps as expected on March 16 despite recognizing the turmoil in its own banking system. That said, there are stark differences between the economic situation in the US compared to Europe.
Markets. Overall, we believe the medium to long term outlook for cryptocurrencies has been reinforced to the upside. The technology behind open trustless blockchains and transparent smart contracts stands in stark contrast to the poor risk management practices that led to the turmoil witnessed in the US banking sector this week. That supports the fundamental arguments in favor of digital assets as an alternative and solution to the points of failure witnessed in the existing financial system. That said, for now, the operating environment for crypto businesses could be more challenging due to the loss of some fiat payment rails, but over time, we expect additional redundancies to be put in place – expanding the crypto ecosystem in more creative ways.
Table 1. Correlation matrix based on 40-day window of daily returns
