Key areas impacted by tightening financial conditions include:
- The banking system, where a large net percentage of institutions are tightening standards on commercial and industrial loans, according to a recent Senior Loan Officer Survey cited by the Federal Reserve Bank of St. Louis (FRED).
- Capital markets, which have been more sanguine ahead of this episode and where large borrowers have termed out fixed-rate borrowing.
Regarding the banking system, the Fed’s rate hikes have prompted an inversion of the yield curve, which reduces net interest margins and profitability, and, over time, leads banks to tighten lending. In addition, the Fed has let its balance sheet passively run off to the tune of roughly US$95 billion per month while also draining its liabilities, including bank reserves, amid its cycle of quantitative tightening. Taken together, this can have a nonlinear impact on banks’ liquidity past a certain point through funding markets.
Right now, it's still unknown if SVB’s fate will pose serious contagion risk or have systemic impacts. The Federal Deposit Insurance Corporation (FDIC) and state regulator have stepped in to protect depositors while the Fed has announced a new lending facility, but further regulatory ramifications are unclear. From a macro perspective, this event emphasises that the typical transmission mechanism from central bank tightening through the financial system (and, eventually, the real economy) is likely still intact and is likely to accelerate. We will be closely watching market volatility and policy reactions in the US and other markets for further cues.
While the US is at the epicentre of the stress, developed markets outside the US are affected due to their higher-beta nature and because any US liquidity tightening will impact global growth. However, there are clearly different dynamics in play from region to region and we expect these to be taken on board by investors over time. For example, China seems largely insulated from recent US events as its economy benefits from reopening, with other Asian regions benefiting as well. While the market has also pared back rate expectations in the eurozone, the European Central Bank will face a tough balancing act between the need to support financial stability and the continued uphill struggle against core inflation pressures.