The past three weeks have put everyone’s sensors on alert. Reflections on the Great Financial Crisis (GFC), given bank failure events over and preceding September 2008, are omnipresent. Participants peruse financial and economic indicators, looking for patterns. Yet, the best advice is to stop looking for patterns and rather focus on the conditions or frameworks that changed the price discovery in rate and credit instruments. Taking it one step further, we arrive at yield curve formation.
A first message that requires some colour is that central bank intervention and control has become the rule and not the exception. The exception translates in a narrow reading of a central bank’s mandate, which is to steer policy rates to balance supply and demand conditions in the economy under stable inflation around 2% and maximum employment. However, central banks’ dispose of a high number of non-conventional instruments. Such instruments are rolled out to protect and/or steer the banking function. Indirectly this results in flavours of yield curve control. Indeed, yield curve control – explicit or implicit – in whatever shape or form has been a constant since the GFC of 2008.
Between 2009 and 2021, the policy rate instrument was put on hold and stuck at the zero bound or into negative territory. Unconventional funding instruments or large-scale asset purchase programs led to full yield curve control. Since Q1 2022, we entered into an episode that reflects a hybrid approach. Central banks combine the policy rate instrument with targeted funding initiatives, while partially reversing the quantitative easing (QE) policy by reducing the size of the balance sheet. However, it is clear that central banks can use flexibility and optionality at any time of day to quell financial or banking instability. Below, we mention some recent examples.
In order to break the contagion risk, the Fed announced on March 12th the Bank Term Funding Program (BTFP). Preventing a savings and loans type of crisis as seen at the end of the 1980s, early 1990s, the BTFP offers loans of up to one year to banks, savings associations, credit unions, and other eligible depository institutions, pledging US Treasuries, agency debt, mortgage-backed securities, and other qualifying assets as collateral. These assets will be valued at par. A US bank consolidation should do the rest of the work.
Mid-March, the Swiss National Bank (SNB) offered a CHF50bn loan to Credit Suisse. To no avail, as fleeing deposits proved fatal for this global systemically important institution. On Friday, March 24, the president of the ECB, Mdme Lagarde, confirmed that “The ECB toolkit is fully equipped to provide liquidity to the euro area financial system if needed.”
Bond markets took note of this. Especially policy rate expectations next to 2-year government bond rates have adjusted aggressively since March 8. According to the current market pricing, the US FED terminal rate has been reached today at 4.75%-5.00%, i.e., no more FED policy rate hikes anymore. Expectations are that policy rates will return to 4.00%-4.25% by year-end. The 2-year Treasury rate dropped from 5.07% on March 8 to close at 3.77% on March 24, a stellar drop of 130bp.
In Europe, we are witnessing a similar reaction. The ECB Deposit Rate is priced to peak at 3.25% or a one-and-done stance by the ECB. The German 2-year bund cratered from a 3.32% high on March 8 to 2.38% last Friday, minus 94bp. Our “Peak Inversion Ahead” piece released on February 13 was reached on March 8th. The US Treasury 2y-10y rate inversion peaked at 107bp to close Friday at 40bp.
This brings me to a second message related to the theme of yield curve clustering. It is based on the ever-strengthening globalisation in financial markets. Notwithstanding geopolitical fragmentation and a growing number of sanctioning and embargo policies, fixed income markets are defined by about 8 yield curves. The US, Canadian, Chinese, Japanese, German, UK, Aussie, and Kiwi yield curves define a high-quality set of risk-free curves. Expect, over time, specific EM economies may join this club, but that’s for another note.
The bracket for 10-year rates ranges from 4.10% for New Zealand at the high-end to 0.27% for 10-year Japanese government bonds. However, ex-Japan, we cluster within a mere 200bp. At the 5-year point, again outside of Japan, we converge within a band of 130bp. Expect more yield curves clustering going forward. Important factors explaining this clustering are found in explicit Japanese and implicit Chinese yield curve control (YCC). On top, many other curves still profit from partial YCC.
The destination is clear: yield curves are converging and, on a journey, to become positively sloped. This condition will be a tailwind for the banking system. On the contrary, the moment inversion conditions become structural, banking systems become increasingly fragile. Another incentive for central banks to return to long-term neutral policy rates in the not-too-distant future.
So, we kick off the last phase in the normalisation of monetary conditions. Two -year forward yield curves across most of the above economies are positive. For Japan and China, it is the case today.
Current market uneasiness may shorten the horizon of this adjustment. Central banks may be forced to reinstitute broad-based use of their non-conventional toolkit. Why? Faltering client deposit confidence can morph into banking system failure. If clients with bank deposits flee into attractive short-dated treasury bills, certificates, or other safe investment solutions, as these are segregated from a bank’s balance sheet, banks could encounter funding issues. In the US and the EU, the effectiveness of depository insurance schemes are questioned. Household and corporate depositors are invited to accelerate transformation into safe (segregated) investment solutions.
And inflation? Well, Asia is not facing any inflationary pressures. China’s YoY inflation currently stands at 1.00%, while 5Y5Y forward inflation swaps in the EU at 2.35% versus 2.55% in the US are well-anchored. It might sound awkward, but inflation is yesterday’s story. The banking sector events over March signal that policy rates are too high for their purpose. On top of that, the banking system holds the keys that might open the door to a more broad-based credit crunch. Recession is guaranteed.
The collapse of the Bretton Woods system in 1973 led to free-floating currencies, and central banks competing for leadership by setting policy rates independently. Between 1973-2008, central banks followed a hands-off kind of policy approach. As of 2009, we have started a new era where central banks became omni-potent, through conventional and non-conventional means to keep the financial system afloat. Yield curve control is now the rule, not the exception. In a historical perspective, we have just kicked off this episode.
