The Worst is Yet to Come: After Interest Rate Hikes, SVB Won’t be the Only Casualty

Something was bound to fall apart. Yet, roughly one year after central bankers started to end an era of easy money, the absence of major casualties was almost puzzling. Sure, plenty of misfortune has been distributed across financial assets, from cryptocurrencies to tech stocks to real estate. But no real cracks in the global financial system – until Silicon Valley Bank.

The Largest U.S. Bank Failure Since the Global Financial Crisis

The sudden failure of Silicon Valley Bank is bringing old fears to the surface about the banking system’s stability. The fallout continued to spread on Wednesday, as news of a potential funding crunch faced by Credit Suisse clobbered bank stocks worldwide. The sudden turbulence serves as a harsh reminder that undoing the excesses of a credit boom is a messy business.

Undoing the Excesses of a Credit Boom

At the start of every rate hike cycle, there is a sense among many investors that the party is over, and for a good reason. “When central banks throw their rate hammer around with abandon, things tend to break — if not in the real economy, then in the financial system,” Paul Ashworth, chief North American economist at Capital Economics, wrote in a note. Stock markets tend to become more volatile, though they don’t reliably turn negative when central bankers turn hawkish. Nor is a recession a sure thing. A downturn in the credit market, however, is hard to escape. Last year was no exception, with high-quality U.S. bonds posting one of their worst calendar years on record and possibly ever.

Unintended Consequences and an Awash of Debt

Almost always, unintended consequences roil some pocket of the financial system. And there are valid reasons to believe this cycle could be considerably more painful than the past year has let on. For starters, policy changes generally take 18 to 24 months to transmit through the financial system fully.

More importantly, policy rates have been hiked with incredible speed and force at a time when the world is awash in debt. The U.S. Federal Reserve has raised its policy rate by 450 basis points in less than a year. In the aftermath of the global financial crisis, it took more than eight years to see 100 basis points of tightening.

“I think the worst is yet to come,” said Sébastien Mc Mahon, chief strategist at iA Investment Management. “There was just so much interest rate risk out there.”

Global debt levels have been rising for decaSinceHowever, ever the West’s last inflation crisis in the 1970s, interest rates have trended downward, steadily borrowing more now. The global financial crisis ushered in a decade-and-a-half of near-zero interest rates, during which households, governments, and corporations binged on debt.

Then came the pandemic, and a level of emergency stimulus dwarfed anything previously. Those actions are generally seen as having prevented a depression-order economic calamity but also generated the largest single-year increase in global debt since the Second World War.

By the end of 2021, global debt soared to nearly US$ 300 trillion, equivalent to roughly 350 percent of annual GDP. That “extraordinarily high debt level” represented a…

Related Facts

• Two large U.S. banks have already collapsed.
• Government agencies are taking emergency measures to backstop the financial system.
• President Joe Biden is reassuring Americans that the money they’ve placed in banks is safe.
• News of a potential funding crunch faced by Credit Suisse clobbered bank stocks worldwide.
• High-quality U.S. bonds posted one of their worst calendar years on record in 2021 and possibly ever.

Key Takeaway

The key takeaway from all of this is that the global financial system is fragile and vulnerable to shocks, despite the efforts of central banks to stabilize it. Moreover, the excesses of the credit boom are now coming home to roost, and more casualties will likely follow in the days and weeks ahead.

Conclusion

As investors brace for more turbulence in financial markets, it is clear that the worst is yet to come. Interest rate hikes have exposed the fragility of the global financial system, and there are valid reasons to believe that this cycle could be considerably more painful than the past year has let on. It is time for policymakers and regulators to take action to protect the financial system’s stability before it is too late.