One year ago, the Federal Reserve decided on its first interest rate increase to counter the surge in inflation that was already being heavily felt back then. They committed to a long-lasting and aggressive hiking cycle, with the consensual expectation that they would stop as soon as something broke in the system. As you have surely noticed, things are breaking. Regional banks in the US are breaking and huge financial institutions in Europe are shaking. But there is another thing that is also falling apart, piece by piece, with all these developments: my brain.
During this week, the center of the discussion was not Credit Suisse, as I was expecting. Even though it was the most tragic banking event since the 08’ global financial crisis, and despite a complete revolution occurring during the weekend (as UBS acquired its main competitor through a government-sponsored deal), everything calmed down in just a couple of days.
The only thing that was still being referred to consistently was something I would like to briefly comment on: the controversial AT1 bonds. Standing for “Additional Tier 1”, AT1s are contingent capital bonds issued by financial institutions to serve the purpose of being bail-in bonds, by absorbing losses and preventing insolvency.
These instruments were introduced after the GFC to solidify the resilience of the banking system. They were supposed to be the bonds to lose first as banks hit their minimum capital thresholds, but only after the equity holders were swept away. Here lies the polemic. These bonds got fully wiped out, while shareholders still received something from the sale to UBS. Therefore, AT1s turned out to be the lowest capital tier in Credit Suisse’s capital structure, which was not supposed to be their rank. While strange and suspicious, it was all completely legal according to Swiss regulations and, more specifically, to the covenants present in the footnotes of the bonds’ prospectus. Nonetheless, the rule of law got somewhat hit, and this may have consequences for this 275-billion-dollar market, mainly in terms of premia required by holders of these bonds in the future.
Despite the apparent calmness that surged out of the weekend’s developments, the week ended again with some turmoil. It feels like Fridays are being a great day for market disorder. This time we saw Deutsche Bank having both its stock drop significantly and its credit default swaps surge to price a probability of default of over 30%. The reasons are mainly threefold: (1) the weak banking situation in the US affecting the generality of Europe banks, following the US Treasury Secretary’s remarks during the week; (2) a Bloomberg report on a possible connection between both Credit Suisse and UBS to Russian oligarchs that curbed European financial sanctions imposed on the country, adding further pressure to European banks; (3) a possible over-exposure of Deutsche Bank to derivatives and to US commercial real estate.
One conclusion is clear: while the banking situation is not tremendously uncontrolled, we may need to have quite some time pass to fully restore confidence in the banking system, which is currently completely shaken up.
But as I said, this wasn’t the most dominant topic of the week. The main discussion revolved around whether the Fed would deliver a “dovish hike” or a “hawkish pause” on its Wednesday FOMC meeting. Simply writing this makes my head spin.
For those unfamiliar with the language, here’s a quick brief: a dovish policy-maker feels that financial conditions shall ease, or at least not be as tight as others expect. This reasoning goes along with desired interest rate cuts or smaller-than-consensus increases. On the other side, a hawkish policymaker thinks that conditions are too loose to combat inflation or high asset price levels. They tend to call for higher increases in the respective Central Bank’s policy rates.
So, how can we be in this dilemma between a “dovish hike” and a “hawkish pause”? The market was playing with words and gaming this Fed’s decision. We were playing mind games. I am Portuguese, so I have to say it: it looked like José Mourinho, the football master of mind games, would be the perfect fit for a Central Bank governor (have I already mentioned that my brain is damaged by all this?).
What is certain is that this was a binomial choice: a dovish pause would frighten the market to death. The rhetoric would be “what does the Fed know that we don’t?” in terms of the banking situation and its effects on systemic risk. A hawkish hike wouldn’t be well-digested either: the banking system is collapsing, and the Fed is making sure it won’t get out of the coma just to get inflation back into control, disregarding the huge possible impact of this instability.
Then what did the committee do after all? They went for what the market was generally expecting. A 0.25% rate increase was 80% priced in, and so decided the Fed in a unanimous way. The case for 25 was convincing, more easily explainable, and less panic-prone. While a pause would be mainly regarded as a way to avoid harming further the banking system, it wasn’t free of second interpretations: the same as those for the dovish pause explained before. So, it had to be combined with sound and sensible communication in the Fed’s statement, the press conference, and the summary of economic projections (SEP) released on the same day.
A 25 basis-point hike didn’t need such carefulness. Inflation had to be dealt with by monetary policy, while the restoration of confidence in the banking system would be covered by the liquidity facilities announced on Sunday the 12th. The dovishness of the hike came mainly in the statement. From the previous reading, the FOMC dropped the reference to “ongoing rate increases” and substituted it with “additional policy firming”: a vague wording that no one really knows what means: and that was the objective – to not commit to anything in the future.
The quietness in terms of headlines coming out of the post-decision conference was notable. Nothing that Jerome Powell said was a trigger to any kind of movement. Not even a hubbub. Surprising may not be the best term to describe it, but it certainly was unusual.
We had started to get used to the fact that there was always something stated in the press conference that would shake the markets. The decisions had almost always been consensual and assertive, but presenting and discussing them normally had not been that much.
It reminded me of my basketball team for the Bocconi’s Intramural tournament, where the exact opposite happens: we are world-class at discussing tactics, but terrible at applying them. If we gave press conferences you would be impressed by our clarity, but if you saw our decisions during games you would want to run away. Probably we may also need Mourinho as a coach to guide us to winning standards. Or would it drive my brain even crazier?