Following the long period of unusually low interest rates, there was a concern at the market that when the central banks shall increase the interest rates unexpectedly, it might result in certain negative outcome. Developments at the global financial markets in the past two weeks (failing of several banks in USA and saving of Credit Suisse in Europe), have served as sharp reminder that still there is a need for compromise between tightening of the monetary policies and maintenance of financial stability.
First, the American bank, Silicon Valley declared a sale plan on the 8th of March for its shares in amount of 2,25 billion USD, at the same time declaring significant losses of its investment portfolio. As a follow up, the next day already, the shares dropped by 60%, whereby the Federal Deposit Insurance Corporation (hereinafter the FDIC) reached a decision that this bank to terminate its operation.
Although Silicon Valey was not considered as a systemic important bank, still its illiquidity has forced the Federal Reserves to act in order to prevent further “systemic infection”. Rapid intervention by FED, which managed to provide whole deposit guarantee, as well as to provide additional liquidity for other endangered banks (by valuating their collateral, treasury bills and bonds of USA per nominal price), indicates to considerable concern in relation with the “financial infection” which might possibly follow up.
Similar faith was experienced by another US bank, Signature Bank on the 12th of March. Namely, this is the 3rd largest bank in the USA history which declared bankruptcy, mainly as a result of rapid withdrawal of around 20% of entire deposit base. Though this bank has not had high exposure to the crypto market, still the regulator lost confidence in the bank management and it ended up under FDIC monitoring.
In continuation of the above mentioned events, the concern around bank system stability has rapidly spillover the Atlantic, resulting in fall of the 2nd largest bank in Switzerland and 19th in Europe, Credit Suisse, and established 167 years ago. This bank was losing the confidence by investors and clients for years, and it culminated last week on March 16th when this banking giant has completely lost the confidence by the clients. Shares of this bank fell by 25%, funds from the investment funds it managed were transferred, and at one moment the bank account owners were drawing deposits in amount of more than 10 billion USD per day. Emergency loan in amount of 54 billion Swiss Francs by SNB was insufficient to prevent the outflow of assets, so the Swiss authorities and the central bank enabled, as only solution, that the bank USB undertakes Credit Suisse for an amount of 3, 25 billion USD, for sole purpose to provide financial stability and prevention of possible domino effects which could spillover to the European banking sector.
Taking into consideration these events, the entire attention of the investors and the financial markets was moved toward the direction in which the monetary policies of central banks, predominantly FED and ECB, might move in future.
At the ECB meeting held on March 16th, the concern around high inflation was more in the focus than the financial stability. In view of downsizing the inflation, the ECB, as indicated, reached decision for increase of the principal interest rates of 0,50pp by which the interest rate of the deposits raised to 3%. Explanation for such decision is that the inflation (especially the basic) is projected to remain higher for a longer period compared to the initially anticipated. According to the latest analysis, the inflation rate in the Eurozone is expected by 2025 to be above the targeted level of 2% of ECB. On the question, in which direction the monetary policy would be moving in the next period, the President of the ECB (unlike at the previous meetings) did not offer clear response and emphasized that the decisions shall be based on updated economic and financial data, principal price growth, as well as the level of transmission of the monetary policy to the real economy. Although ECB has not indicated what could be the decision at the next meeting due in May, still certain projections indicate to two more increasements of the principal interest rates of 0,25 percentage points in May and July, whereby the deposits would reach 4%. Expectations are that they shall be maintained at this level until the end of the year, and the possible reduction might be expected at the beginning of 2024 at earliest.
Following the meeting of ECB, the entire focus of investors and the financial markets turned to expectations of the decision by the FED, i.e. direction in which the monetary policy shall move to. In spite of the concern that the higher interest rates could endanger the stability of the banking system, still, at the meeting held on March 22nd, FED continued its one-year old fight against high inflation by increasing the principal interest rate by 0,25 percentage points. At the meeting, FED warned that the financial turnover, resulting from the collapse of the two large banks, shall probably result in more severe credit terms and shall have impact over the economic activity, employment and inflation. In addition, at this meeting FED signalized that the end of the growth policy of interest rates might be insight, by which the panic in the banking sector could be reduced, both in USA and in EU. As per the new projections, at the next meeting in May, there could be another and maybe last increase of the interest rates of 0, 25 percentage points, i.e. reference rate which would amount 5% – 5,25%. Accordingly, any possible relaxation of the monetary policy would be expected no sooner that end-2023.
Fears from the increased systemic risk also reflected over the world currency markets, wher during the past period high volatility of currency was noted with G-10 economies currencies. Following the press conference of FED, USD fell relative to EUR and reached level of 1.0920 USD for 1 EUR. According to the current consensus between several financial institutions, currency pair EUR/USD would be moving in the following direction: 1M 1.07; 3M 1.08; 6M 1.10; 12M 1.11. Projections for movement of the currency pair EUR/USD at the end of the year should be taken with a considerable amount of reserve, because at the moment, there is high uncertainty about future prospects of the world economy.
Recent developments have emphasized the compromise that the central banks should make in terms of monetary policy maintenance. More moderate growth of interest rates having in mind the risk of endangering the stability of the banking system, as well as the influence over the entire global and economic growth, or continuation of the tightened interest terms as a response to the durable inflation.