Silicon Valley Bank collapse reveals cracks emerging in the system

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Good morning,

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It was the collapse heard around the world, quite literally.

Since Silicon Valley Bank (SVB) was put into receivership on March 10 regulators in nations from the U.S. to China to Canada have been scrambling to ensure contagion doesn’t spread through the global financial system.

Banking regulators closed the California-based lender, which specializes in venture capital and tech start-ups, amid a run on deposits, the largest bank failure since the global financial crisis.

Two days later another U.S. bank, Signature was closed by authorities after a similar run, becoming the third largest bank failure in U.S. history.

The reaction around the world has been startling and the news continues to pour in this morning.

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The Silicon Valley Bank was unique enough that most are hopeful global contagion won’t spread from its collapse. But many also believe it is a sign that cracks are finally showing in the financial system after the steepest run-up in interest rates since the 1980s.

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“Amid the rapid-fire rate hikes of the past year, many financial commentators were steadily looking for any cracks to emerge, as almost inevitably happens amid every serious monetary tightening cycle,” said BMO chief economist Douglas Porter.

“Given the massive 450 bps of hikes in under a year, perhaps the big surprise was the near absence of such cracks — at least until now. The Silicon Valley Bank’s woes may not have been directly related to the ultra-aggressive rate hikes, but they are clearly a side effect.”

Fed funds futures rate expectations reacted quickly to news of the bank’s failure, betting it would spur the Federal Reserve to pull back. Markets on March 10 were predicting a lower peak to Fed hiking and rate cuts later this year.

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The saving and loan crisis, Asian currency crises, the bursting of the dot com bubble and the U.S. housing crash that triggered the great financial crisis were all at least in part triggered by the Fed hiking interest rates, said Paul Ashworth, chief North America economist for Capital Economics.

Recession quickly followed most of these events.

Capital says even if SVB doesn’t trigger contagion in the global financial system, it could still lead to a tightening of credit conditions that could tip the economy into recession.

“It is a timely reminder that when the Fed is singularly focused on squeezing inflation by jacking up interest rates – it often ends up breaking things,” wrote Ashworth.

“Regardless of whether the problems show up first in the real economy, asset markets or the financial system, they can trigger an adverse feedback loop that develops into a hard landing, which takes down all of them.”

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Capital still considers a “softish” landing the most likely outcome, but it acknowledges risks to their view are mounting. The chance of a severe recession is now much higher that the risk of “no landing” where the economy and financial markets continue to shrug off the impact of higher rates, Ashworth said.

Two things will matter in the days ahead, said Neil Shearing, Capital’s chief economist.

First whether authorities can maintain confidence of depositors and investors in the U.S. banking system.

“We think the steps taken by the Fed, Treasury and (the Federal Deposit Insurance Corp) will decisively break the psychological ‘doom loop’ across the regional banking sector,” Karl Schamotta, chief market strategist at Corpay in Toronto, told Reuters.

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“But, fairly or not, the episode will contribute to higher levels of background volatility, with investors watching warily for other cracks to emerge as the Fed’s policy tightening continues.”

Second, whether there any other institutions with similar vulnerabilities to SVB out there.

Only time will tell on that one, said Shearing. “As the old adage goes, it’s only when the tide goes out that you see who has been swimming naked.”

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Canada gained almost 22,000 jobs in February, more than double forecasts, but a far cry from the 150,000 new jobs in January. Nonetheless, the gain was another sign that the economy is starting the year with more momentum than expected, said CIBC economist Andrew Grantham.

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“With the unemployment rate also remaining at a historically-low 5.0%, and wage growth accelerating by more than anticipated, there’s plenty of reason for the Bank of Canada to leave the door open to future rate hikes,” said Grantham. “However, we still think that the economy will cool enough later in the year to prevent policymakers from needing to walk through that door.”

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For those who get paid biweekly, March might be a month when you get that “extra” paycheque. Credit counsellor Sandra Fry has some suggestions on how to use that cash to make a real difference in getting on top of your budget.

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Today’s Posthaste was written by Pamela Heaven, @pamheaven, with additional reporting from The Canadian Press, Thomson Reuters and Bloomberg.

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