While it’s easy to believe that the mess around Silicon Valley Bank and its UK branch is only of interest to members of the tech community and finance nerds, it’s already having a very real impact on all of our lives.
The evidence is in the money markets, where investors are betting on the future path of interest rates.
Until last Friday, they expected UK rates to peak at around 4.75% – perhaps even a bit higher.
but Shock of bank failures caused a sudden re-evaluation. By Monday night, their pricing peaked at just 4.25% — a pretty steep drop under those plans. The story is similar in the US, where expected peak interest rates have fallen by about half a percentage point.
Why are the two stories – interest rates and an unnamed bank failure – colliding?
That’s largely because they’ve always intertwined — not that no one hadn’t paid much attention to them before last week.
part of the reason Silicon Valley Bank (SVB) collapsed after rising interest rates caused the value of the bank’s bond holdings to fall precipitously over the past 18 months.
In large part, it was these losses and the impact on SVB’s balance sheet that prompted depositors to flee the bank late last week (which in turn triggered UK branch closed).
In other words, one of the consequences of the implosion of the SVB is that the Fed and the Bank of England may become more cautious in raising interest rates in the future.
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Everyone knows that there are unexploded bombs in the financial system that start to explode when money gets more expensive; the fear now is that there may be more explosions.
This is not the only explanation for the drop in interest rate expectations. Then there’s the fact that the dislocation of SVB, Signature Bank (which also failed) and much of the US banking system could dampen growth and even trigger a recession.
And, in most cases, central banks tend to cut rates rather than raise them in the face of a recession. We are already close to a potential peak in borrowing costs.
Even so, this interplay between a strained financial system and interest rates is an important part of the story.
This has some consequences for us.
‘Things can get really tough’
Let’s assume that the Fed and Bank of England will indeed allow interest rates to peak at a lower rate than previously expected.
Does this mean we have to expect higher inflation going forward? What if inflation turns out to be much stickier than most central banks expect (they mostly think it will come down soon)?
The short answer is that things can get pretty tricky: the Bank of England has a responsibility to try to keep inflation low and to try to keep the financial system stable, but among many things the SVB episode illustrates, these two goals can sometimes conflict with each other.
In this case, higher interest rates (to fight inflation) lead to financial instability. Yes, there are many other things going on besides this – there are good reasons why the Fed is not doing enough to monitor the risks posed by unusual banks like SVB – but the rising cost of funds is a big part of it part.
good news and bad news
If inflation does turn out to be much higher than the central bank expects, then we could be heading into a more volatile period.
How worried should we be about this? The next few months will tell, but for now there is good news and bad news.
The good news is that headline consumer prices in both the UK and the US appear to be more or less beating central bank expectations – falling gradually. earlier today, US CPI annual rate 6% – In line with expectations.
The bad news is that when you look beneath the surface, there are signs that inflation may be more stubborn than expected.
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In particular, core inflation — the behavior of prices that strip out volatile items like energy and food — is still rising, especially when you ignore housing costs. This suggests that there is still upward pressure on prices.
Sure enough, interest rate expectations rose slightly in both the UK and the US immediately following the release of these data.
Now, the peak UK rate is expected to be not 4.25%, but 4.4% (which actually means that quite a few people – though not everyone – expect rates to be 4.5%).
In short, we are in for a bumpy few months.