Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
The guessing game is on
Peter Garnry
Chief Investment Strategist
Summary: Equities reacted initially on a positive note to the US government bailout of uninsured deposits at the now failed banks SVB Financial and Signature bank. However, the immediate sigh of relief has been substituted by one big guessing game of what happens next. The financial system is extremely complex and nobody knows what will happen next. We go through the cross-asset moves in today's trading session and explains the current dynamics unfolding including which indicators investors should be watching.
Nobody knows what happens next
The fallout from SVB Financial as we wrote in our Friday equity note The deposit game: A warning shot has been fired is a massive unknown at this point. When a crisis like this comes out of the blue for regulators it means that this is big hidden risk in the system. The equity market initially celebrated the full backstop of uninsured deposits at SVB Financial, the HSBC takeover of SVB’s UK unit, and the inclusion of Signature Bank (which was taken over by US regulators yesterday) into the deposit backstop. But the mood quickly reversed with banking stocks falling in Europe and US banks down in pre-market session. Bond yields are coming down, further Fed and ECB rate hikes are being significantly reduced in futures markets, the USD is weaker, and interbank stress is rising. Listen to our podcast from today and our QuickTake from this morning for more cross-asset perspectives.
The most significant movement we are observing in the market is the plunge in short-term bond yields with the US 2-year yield trading 4.08% down 50 basis points. Corporates, which are the biggest holders of uninsured deposits, are most likely converting on a large scale deposits to short-term bonds. This is naturally increasing the risk in the system as it drains the banking system for deposits for some financial institutions. As we highlighted in our equity note on Friday, we are observing a very unique situation with deposits in both the US and European banking systems falling the most ever observed over the past year. According to a Wall Street Journal article in early March US bank deposits fell on an annual basis for the first time since 1948. Not even during the S&L crisis or the Great Financial Crisis caused this drainage of deposits.
Key indicators to watch
Interbank market
Due to the conversion of deposits in the system there is a lot of pressure on funding. This is measured by the FRA-OIS 3-month spread. This spread measures forward rate agreements (FRA) pricing among financial institutions relative to the risk-free overnight rate. It thus measures the stress in the interbank market. It is important to note that there are other indicators on the interbank market and this indicator does not reflect the full picture.
VIX level and forward curve
Equity options are another part of the market worth watching these days as equity options were relatively relaxed well into Friday’s session before they finally began to move. The VIX Index has jumped to ~30, the highest level since late October, and the VIX forward curve is now the most inverted since the lows during the start of pandemic.
Banking stocks
US and European banks are of course the epicentre of the ‘deposit game’ and thus investors should monitor these two markets. We have highlighted the Lyxor STOXX Europe 600 Banks UCITS ETF and iShares S&P US Banks UCITS ETF below on a 5-year total return performance chart.
Private equity
Listed private equity firms were one of the hardest hit parts of the equity market on Friday and one of the hardest hit segments again today. Like venture capital firms the private equity industry relies on smooth access to capital markets and funding. Contrary to 2008 the private equity industry is much larger today and thus a much bigger risk to the financial system and economy than ever before.
Italian yield spread and equities
Based on today’s price action it is clear that the market is the most worried about Italy so investors should also be tracking Italian equities and Italian-German bond spreads.
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