Taking Stock: The Fed – love thine enemy

The Fed raised its funds rate by 25bps to a target range of 4.75-5% yesterday, in a sign of confidence that it does not believe a financial crisis is upon us. Rather, it said, policies are in place to absorb and deal with any further bank runs, and inflation remains our prime concern.

Treasury yields fell across the yield curve. Stocks fell too. But was this the effect of a slightly hawkish Fed statement, increasing the risk of recession? Or was it in response to a simultaneous statement by Treasury Secretary, Janet Yellen that new bank regulations are being considered?

Embracing the crisis

Jay Powell argued that there is no threat to macroeconomic stability (the banking system is ‘sound and resilient’) arising from the bank crisis. And because of the crisis, there is no need to raise rates by the 50bps thought likely by the market just a few weeks ago. The banking crisis is equivalent to a rate hike, as it is tightening credit conditions.

And so the bank crisis can help in the war on inflation. It is ‘love thine enemy’ time.

The Fed’s growth and unemployment projections are still based on a soft landing scenario (unemployment peaking at 4.6% late this year, GDP growth falling to 0.4% this calendar year, followed by 1.2% next year). With inflation falling steadily – core PCE is to fall below 3% next year, according to a consensus of economists.

The bond market thinks differently, judging by the 50bp 2yr/10yr yield inversion, which many economists believe is predicting a recession. Some, such as Danny Blanchflower*, believe the Fed will be forced into a policy U-turn, and there will be cuts by the autumn. This contrasts the Fed’s news dot chart, which suggests a further hike to come.


The Fed’s hike validates the rate hikes seen elsewhere, such as last week’s ECB 50bps hike last week, at which chair Christine Lagarde also reiterated her determination to focus on inflation.

The Bank of England,** which was thought ready to call an end to its rate hikes, may be feeling in need of a further 25bps hike when it meets today. This morning saw a surprise rise in February headline and core inflation, while growth-related data has been not-as-bad-as-expected.

Credit Suisse ‘CoCos leaves a bad taste in the mouth

Contingent convertible ‘Advanced Tier 1’ capital, otherwise known as ‘CoCos,’ were a form of hybrid bank capital introduced after the GFC. It is a junior bond that, when a bank’s balance sheet is under stress, automatically converts into equity. Equity that can absorb any losses.

CoCos proved popular with investors because they offer a higher yield than most other bank debt. This reflects the risk of them converting into equity and potentially seeing the share price shrink if losses have to be absorbed. Thanks to strong demand, banks have been big issuers of CoCos since the GFC, using them to boost their core capital ratios without having to issue equity (which dilutes existing shareholders).

But we now know that Credit Suisse CoCos came with small print that some investors didn’t read. Instead of converting into equity, they lost all their value.

They bypassed the equity stage. Oddly, while equity owners will get some share value from the merger with UBS, the CoCos owners will get nothing, losing CHF 17bn.

The idea of a bondholder ranking below an equity holder is unusual (unheard of) in finance. There is speculation that a group of Asian investors may litigate.

The problem for other banks is that Credit Suisse’s unusual CoCos may raise the cost of using them for other banks as investors become wary. And if the cost of bank capital goes up, bank profitability may reduce.

CoCos worked well for Credit Suisse the first time they were tested. But have left a sour taste in the mouths of investors in CoCos everywhere.

The risk of recession may have risen

Investors should remain invested in diversified, multi-asset portfolios that invest in bonds, equities and other asset classes. The risk of recession must be higher than the Fed allows, given the risk of further mishaps in the financial system while the Fed raises rates to fight inflation.

*Danny Blanchflower is a British-American labour economist and academic. He is a tenured economics professor at Dartmouth College, Hanover, New Hampshire.

** At the time of this market commentary going to publication, the Bank of England announced a 0.25bps interest rate rise.

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