US bank's tap Fed for US$165 bln in borrowing via the discount window and emergency loan program. Focus this week will remain on distress in funding markets; Uncertainty reins

Fears of bank contagion risk continued to grip the market at the end of last week. Key US and European equity market indices fell by over 1% on Friday, credit spreads widened, global rates tumbled back down towards the lows seen earlier in the week and the USD remained under pressure. The NZD finished the week on a strong note, outperforming to see it close near its high for the week, just under 0.6270.

At the end of a tumultuous week in markets, investors remained nervous about the outlook, with more US banks under the spotlight and investors fleeing for safer havens. First Republic Bank (FRB) was offered a liquidity lifeline by a number of major US banks with them contributing $30b worth of deposits – a signal of their confidence in FRB and a show of support for the banking system.  But this failed to calm investors, as its stock price came under further pressure, falling another 33%. All 22 banks in the KBW index fell by at least 3%, with over half of them down by over 5%.

There’s an old saying, “when the Fed taps on the brakes, somebody goes through the windshield”. After 450bps of Fed hikes, the casualties are starting to mount, with Silicon Valley Bank and Signature bank last weekend, and Credit Suisse and First Republic Bank following. Who’s next is the key question, and there is a long list of banks that could fit the bill, and after which we might add players in the US commercial real estate market.  A circuit breaker still seems to be needed to turn around confidence in the US banking sector in the face of significant deposit outflows towards money market funds and the larger banks.

One source of possible contagion risk has been quashed, with breaking news that UBS is reported to agree to buy Credit Suisse for about CHF2bn, at a fraction of Credit Suisse’s closing share price on Friday. The deal was negotiated over the weekend, brokered by the Swiss government, with the Swiss National Bank offering a $100bn liquidity line to UBS as part of the deal. Further details will emerge this morning and the deal will set the tone for markets in early trading this week.

On Friday, the Fed released data showing banks borrowed $165b, around $150b from the traditional discount window and $12b from the new emergency loan programme. Almost all of the borrowing came from the New York and San Francisco Fed districts. In addition, there were new loans of $143b to the new FDIC-owned banks that the FDIC set up to cover depositors of the failed Signature Bank and Silicon Valley Bank. In total, assets on the Fed’s balance sheet rose by about $300m, this expansion over the week unwinding about half of the Fed’s quantitative tightening program so far.

US Treasury yields showed chunky falls, reflecting safe-haven flows and as the market continued to re-evaluate the US monetary policy outlook. Debate rages on what the Fed will do at its monetary policy meeting this week. After all, tighter lending standards as banks hoard cash will be doing a lot of work reining in domestic demand over coming months.  A large majority of analysts see the Fed still hiking by 25bps, with a slight skew towards no hike over a larger 50bps move. Market pricing for the meeting closed at 15bps, suggesting slightly more chance of a 25bps hike than no change. However, the real debate is what happens after that, with pricing consistent with nearly 100bps of rate cuts from the June meeting – one possible interpretation being a reasonable chance of policy remaining on hold but tail risk of more than 400bps worth of cuts under a GFC Mark II-type scenario.

The 2-year rate fell 32bps to 3.84%, towards the lower end of the range seen mid-week, with a 75bps fall for the week overall. The 10-year rate fell 15bps to 3.43%, taking tis weekly fall to 27bps, so a significant steepening in the curve, a strong signal of pending recession following the extreme prior curve inversion. Reflecting global ramifications of the shock to the banking system, global rates were universally lower (Japan an exception), with short end-led falls in rates across Canada, UK and the Euro area.

The S&P500 fell 1.1%, with all sectors falling, led by financials. Still, the index managed to gain 1.4% for the week, with the plunge in interest rates more than compensating for the likelihood of a tougher economic environment ahead. The Euro Stoxx 600 index fell 1.2%, taking its weekly decline to nearly 4%, the underperformance reflecting the larger weight towards financials in the index.

The USD came under renewed pressure, with the DXY index down 0.7% on the day. JPY was the clear outperformer, on safe-haven flows and narrowing rate differential considerations, with USD/JPY back below 132. The NZD outperformed, with a steady gain through Friday and closing the week near 0.6270 and taking its gain for the week to over 2% – higher NZ-global rate differentials through the week supporting the currency in the face of weaker risk appetite. The AUD showed no further gain in overnight trading after gains through the NZ trading session, closing at 0.67 and NZD/AUD at 0.9355. Other NZD crosses were all higher, apart from NZD/JPY falling modestly to 82.6.

Economic data continued to play second fiddle but for the record, University of Michigan consumer sentiment fell to 63.4, with only a small part (15%) of the survey capturing the period of distress in the banking sector. More importantly, both short-term (1yr) and long-term (5-10yr) inflation expectations fell, the former at a near 2-year low of 3.8% and the latter at a 6-month low of 2.8%.

In China, the PBoC cut the reserve ratio requirement for most banks by 0.25 percentage points, to support lending growth and strengthen the economic recovery, continuing along the easier monetary policy path in train for some time now.

Domestic rates rose on Friday and continue to be whipped around by global forces. The chunky fall in global rates after the NZ close (the Australian 10-year bond future down 10bps in yield terms) sets the scene for lower NZ rates on the open. The domestic curves showed a flattening bias, with NZGBs up 10bps at the short end and 5bps at the long end. The 2-year swap rate rose 15bps to 5.14%, while the 10year swap rate rose just 4bps to 4.38%. Over the course of the week, NZ rates fell by much less than seen across other markets, raising the prospect of lower NZ-global rate differentials ahead once the dust settles and the relative value comes back into focus.

The week ahead begins on a quiet note.  The focus for the week will remain on US and European banks and conditions in funding markets, over-riding the economic calendar. Both the Fed and BoE meet this week. We’ve noted Fed policy expectations on rates but there will be also strong interest in what it does with its QT policy. Continuing QT and draining bank reserves doesn’t make a lot of sense against a backdrop of strong demand for liquidity from banks. Expectations for the BoE are finely balanced between no change and a step down in its rate hike cycle to 25bps.