1. Why has money been so cheap for so long?
To prevent the 2008 global financial crisis from triggering a depression, central banks used low interest rates and other measures to boost business activity. They kept rates low for years in the face of a noticeably anemic recovery, then turned the taps back on when the pandemic hit: The Fed cut rates back to near zero, not raising them until March 2022.
2. What did this lead to?
It helped fuel a period of exceptional growth in U.S. financial markets, barring the brief, sharp pandemic slump of 2020. The U.S. stock market rose more than 580% in the wake of the financial crisis, driven by price gains and dividend payments . It also led to a massive increase in corporate and sovereign debt. From 2007 to 2020, public debt as a percentage of gross domestic product rose from 58% to 98% worldwide, and non-financial corporate debt as a percentage of GDP rose from 77% to 97%, according to data compiled by Ed Altman. Professor Emeritus of Finance at New York University’s Stern School of Business. In pursuit of better yields than safe-haven debt such as short-term government bonds on offer, investors flooded companies with cash and bought bonds from risky companies that paid higher yields while ignoring their lower credit quality. But despite rising debt, inflation has remained subdued in most advanced economies – in the US it rarely reached the Fed’s 2% target.
Inflation came with a roar in 2021 as pandemic restrictions eased while supply chains remained disrupted. In 2022, inflation, exacerbated by energy shortages and Russia’s invasion of Ukraine, reached over 9% in the US and 10% in the European region. Led by the Fed, central banks began raising interest rates at the fastest pace in over four decades. They aim to slow growth by reducing consumer demand, and in return hope prices will cool as well. Between March and November, the Fed raised the cap on the interest rate it uses to steer the economy, known as the federal funds rate, from 0.25% to 4%. Before the banking crisis, economists assumed that the central bank would raise interest rates above 5% and stay there for most of the year.
4. What has this meant for investors and markets?
After rate hikes began, the US stock market fell as much as 25% from its peak as investors braced for the slowdown that rate hikes were likely to bring. The pain was particularly concentrated in the technology sector, where both stock prices and employee numbers had soared during the pandemic. Bond prices fell the most in decades as the prospect of new issuance with higher yields made the value of existing low-yielding bonds less valuable. Both investment-grade and high-yield companies are reducing their borrowing. One of the most interest-rate-sensitive areas of the US economy, the housing market, saw sales fall sharply.
5. How did this cause financial hardship?
In September, a hedging strategy routinely employed by UK pension funds failed as government bond yields rose faster than the funds’ models allowed. The Bank of England’s intervention was needed to calm the market turmoil. Then, in March, the collapse of the Silicon Valley Bank (SVB) also involved rate hikes, but in a different way. It had invested more than half its investment portfolio in long-dated government bonds and other so-called agency bonds, far more than other large banks. These long-term bonds paid a higher yield than shorter maturities. But like other long-dated bonds, their value had fallen sharply. That might not have mattered in better times, when the bank could have held the bonds to maturity. But when its tech-heavy clientele began withdrawing funds to offset the slowdown in venture capital investment hitting the sector, SVB was forced to sell a large chunk of its portfolio at a $1.8 billion loss. News of this triggered an exodus of deposits, almost all of which were uninsured, leading to their closure on March 10.
6. Can this lead to a financial crisis?
Lending rules were tightened after the credit market collapse in 2008, particularly for the largest banks, boosting confidence in the resilience of the financial system. But no bank was unaffected by the interest rate changes: At the end of 2022, banks had suffered losses of $620 billion on their holdings, according to the FDIC. SVB’s collapse came days after the collapse of Silvergate Capital Corp., a bank specializing in services to crypto customers. Two days after the SVB was overthrown, New York state regulators were so concerned about accelerating deposit outflows that they ordered another mid-sized institution, Signature Bank, to shut down. Federal regulators were concerned enough to invoke emergency powers, to say federal deposit insurance would cover all deposits at both banks, and to announce changes to the Fed’s lending programs intended to support banks whose portfolios were falling in value had. Bank stocks fell around the world as Credit Suisse’s share price plummeted before the Swiss National Bank announced it would make up to $54 billion available.
7. What other damage can it cause?
The risk is that the turmoil in the banking sector could exacerbate the credit crunch already started by interest rate hikes. Lenders were expected to be more concerned with supporting their own finances than providing the credit that allows economies to grow — even without a systemic bank collapse. JPMorgan Chase & Co. estimated that the US economy would face a possible half to a full percentage point contraction in gross domestic product due to slower credit growth following recent banking sector woes. The worst outcome would be a collapse of a giant bank, drying up the flow of credit and almost guaranteeing a recession.
8. What does this mean for the Fed’s plans?
It certainly complicates them as market activity reflects. Global government bond yields tumbled as mounting concerns about financial stability prompted bond traders to abandon their bets on further central bank rate hikes and begin pricing in rate cuts by the Federal Reserve. Stress in the global banking system is expected to test the Fed’s resolve to continue raising interest rates in a bid to contain inflation. At the same time, a series of economic data showing that both inflation and growth remained strong indicated that the pressure to continue raising interest rates is likely to persist.
9. What does a credit crunch mean for consumers and businesses?
The impact of rate hikes that started in early 2022 was felt towards the end of the year. For US companies, average yields for newly issued investment-grade bonds rose to around 6% by November and for high-yield bonds to almost 10%. Added to this were higher labor costs, particularly in sectors such as healthcare. Homebuyers faced significantly steeper monthly payments as the interest rate on 30-year fixed-rate mortgages topped 7%, its highest level in two decades. And despite significant wage increases for US workers over the past two years, record inflation has begun to eat away at wages. Outside the US, the Fed’s rate hikes also strengthened the dollar against other currencies, meaning dollar-denominated government and corporate bonds in emerging markets became much more expensive to redeem. The questions raised by the recent financial turmoil are whether the local and regional banks, which provide much of the nation’s small business and consumer lending, are retreating in a way that slows growth — and whether the economy as a whole is more likely to slide into recession becomes .
10. What are the risks of company failures?
Easy access to money in the US has led to ever-increasing levels of debt among the riskiest corporate borrowers, particularly those owned by private equity firms. A commonly cited measure of leverage to earnings has increased over the past 10 years in the leveraged loan market. This means that portfolios of collateralized loan obligations, i.e. loans bundled in bonds, are also increasingly exposed to risks. Zombie firms—companies that don’t earn enough to cover their interest expenses—have become increasingly common around the world. Companies that have relied on venture debt from Silicon Valley Bank could also find themselves in trouble in the absence of the bank’s specialty loans. Generally higher costs – for capital, labor and goods – have raised expectations that the default rate will rise, particularly for highly indebted companies.
–Assisted by Christopher Anstey.
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