Gareth Gettinby: High interest rates continue to cause volatility

In turn, the higher interest rate environment is now testing the strength of the banking sector.

More than a month has passed since banking stresses hit the headlines, firstly in the US with Silicon Valley Bank (SVB), Signature Bank and, latterly, First Republic Bank all collapsing.

The turmoil then spread to Europe, and troubled lender Credit Suisse − a 166-year-old banking institution − as investors deemed it to be too risky of default in the high-rate environment. The Swiss National Bank engineered a forced takeover by its Swiss competitor, UBS. Markets were consequently reassured as authorities in both regions responded with speed to ensure the any banking crisis was contained.

The global banking sector is on a much stronger footing than in the 2008 great financial crisis (GFC), as the system is better managed, with more rigorous regulation and much higher capital and liquidity levels.

However, while the risk of a repeat of the GFC is highly unlikely, further challenges are to be expected in this higher interest rate world. US interest rates have risen at speed, from near zero at the start of last year to a target range of between 5% and 5.25% - the highest since mid-2007. This sharp increase will have unintended consequences for many other sectors, including real estate and private equity, where refinancing costs are vulnerable to higher interest rates.

Credit conditions have also tightened. Liquidity has been withdrawn from the system, which has caused bank lending to non-financial corporations to decline. For example, money supply in the UK, US and Eurozone has fallen sharply, with the US falling at the fastest pace since the 1930s.

Credit conditions are likely to tighten further, particularly if the US economy becomes increasingly recessionary, as more banks will need to strengthen their balance sheets. This will result in a higher cost of capital and less available credit, which will accelerate a decline in corporate earnings and likely push unemployment higher.

While inflation has undoubtedly peaked in the US, core inflation remains elevated (particularly due to food and services) and is significantly higher than the US Fed’s 2% target.

At the same time, unemployment is historically low, which means it is somewhat difficult to justify financial markets pricing-in rate cuts in the US later this year (0.75% cuts are priced-in by the markets by year-end).

Notwithstanding a financial crisis or a deep recession, the Fed is unlikely to pivot and reverse its hiking drive as fast as the market expects. It will hold interest rates higher for longer to eliminate any remaining inflationary pressures.

High inflation aside, one upcoming threat to markets is a potential US debt crisis. This will intensify during the summer months as the US will likely breach its $31.4 trillion debt ceiling, which requires a legislative solution.

In recent history there have been three debt ceiling crises of note in the US – 1995, 2011 and 2013. Of these, 2011 has the most similar backdrop to today: an economy recovering from a crisis that involved massive stimulus, and a comparable political landscape. The 2011 US debt crisis was a risk-off event that saw equity markets fall sharply, high yield spreads widen, and traditional haven assets in demand.

Currently, Democrats and Republicans remain divided over how to resolve the debt ceiling. If there is little progress on negotiations and fears of a US default increase, risk assets will feel the brunt. This will only be exacerbated by an increase in US recession risks and further credit tightening.

The risks to the global economy are, therefore, skewed to the downside, particularly as credit conditions continue to tighten.

Banking stresses seem not to be abating as further price pressure continues on US regional banks. The challenges of higher interest rates will bring increased volatility for financial markets as cracks develop.

Gareth Gettinby is an investment manager at Aegon Asset Management