“Beware the Ides of March”
Not just a Shakespearean tragedy but this year, a warning sign for the banks and the wider economy that rising interest rates and the end of ‘easy money’ brings with it considerable risk.
The recent banking crisis, which began on March 8th when Silicon Valley Bank (SVB) announced its intention to raise more than $2B to shore up its balance sheet, is now contained.
But the SVB story is a sobering one for global banks.
Although this crisis may be a storm in a teacup, it raises important questions about regulation and the inherent risks due to the increasing financialisation of the commodities complex.
The 2023 Banking Crisis
“You don’t find out who’s been swimming naked until the tide goes out”Warren Buffet
Warren Buffet’s immortal words from 1994 have never been more prescient. The tide (of interest rates) went out at a record pace, and it exposed financially fragile entities.
Not just SVB, but the crypto-currency-focused Signature and Silvergate Banks, a $30bn rescue package for First Republic, and in Europe, Credit Suisse was finally forced to admit defeat and submit to a hasty merger with UBS.
SVB was the second largest bank failure in US history, and it was quickly followed by the third, Signature Bank. Both succumbed to classic bank runs as depositors withdrew large amounts of capital.
In SVB’s case, it was a victim of its own success. From 2018 to 2022, its deposit base went from $49B to close to $200B, reflecting the booming tech sector where most deposits originated. However, the bank’s meteoric rise was undermined by a catastrophic failure in risk management.
SVB took its deposits and invested in 10-year US treasuries, not a bad prima facie bet, but timing is everything and shortly after SVB made its decision, the Fed started raising rates.
Time, tide (and interest rates) wait for no-one
In March 2022, very few market-watchers were predicting interest rate increases at the speed and scale we’ve seen in the last year, and the board at SVB certainly weren’t. The pace of global interest rate rises since the beginning of 2022 has been relentless, with the Fed raising rates 9 times in the last 12 months, from 0.25%-0.5% to 4.75%- 5%.
SVB is far from an isolated case.
The US Federal Deposit Insurance Corporation (FDIC) estimated that at the end of 2022, banks held $620B in unrealised losses on longer-term securities, like bonds, with many using the accounting method ‘held to maturity’ to ensure that they don’t have to declare any losses from the declining value of their bonds. No losses on the balance sheet, but they do have to hold them until they mature.
SVB’s unique case
For most banks, these unrealised losses don’t present a problem in the near term, as long as confidence in the banking system doesn’t fall further, but what made SVB’s case unique was the size of its uninsured deposits (accounts over $250k) and its overexposure to the funding crunch impacting US tech start-ups.
The financial intelligence firm GlobalData estimate that VC deal volumes dropped by almost 60% between January 2022, and January this year.
As funding dropped, SVB’s depositors started to get nervous and began to draw down their deposits from the bank.
Over 90% of SVB’s deposits were greater than $250k, meaning that once the tech liquidity crunch came, those depositors were particularly nervous. That trickle of withdrawals became a flood, and SVB were forced to offload USD24bn of bonds, recognising a loss $1.8B in the process.
The bank announced this loss, and a planned capital raise to plug it, on Wednesday, March 8, but this didn’t calm their customers, who attempted to withdraw $42B in deposits. By Friday, SVB had been taken over by the FDIC.
48 hours that shook the markets
The fact that a bank with $200B in assets capitulated in 48 hours shocked the markets, policymakers and depositors, and the fear of contagion quickly spread.
The data we had for the week of March 15 showed that there was $125bn in deposit flight from small banks (outside of the top 25 with assets <$100B) and a small increase in the deposits of large banks (top 25 banks with assets >$100B). Most of those deposits have gone to money market funds (MMF), which now hold the most assets under management (AUM) on record at $5.1T, up $300B in the last month.
While the deposit flight from US small-cap banks has stopped – the latest figures for week up to March 22 show that deposits actually increased by $6B – the past few weeks have exposed a glaring weakness in how some have managed their balance sheets. SVB, Signature Bank and First Republic have dominated the headlines, but many more have been caught flat-footed by the rate hikes.
As the fear of contagion spread to Europe, the banking crisis in the US was the final straw for investors in Credit Suisse. Too big to fail but too wounded by a series of scandals, losses and failed restructures to continue operating, the Swiss Government and National Bank stepped in and orchestrated a merger between Credit Suisse and UBS, creating a financial behemoth with $5T in AUM after the deal.
The big questions to consider now are:
• Has the danger of the banking crisis passed?
• And what challenges does the March crisis pose for commodities?
Is the banking crisis behind us?
The immediate threat of the March banking crisis has now passed, but financial markets in the US and Europe are still febrile, and the capital inflows into MMFs suggest that confidence in the banking system is low.
Question marks remain about the future of First Republic Bank, which was propped up by loans from some larger banks led by JP Morgan on March 16.
Deutsche Bank has also seen significant volatility in its share price, and a significant rise in the cost of insuring its debt against default, amid speculation that it may need European Central Bank intervention at some point.
The immediate risk of contagion may be contained, but the drop in deposits and confidence in the banks will lead to an incremental tightening of lending conditions.
The US Fed said last week that:
“Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”
Further Fed tightening would continue to ‘lower the tide’ and potentially expose other institutions.
Is there a contagion risk to commodities?
Whether the banking crisis will push the US closer to recession has been an issue weighing on some commodities markets in recent weeks.
The petroleum complex endured one of its most volatile weeks for a decade between March 7 and March 14.
Hedge funds and other money managers sold the equivalent of 139 million barrels in the six most important futures and options contracts over the main week of the crisis, preparing for tighter credit conditions and a possible US recession.
However, the banking crisis has again underlined a more systemic challenge across the commodities complex: the increased financialisation of commodities markets and the risk of contagion from financial markets to commodities.
The return of the macro funds
In 2022, we saw macro funds return to the commodities markets, attracted by price volatility. Unlike the specific sector expertise of our traders at Engelhart, these funds are often trading on price alone and have no interest or understanding of the underlying physical asset or supply and demand fundamentals.
This speculation injects spurious price signals into the market and can move prices far from the level justified by the fundamentals for extended periods.
Similarly, in 2023, commodities have been one of the favoured instruments for asset managers and macro funds as an inflation hedge and to provide exposure to the Chinese “re-opening”. The latter was widely anticipated to drive a jump in commodity demand.
You can read more about our perspective here: China Reopened: Where Next for Commodities in 2023?
The most recent banking crisis was viewed by many, alongside the Fed’s rising rate policy, as another potential way to temper inflation, reducing the need for commodities as an inflation hedge and weighing on risk assets in general.
The Chinese reopening has also arguably been disappointing in terms of incremental commodity demand, which has led to the unwinding of bullish commodity bets by many macro funds and injected more volatility and uncertainty into the markets.
Both factors have underlined how sensitive key commodities markets are to the macroeconomic environment.
The macro risks and opportunities are clearly driving flows across the asset class, leading to new types of volatility often unfamiliar to conventional commodity traders.
At Engelhart, one of our most important areas of research is the tracking, analysis and modelling of investor flows in commodities and the extent to which they cause prices to decouple from fundamentals.
The financialisation of commodities isn’t new
The 2000s commodities boom was probably the first indication of how commodities markets were becoming more financialized by the inflow of funds from investors, including pension funds, insurance companies, and other institutions like macro hedge funds. Inflows grew from $15B in 2003 to $250B in 2009.
That scale of institutional money flowing into commodity markets exposed commodity prices to the investment behaviour of financial investors; it drove prices to record levels because of speculation and then sent them crashing after the 2008 Financial Crisis.
Although this banking crisis now looks largely contained, with no real contagion to commodities markets, it’s served as a useful warning for commodities investors. Financial markets and commodities are more closely aligned than they have been for years as the big macro funds have once again increased their exposure to commodities
The banking crisis may well have been a ‘storm in a teacup’, but the full story may yet take time to play out, and the systemic risk of contagion remains a real risk for the rest of 2023.