Excavations across

• Bankrupt Silicon Valley Bank is unique in many ways.
• Other US banks are better diversified.
• Ten-year US interest rates are a full per cent below two-year rates.
• A shrinking money supply and a falling housing market could push inflation towards 2 per cent relatively quickly.

Last week, the 16th US bank collapsed. On Tuesday, there was still nothing to worry about, but after a real bank run, Silicon Valley Bank is now under direct regulatory scrutiny. Many people will never have heard of Silicon Valley Bank until last week. Yet the fall is causing a lot of turmoil in the stock market. For instance, US bank prices fell 15 per cent last week. Since the Great Financial Crisis, many measures have been taken to limit the risk of contagion to the rest of the financial system in such a case, and that is the most likely scenario this time too. If so, things will end with a hiss. It helps that Silicon Valley Bank is unique in several ways. The bank has grown strongly in recent years thanks to large inflows of deposits from young tech companies. Those young companies are often still running at a loss and need constant cash to pay all the charges. Without that money, they might be in acute trouble. Then they won’t even be able to pay salaries for the month. Normally, a bank will lend any funds received to other customers on a spread basis at a variable interest rate, but because of the strong inflows, Silicon Valley Bank chose to invest the proceeds in US government bonds. Those bonds, unlike a bank loan, do not have variable but fixed interest rates. So there was a big mismatch. Against variable deposits, rates were assets with fixed interest rates. No problem as long as interest rates remained low, but after interest rates rose, large paper losses arose. When some of the tech companies opted for the higher yield on money market funds, large losses had to be taken on government bonds. A last-minute organised equity issue was to no avail. Other US banks are better diversified, less dependent on tech companies and also normally do not have such a large mismatch, although more have government bonds on their balance sheets as well. Furthermore, European banks also still have too large positions in government bonds, which helped to make the 2012 euro crisis not so easy to solve. But even in Europe, the ECB knows what to do if history were to repeat itself.

The risk of such financial mishaps is relatively high right now due to tightening central bank policies. In the United States, the money supply is shrinking for the first time in many years. In such a situation, companies and other institutions that have taken on too much financing risk in the past may collapse. Usually, the small ones fall first and, with some delay, the big ones. The moment this translates into systemic risks, it may prompt central banks to change course. Indeed, central banks were created to counter such risks. But countering systemic risks conflicts with fighting inflation. With better-than-expected economic growth in recent months and disappointing inflation data, the plan is still for the ECB to raise interest rates by 0.5 per cent in the coming week after which the Federal Reserve will raise rates by 0.5 per cent the following week. When central banks decide to take a more cautious approach, it is a signal that they are taking the risks stemming from Silicon Valley Bank seriously.

Central banks’ tightening policies have created an inverted yield curve. In a normal situation, short-term rates are lower than long-term rates, but now the situation is reversed. In the United States, the 10-year rate is a full per cent below the two-year rate, a situation not seen since the 1970s. In Europe, the difference is 0.7 per cent. This phenomenon contributed to the collapse of Silicon Valley Bank. The high short-term interest rate caused tech companies to look for better alternatives to the too-low deposit rates at Silicon Valley Bank. However, thanks to the relatively low-interest rates on longer-term government bonds, the bank was unable to move forward. An inverted yield curve is also a signal from the market to the central bank that policy rates have been sufficiently raised. The market assumes that a 10-year loan at 4 per cent can eventually earn at least as much as a two-year rate of 5 per cent. This can only happen at the time of a recession. That is when interest rates fall across the curve, so long-term loans benefit the most.  So it is not obvious to invest in a short-term paper when there is an inverted yield curve.

Underlying, inflation will clearly decline in the second quarter. The economy may be stronger than expected, but the coming months should be compared with the sharp rise in inflation following the Russian invasion of Ukraine a year ago. Combine that with the shrinking money supply and the falling housing market, inflation could move relatively quickly towards the 2 per cent target. That gives central banks more room to pause policy. With the fall of Silicon Valley Bank, that moment is approaching faster. Every disadvantage has an advantage here too. That pause should see whether inflation can indeed remain low. If it does, central banks quickly gain hero status and there is a lot of upside price potential. If inflation does remain stubbornly high, it will take longer for interest rates to be cut in the first place, which could cause further financial crashes in the meantime. It is possible that interest rates will then be raised even further, to the point where there is a definite recession. This is not good news for the economy, but for investors, the start of a recession historically proves to be a good time to get in. Even in private markets, recession years are among the best vintage years. We maintain an overweight position in equities and alternative investments and an underweight position in bonds. However, there will be a bumpy ride due to increased volatility, but that is the price to pay for higher returns over time.