How the US Banking Crisis of 2023 Could Trigger a Global Recession: A Guide for Fixed Income Investors

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In 2023, the global economy faced a whirlwind of challenges, from the Russia-Ukraine conflict to the US-China trade tensions and an impending US election. Unexpectedly, the US banking sector took a hit, with several major banks collapsing.

Several US banks collapsed in 2023, Silicon Valley Bank, Signature Bank, Silvergate Capital, and First Republic Bank. These banks were affected by different factors, such as their exposure to the cryptocurrency market, their holdings of low-yielding government bonds, and their vulnerability to rapid interest rate hikes by the Federal Reserve. The collapse of these banks had major economic and regulatory repercussions for lenders across the globe, some of which may be felt for years to come.

The fallout from the US banking crisis reverberated globally. It tightened credit availability and raised borrowing costs for households and businesses, leading to decreased spending and investment. Investors sought refuge in safe assets, causing the US dollar to surge and bond yields to drop. Emerging markets with substantial dollar-denominated debts felt the pressure, and overall, confidence in the financial system waned.

The big question looming is whether this crisis could trigger a global recession akin to the 2007-2008 subprime mortgage crisis. In this article, we will explore how inflation expectations and interest rates affect bond prices and yields, how different types of bonds react to changes in market conditions, and how bond investors can protect their portfolios from geopolitical uncertainties. We will focus on the Asian bond market, which is one of the largest and most dynamic in the world, and which has some unique features and challenges that distinguish it from other regions. We will also provide some insights and recommendations for financial institutions (FIs) that invest or trade in fixed income instruments in Asia, and how they can optimize their performance and mitigate their risks in this challenging environment.

The Fed’s Dilemma: Monetary Policy versus Crisis Management

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The Fed utilizes monetary policy tools, mainly by adjusting the federal funds rate, which impacts short-term interest rates and borrowing costs. However, during financial crises, the Fed faces a challenge: balancing its monetary policy goals with crisis management. It is important to create a balance between monetary policy goals and crisis management because these two objectives may sometimes conflict or complement each other, depending on the effects of the Fed’s actions on interest rates, inflation, bank profitability, solvency, and stability.

These crises can disrupt financial markets and institutions, hindering the effectiveness of monetary policy and jeopardizing financial stability. In such scenarios, the Fed may need to go beyond adjusting interest rates and take additional actions, including:

• Providing liquidity to banks and financial institutions to meet short-term funding needs and prevent forced asset sales. During critical financial crises like the 2007-2008 global financial crisis, the Fed took measures to provide liquidity to banks and financial institutions. This was achieved through emergency lending facilities like the Term Auction Facility, Primary Dealer Credit Facility, and Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. These facilities offered short-term loans, preventing forced asset sales and assisting institutions facing liquidity challenges due to disrupted money markets and eroding investor confidence.
• Supporting crucial credit markets to restore normal functioning and reduce interest rate spreads. During the COVID-19 pandemic of 2020-2021, the Fed acted to support essential credit markets. Initiatives such as the Commercial Paper Funding Facility, Money Market Mutual Fund Liquidity Facility, and Primary and Secondary Market Corporate Credit Facilities were established. These programs facilitated the flow of credit to households and businesses by purchasing commercial paper, corporate bonds, and other securities from issuers and investors, ultimately working to restore normal market functioning and reduce interest rate spreads.
• Purchasing longer-term securities to lower long-term interest rates and ease financial conditions. This happened during the 2008-2014 period, when the Fed implemented a series of large-scale asset purchase programs, also known as quantitative easing (QE), to purchase longer-term Treasury securities, agency debt securities, and agency mortgage-backed securities from the open market, in order to put downward pressure on longer-term interest rates and support mortgage markets.

The Fed’s actions to balance its monetary policy goals with crisis management have implications for the Asian bond market, as they affect the interest rates, inflation, exchange rates, and capital flows in the region. For example:

When the Fed lowers its policy rate to stimulate economic activity and ensure bank stability, it can amplify the demand for higher-yielding Asian bonds. Investors seek enhanced returns in emerging markets, potentially leading to lower bond yields, higher bond prices, and local currency appreciation against the US dollar in Asia. However, this may also introduce inflationary pressures and asset bubbles, raising vulnerability to sudden capital outflows if the Fed shifts its stance or a geo-political shock occurs.

Conversely, when the Fed raises its policy rate to counter inflation and mitigate bank instability, it may reduce interest in higher-yielding Asian bonds as investors decrease exposure to emerging markets. This could result in higher bond yields, lower bond prices, and local currency depreciation against the US dollar in Asia. Nonetheless, such actions can help alleviate inflationary pressures and asset bubbles, bolstering resilience to sudden capital outflows if the Fed maintains its stance or geo-political shocks arise.

Navigating and Taking Advantage of the Fixed Income Environment

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The fixed-income environment in 2023 is characterized by higher interest rates, lower inflation, and slower economic growth than in 2022. The Fed has raised its target range for the federal funds rate by 375 basis points since March 2022, and it now stands at 3.75% to 4%, with further increases likely. Meanwhile, the SPF consensus predicted that both headline and core CPI inflation will drop sharply in 2023, from a projected 7.7% and 6.3% in 2022 to 3.4% and 3.5% in 2023, respectively. These factors have different implications for various types of bonds, such as government bonds, corporate bonds, ESG bonds. Financial institutions (FIs) that invest or trade in fixed-income instruments need to adopt appropriate strategies and best practices to optimize their fixed-income portfolios and enhance their performance.

Some of the strategies and best practices for FIs are:

• Diversification: Investing in a variety of assets that have low or negative correlations with each other to reduce the overall risk and volatility of a portfolio.
• Duration management: Adjusting the maturity structure of a portfolio to match the interest rate outlook and risk appetite. Increasing duration exposure when expecting interest rates to fall or remain stable, and decreasing duration exposure when expecting interest rates to rise or become volatile.
• Credit analysis: Evaluating the creditworthiness and default risk of a bond issuer or a bond issue. Identifying undervalued or overvalued bonds based on their credit ratings, spreads, yields, covenants, etc., and avoiding or mitigating potential credit events, such as downgrades, defaults, or restructuring.
• Active management: Making frequent buying and selling decisions based on market research, analysis, forecasts, etc., to outperform a benchmark index or achieve a specific objective. Exploiting market inefficiencies, capturing market opportunities, adjusting to changing market conditions, and enhancing portfolio returns.

FIs in Asia need to adapt their fixed income strategies and portfolios to the changing environment, and leverage the regional cooperation and integration initiatives to access new sources of funding and growth. Inflation remains the key driver of bond yields in Asia, but local factors also play a role in determining the performance of different types of bonds.

Protecting Portfolios from Geo-Political Uncertainties

FIs need to protect their portfolios from geo-political uncertainties by adopting some measures and tools to hedge their exposure and mitigate their risks. Some of these measures and tools are:

• Diversification: As mentioned earlier, diversification is a key principle of portfolio management that aims to reduce the overall risk and volatility of a portfolio by investing in a variety of assets that have low or negative correlations with each other. FIs can diversify their fixed-income portfolios across different types, sectors, regions, maturities, ratings, and currencies of fixed-income instruments to benefit from different sources of return and hedge against different sources of risk.
• Hedging: FIs can employ derivatives such as futures, options, and swaps to protect against adverse price movements in fixed-income assets. Exchange-traded funds (ETFs) can also be used to gain exposure to specific market segments or themes and hedge against potential reversals.
• Scenario analysis: FIs can use scenario analysis to assess potential outcomes and implications of geo-political events on their fixed-income portfolios. This approach allows them to identify and quantify risks and opportunities while testing the resilience and robustness of their portfolio strategies and allocations.

Geo-political events affect inflation and recession in Asia, the main drivers of bond yields. FIs in Asia need to protect their portfolios by diversifying, hedging, and scenario analysis. This will enhance their performance and profitability in the fixed income market.

Conclusion

The US banking crisis of 2023, triggered by the Fed’s policy quantitative tightening (QT) to combat runaway inflation, poses a significant global threat. This crisis, compounded by geopolitical factors, could potentially lead to a global recession akin to the 2007-2008 subprime mortgage crisis. However, Asia possesses inherent strengths and opportunities that could aid in mitigating the crisis’s impact and fostering a quicker recovery.

Asia's resilience in the face of the 2023 US banking crisis is underpinned by its expansive domestic market, robust export sector with diversified markets, innovative private sector, proactive policy responses, and enhanced regional cooperation. Its population of 4.6 billion, accounting for 60% of the world's populace, alongside a growing middle class, fuels domestic consumption and investment.

A significant exporter, Asia represents about 35% of global merchandise exports and 27% of service exports, mitigating dependence on any single sector or country. The region's innovation capacity, vibrant entrepreneurial ecosystem, swift response to the COVID-19 pandemic, and deepened regional cooperation, including participation in initiatives like the Belt and Road Initiative (BRI) and the Regional Comprehensive Economic Partnership (RCEP), contribute to its resilience.

In the Asian fixed-income market, inflation continues to be the key driver of bond yields, influenced by factors such as economic growth, fiscal and monetary policies, trade dynamics, and geopolitical events. These multifaceted elements collectively shape Asia's response to the US banking crisis and its bond market dynamics. 

Join us at the Fixed Income & FX Leaders Summit APAC as we delve deeper into this topic:

Day 1, 09.20 C-level Chat: How can you adapt your global market businesses to best navigate geopolitical uncertainty, changing central bank policy and heightened market volatility?

Download 2023 Agenda Here!