With the collapse of Silicon Valley Bank early in March 2023, markets are experiencing increased volatility. Especially, the banking sector was hurt substantially. It also led to the collapse of other banks, such as Silvergate and Signature Bank. With the recent shock in the stock market following the collapse of SVB, other banks are feeling the pressure and there may be more defaults on the horizon. Even established banks such as Credit Suisse are now in a very dangerous situation. While the stock market started strong in the year 2023, the most recent shock almost evaporated all the gains of the beginning of the year. The S&P 500 is now only up 2% from the beginning of 2023. The SVB collapse also induced further volatility in the Treasuries market, which was quite volatile even before due to discussion on continuously increased rates by the Fed. The 10-years US Treasuries were close to hitting the 4% mark again, but fell by almost 50bps after the SVB collapse. The impact on 1-year Treasuries was even more severe, resulting in a drop of almost 80bps. Within two days, the 2-year yields dropped almost 50bps, which only happened in five prior crises before. Figure 1 shows the historical drops in 2-year yields after the Black Monday in 1987. Cryptocurrencies also experienced a similar volatility increase. Bitcoin was steadily trading around the $23k and $24k mark in the past month. After the initial announcement, it dropped to $22k and later on shortly below the $20k mark. Nonetheless, it seems that Bitcoin already recovered this shock and surged above the $26k mark.
Although 2022 is over, the problems it brought with it are not. Inflation is still high, albeit not at peak levels of 2022. With this development, central banks are likely to stop hiking relatively soon, given that inflation keeps coming down. In the short-term, central banks will continue to hike with some of them reducing the size of the steps. The ECB raised its target rate in early February by another 50bps and announced they will continue to do so. While inflation in the US is better under control than in Europe, they also have their share of problems with a recession on the horizon. Rates are much higher with a lower (but historically still very high) inflation. The US is also facing the largest yield curve inversion since the 1980s, which is persisting for more than half a year by now. In this ecosystem, it is also not surprising that the US reached another peak in its trade deficit. While these developments are somewhat to be expected from the underlying economic situation, the labour market has been as a positive indicator for the entire 2022. In January 2023, the largest job cuts since 2020 was observed. However, this is largely stemming from huge job cuts of big tech stocks, which have suffered a contraction in 2022 after their bull run in 2021. The job cuts are also understandable given that many big tech firms have had their worst or close to their worst growth rate in their history. Similar things can be observed when looking at their revenues. Regarding the unemployment rate in general, it is still very low and there was consistent decline since the beginning of Covid-19. At least this indicator eases some of the pressure of the otherwise highly uncertain economy. In this ecosystem, market participants expect few further hikes with lower rates towards to the end of 2023 and thereafter. With the strong labour market in mind, it would be a great achievement for the Fed to combat inflation effectively without destroying the currently strong labour market. In this instance, it is realistic, as the cause of inflation were the policies applied during Covid-19, most notably the financial stimulus and essentially unlimited borrowing, led to inflow of available of money, which is in itself independent of the labour market. Figure 1 summarizes the expected development of the Fed fund rate until 2025. In the UK, the situation looks a bit more dire. While the BoE has hiked in similar frequencies, it could not combat inflation as effectively as the US. In addition, the UK is more directly affected by the war, which increases the overall pressure on markets. Despite, the BoE substantially adjusted their recession forecast, in which the GDP should only drop by 0.8% compared to almost 3% in their prior forecast. Figure 2 provides an overview of the new and old forecast of the BoE until 2025.
2022 was a year that tested the worldwide economy. The highest inflation in 40 years, unprecedented interest rate hikes, and the invasion of Russia into Ukraine were only some contributors to the hugely difficult year of 2022. In the US, inflation started soaring during 2021 and peaked in the summer of 2022 at 9.1%. Thanks to the central bank’s quick response, inflation has since continuously slowed down and is currently at 6.5%. Europe had significantly more issues handling the inflation crisis. The EU started the year at an inflation rate of slightly above 5.5% and it continued to soar until October 2022 when it reached its peak at 11.5%. The UK was similarly affected, despite the BoE being the fastest-acting central bank to raise interest rates. However, its inflation behaved like the EU’s and soared to its peak at 11.1% in October 2022. Both economies have not been able to reduce inflation below 10% so far. In contrast to the US, European countries were much more affected by the direct impact of the war between Russia and Ukraine. Soaring energy and food prices, for both of which Russia and Ukraine are crucial suppliers, were the main constituents causing the high inflation. Additionally, the ECB did not enjoy as much freedom as the Fed had when raising interest rates. This is in large part due to the high indebtedness of certain European countries that would have gone bankrupt if interest rates would have been raised as much as the US did. Other countries, such as Switzerland, Japan, and China stand out in this discussion, as those countries managed to keep their inflation relatively low. Switzerland managed to avoid such high inflation due to its strong currency, and a limited dependency on fossil fuels. Japan avoided high inflation through the continued quantitative easing by the BoJ. However, in contrast to the other countries, Japan’s inflation is still soaring and poses substantial issues to the country. China avoided high inflation through its rigorous Covid policies and its limited governmental support when Covid emerged. The source of this soaring inflation is a combination of the war but is largely based on unprecedented central bank intervention to save the economy during the early Covid days when large parts of the economy were completely unable to function. Figure 1 shows the inflation levels of the previously mentioned countries during 2022.
Inflation was a core issue in 2022 and remains to be one in 2023. In the US, inflation started to decline in the summer of 2022 and remains currently at a level of 7.1%. Contrarily, in Europe and the UK, inflation remains a huge issue and has barely declined from its peak in 2022. It remains at 11.1% for the EU and at 10.7% for the UK. The difference between the inflation can largely be attributed to two factors. Firstly, the Fed hikes interest rates more aggressively than its European counterparts. This led to a quicker response to inflation. Secondly, Europe is more directly affected by the war between Russia and Ukraine and is largely dependent on Russian oil and gas, which soared in price following the war. Contrarily to other European countries, Switzerland managed to keep inflation relatively low with a peak in late summer 2022 at 3.5% and 3% currently. Switzerland managed to avoid high inflation due to its strong currency and relatively low demand for fossil fuels, as most of its electricity stems from hydropower and nuclear power. In Asia, both Japan and China also experience limited inflation issues. Japan achieved this through its central bank which continuously intervenes with large-scale monetary easing. Despite the low inflation, Japan is still suffering, as wages remain stagnant unlike in other major economies where it helps offset the higher inflation to some degree. China does not face an inflation problem, due to their different handling of the Covid crisis. Unlike most economies, they did not provide large stimuli to the economy. Additionally, their zero-Covid policy substantially reduced household demands. Figure 1 shows a summary of the inflation rates across the highlighted economies during 2022. Regarding 2023, it is widely expected that inflation, especially in high-inflation countries, will come down. For instance, in the US, it is expected that inflation will be around 4% on average, and close to the 2% Fed target by the end of the year. Inflation forecasts in the EU and the UK are more difficult to estimate, due to their dependency on the war and its outcome. Additionally, unlike in the US, inflation has not really started to decrease. Assuming further strong interventions by the European central banks, it is expected that inflation will drop substantially. The ECB expects the average inflation to be around 5%-6% during 2023 with inflation slightly below 4% by the end of 2023. In the short term, Europe will be under pressure and the measures take time to become effective, as shown in the example of the US. Despite a similar outlook to the US, albeit with a delay of around half a year, it is less promising. One important wildcard is energy prices, which are strongly linked to the war. While the EU managed to get its oil largely from other sources than Russia, it still needs Russia, and gas is not as easily substitutable. With the prospect of Russia’s supply cut and China reopening, prices of energy sources are likely to increase. Depending on the scale, if it occurs, the anticipated target may not be reached and inflation will remain higher than the target. In Switzerland, inflation is expected to remain around the 3% mark for 2023. Given the strong involvement of the BoJ, Japan’s inflation is expected to end the year 2023 below the 2% inflation mark. It is additionally expected that wages will rise for the first time in three decades. Inflation in China is expected to rise to around 2% in 2023. This is a combination of the reopening of the economy and the end of the zero-Covid policy. This will lead to an increase in economic activity and the necessity for further energy. Additionally, the price pressure across will also be felt in China, once demand picks up again. The interest rate hikes by most countries have been another crucial topic during 2022. So far, the hikes have shown limited effectiveness in dealing with soaring inflation. In high-inflation countries, it was effective for the US and had little impact on the European countries. However, this discrepancy is likely due to the steeper hikes in the US and less dependency on the war by the US. The US employed the strongest measures, as it hiked from 0% at the beginning of 2022 to 4.25% at the end of 2022. In contrast, the ECB just started hiking in June 2022 at -0.5%, which increased to 2% by the end of 2022. The BoE employed a mixture of the two. The UK started hiking at the end of 2021 but hiked in smaller steps than the US. Towards the end of 2022, it increased the step size and is currently at 3.5%. Switzerland started hiking earlier than the ECB, despite substantially lower inflation. Switzerland’s prime rate became positive for the first time in years in September 2022. Currently, the prime rate is sitting at 1%. Japan was one of the exceptions, as the BoJ did not hike at all. Its prime rate remains at -0.1%. However, the central bank still strongly intervened in the market as elaborated previously. The People’s Bank of China even lowered its prime lending rate over 2022, albeit to a minimal degree. Currently, the rate is at 3.65%. There is a strong consensus for the year 2023 in the US and Japanese markets. Most market participants expect the Fed to keep raising interest rates to around 5%-5.25%. The Fed is likely to do this in smaller steps than previously. Nonetheless, this level should be reached by the end of Q1 2023. Afterward, a majority of institutions do not expect further hikes or cuts in 2023. The remainder anticipates potential interest rate cuts in Q4 2023. The exact outcome of potentially further hikes or cuts largely depends on the state of the US economy in the latter part of 2023. While the measures seem to be effective and inflation is going down considerably, the risk of a recession is considerable. This largely stems from substantially higher financing costs for businesses, and lower demand from consumers as Covid reserves are exhausted and households feel the pressure from the inflation over the past year. Given that the BoJ has not intervened by raising interest rates, it is not expected that it will in 2023. It is more likely that it will continue its qualitative and quantitative easing philosophy employed so far. In particular, as Japan does not face an imminent inflation problem. With expected wages adjusted, the pressure of inflation should also be eased without a strong necessity to make policy adjustments. For the EU, it is expected that rates will be hiked further to combat the prevalent inflation. Market participants expect interest rates of around 3%, which should be reached during Q2 2023. For the UK, additional hikes of 1% are expected, resulting in interest rates of around 4.5% for 2023. For both economies, no rate cuts are expected in the latter half of 2023. In Switzerland, the SNB is anticipated to hike another 0.5% in 2023 with no rate cuts as well.
|
|