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What the rate cycle and financial crisis fears mean for crypto, banks and investors

21 March 2023

AJ Bell investment research head Alena Kosava explains why investors should expect 2023’s bumpy ride to continue.

By Alena Kosava,

AJ Bell

Following a bruising performance for most asset classes last year, 2023 so far has been a roller coaster. Global equity markets started the year on a strong footing, registering gains in January, while bond yields fell, sending fixed income prices higher. However, February showed the opposite of January as bond yields rallied and equity markets sold off.

The Fed’s narrative has been volatile. Just as the markets were ready to call nearing the end of rate hikes, investors were being forced to re-price terminal interest rates higher amid the bank’s comments around its willingness and ability to re-accelerate the pace of the rate hiking cycle if necessary and in the event of inflationary pressures persisting.

As developed market central banks continue tightening interest rates in unison in their pursuit to curb the inflationary price spiral, there has been much talk about the financial system coming under considerable pressure and things starting to break. Recent events highlight the need to carefully consider the lagging impact of higher and rising rates on portfolios, current positioning and direction of travel.

Back in November, markets were buffeted by the sudden collapse of FTX, one of the world’s largest crypto exchanges. A collapse that some called crypto's ‘Lehman moment’ unfolded following a mass exodus from FTX. This was soon followed by strains starting to emerge in commercial real estate, resulting in Blackstone’s BREIT, KKR’s KREST and Starwood’s SREIT gating redemptions after elevated investor withdrawal requests began to gather pace. We also saw Blackstone’s recent default on Nordic CMBS, a bond backed by a portfolio of Finnish offices and stores, showing signs of stress in European commercial real estate market amid rising interest rates.

As the macro backdrop remains increasingly volatile and financial conditions even tighter, there are further signs of stress emerging. Last week saw something we have not seen in a while – the largest bank failure since the 2008 financial crisis. Silvergate and Signature banks were the two main banks for crypto companies, while Silicon Valley Bank (SVB) had crypto start-ups, crypto-friendly VC and digital asset businesses as its customers. The shutdown of the crypto banking trifecta led to US bank runs.

A combined liquidity backstop by the US Treasury Department, Federal Reserve and FDIC to prevent bank runs across small- and medium-sized banks sent a strong message to the market. Taking steps to shore up confidence in the banking system, authorities launched emergency measures guaranteeing all deposits held at SVB and Signature Bank, while the launch of Bank Term Funding Program lending facility was set to ensure liquidity and provision against depositor demands at other banks.

History never repeats itself, but it does often rhyme – the increasing frequency of anomalous events are pointing to a continuation in the bubble-bursting debt cycle, through tighter financial conditions leading to restricted credit growth and liquidity struggles. While the crisis of 2008 saw a bubble in residential real estate, this time we are seeing commercial real estate and negative cash flow venture and private equity sectors, as well as the crypto market, coming under pressure from higher rates and tighter financial conditions. The problem is manifesting itself through liquidity and interest rate (duration) risk.

After 2008, the Dodd-Frank legislation was designed to eradicate ‘Too Big to Fail’, in order to promote financial stability. Jen Hensarling’s Wall Street Journal remarks resonate today: ‘Too-big-to-fail institutions have not disappeared. Big banks are bigger, small banks are fewer, and the financial system is less stable. Meanwhile, the economy remains in the doldrums.’

With the recent unravelling of SVB, ‘Too Big to Fail’ may not be simply about size. Dodd-Frank also banned banks’ proprietary trading activities, curtailing liquidity. This, many believe, may be the cause of the next financial crisis but, for now, the crypto banking trifecta failure is a canary in the coal mine that will likely have further impact on the venture capital sector and beyond.

Where from here? The recent exercise by the Fed to offer liquidity to the banking sector in order to stem any spill over effects sends a conflicting message, as tightening (rather than easing) financial conditions remains appropriate in the current economic environment. Central banks are in a tricky spot, though. As inflation remains elevated while things are starting to break and market sentiment is showing signs of stress, central banks will increasingly have to assess the situation more holistically, likely nearing the turning point in the hiking cycle.

For now, investors should look to draw on some of rules that have stood the test of time: seek value, control your emotions, focus on the long run and diversify your portfolio. Otherwise until the rate cycle ends, fasten your seatbelts – it’s going to be a bumpy ride.

Alena Kosava is head of investment research at AJ Bell. The views expressed above should not be taken as investment advice.

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