Black Swan and the Rate Rise
June 14, 2018 | Expert Insights
Sixteen of the world’s biggest banks have slipped into a bear market, indicating possible global financial risks even as stock market indices are on high.
The banks have slipped nearly 20% before the US Federal Reserve voted to raise their benchmark interest rate by 0.25%.
President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913, whereby the Federal System would serve as the US Central Bank. Prior to the Act, the US financial and banking system was plagued by credit scarcity and frequent bank failures. American colonial banks were driven by the barter system and commodity money. Secretary of the Treasury, Alexander Hamilton, developed a plan for a federal banking system to solve the nation’s credit problems after the War of Independence.
The onset of the Industrial Revolution saw expansion of finance and commerce with private entities functioning within the larger decentralised banking system. Bank panics or “runs” occurred frequently where lenders would hurriedly withdraw deposits leading to financial crises. Hence, it was necessary for the Congress to pass a law for state controls and policies for the banks.
To maintain a healthy economy, the Federal Reserve chooses to keep interest rates between 2 - 5%. High inflation in the late 70’s saw rates rise to 9.6%. The lowest rate was 0.25% during the 2008 financial crisis. Interest rate hikes are seen as an effective way of curbing inflation as lenders would find it more profitable to deposit their money in banks which would, in turn, increase profitability for big banks. From a global perspective, higher US rates would encourage investors to return from emerging markets around the world. The retreat, however, strengthens the dollar and fuels currency crises as seen in Brazil and Argentina.
Black Swan Alert:
The idea of a black swan event was pioneered by the finance professional turned writer Nassim Nicholas Taleb after the results of the 2008 financial crisis. Taleb argued that black swan events are impossible to predict yet have catastrophic ramifications. The unprecedented rise in inflation of more than 79.6 billion percent in Zimbabwe and the dot-com bubble burst have been seen as Black Swan events. Moreover, recent trade wars between US, Europe and China will have a spill-over effect on the markets.
The increase in Fed rates do not have a direct effect on stock markets, however, a ripple effect is expected to follow. Before the Federal meeting on Wednesday, investors sent Nasdaq to a record close. However, appreciable economic data has hidden deeper big bank strains.
Among the 39 “Sifis”, financial institutions considered systemically important by the Basel-based Financial Stability Board, 16 are down more than 20% from their recent peaks in dollar terms, meeting the standard definition of a bear market. These include Deutsche Bank, Nordea, ICBC, UniCredit, Crédit Agricole, ING, Santander, Société Générale, BNP Paribas, UBS, Agricultural Bank of China, AXA, Mitsubishi UFJ Financial Group, Bank of China, Credit Suisse and Prudential Financial. The synchronised dips were seen as a sign of financial strain causing Absolute Strategy Research in London to release a Black Swan alert.
Ian Harnett, managing director of global strategy at Absolute Strategy Research in London said, “central bankers might have to respond to bearish signals from almost half the global Sifis, rather than continuing to tighten monetary policy.”
The Fed’s twin mandate is to bolster employment while controlling inflation, and in the current environment more rate rises appear inevitable. Furthermore, an ongoing trade war initiated by US protectionist policies will affect global banks and markets alike. The positive effect of domestic monetary policies might endanger the financial market, if necessary steps are not taken to counter the ill-advised trade wars.
Credit Suisse Group AG's global equity team said in March that technology companies, banks, and health care companies are most likely to fare well, while supply chain dependent industries will be affected by the $50 billion tariff on Chinese goods. President Trump is set to meet top economic advisors on the proposed tariff on 14th June.
The move toward activating U.S. tariffs on Chinese goods follows negotiations between U.S. and Chinese officials centered on increased purchases by Beijing of American farm and energy commodities and cutting the U.S. trade deficit with China, according to a Reuters report. Tariffs and duties on Canada, Mexico, European Union and China will be met with retaliatory measures that can affect banks and stock markets alike.
Asked if there was a risk for the global economy, WTO Director-General Roberto Azevedo told business daily Handelsblatt: “Absolutely. If the trade dispute escalates, there’s the risk of a global downturn and we’re already seeing signs that this downward process has already started.”
Capital flight from emerging markets, especially by Foreign Institutional Investors could see a dip in the short run. The Reserve Bank of India (RBI) has recently increased their repo rate to 6.25%.
Our assessment is that the Black Swan alert has been released in time for investors to keep their ear to the ground for developments across major economies. Ongoing trade wars will see a plunge in commodities before industries are affected by supply prices and retaliatory measures. We believe that the gap between the growth percentage in emerging economies and that of developed countries is widening. Presently, this should support the fundamental value of assets, regardless of the increase in fed rate.