Federal Reserve/ECB: credit tightening has not yet done its worst

Throughout economic history, interest rate tightening cycles tend to end with a bang, not a whimper. Whether the multiple bank failures in the past two weeks were loud enough is moot.

US Federal Reserve chair Jay Powell raised rates by a quarter rather than a half percentage point on Wednesday. The Bank of England increased by the same amount on Thursday. The question is whether any more increases will follow. European Central Bank president Christine Lagarde, who defended rate rise policy last week, softened her tone this week.

Though European bank shares have dropped recently, they are up 7 per cent in the year to date, helped by rising rates and the boost to their net interest income (NII). The Stoxx 600 European bank index has royally outperformed the KBW US bank index.

Some say stricter European regulation, including tougher capital buffers, has made all the difference, despite the woes of Credit Suisse, forcibly sold to UBS last weekend.

Liquidity was what mattered there. Contagion and deposit withdrawal can occur rapidly. An avalanche of withdrawals can quickly turn into a credit crunch as banks pull back on lending.

Credit markets are already fragile. Bank of America’s high-yield spread index has widened by a quarter to 500 basis points over risk-free rates in March alone. Trading volumes in secondary debt markets have plummeted. Primary issuance has vanished altogether. Borrowing is as costly as it has been in a decade.

Any further rate increases would ignore the impact of previous rises. US Fed rates have climbed more than twice as fast in the past year as they did in the run-up to the financial crisis. Everywhere, bank lending rates are still catching up with central bank policy rates.

Since the ECB began tightening last summer, only half of that increase on average has passed on to borrowers as of January this year, according to S&P. A trend of using expensive high-yield bonds to refinance the disappearing supply of bank loans has begun.

Bank investors can sense a shift, pricing in a peak in NII growth, the driver of bank profits. Every 25 bps shift in ECB rates drives a 4 per cent move in earnings per share on average, says Citigroup. A lagged effect on loan pricing should keep NII rising this year in Europe, but probably not in 2024. This boom period for Europe’s banks could be as good as it gets.