Market update as regulators take control of troubled banks

What happened?

Since Friday, March 10, we’ve observed the distress of two banks, Silicon Valley Bank and Signature Bank, which have both been placed into FDIC receivership. The FDIC has taken the step of guaranteeing the deposits of both banks above the legislated $250K per account limit, and the Federal Reserve has demonstrated further commitment to ensuring bank liquidity by establishing the Bank Term Funding Program.

Market impact

With the bank failures tied to the narrative around the market impact of higher interest rates, interest rates fell precipitously across the curve today. 2- and 10-year Treasury yields fell by ~60 and ~14 basis points today, extending cumulative declines since close of business Wednesday (March 8) to ~109 and ~42 basis points, respectively. The market is now pricing peak 1-month Term SOFR of 4.74% in May, vs. a peak rate of 5.67% in August as of last Wednesday.

Rate movements were driven by the typical “flight to safety” that occurs in difficult market conditions with investors buying Treasuries (pushing down yields) as well as a dramatic shift in sentiment around the likely going forward path for Federal Reserve policy decisions. As recently as last week, market expectations for further hikes were moving up as Chair Powell took a hawkish tone. With clear connection between the Silicon Valley Bank and Signature Bank distress and tightening economic conditions, the market has massively repriced its forward-looking view of Fed policy decisions, with less than a single hike priced in for the remainder of the year vs. three or more last week. The market seems to be wondering if the effects of the Fed’s tightening – which were always expected to lag the policy decisions themselves on a “long and variable” basis – are starting to be felt in earnest.

Client considerations

Valuation

Similar to past events that disrupted financial markets, the reaction in the commercial real estate lending markets is measured, resulting in a pause in transactions as lenders and borrowers assess the impact on macro markets to decide how recent events change their view of investment-level risk.

Early market sentiment indicates that fixed-rate lenders are increasing spreads in light of current Treasury yields, including life companies who are likely to follow the recent increases seen in corporate spreads trends. Freddie Mac widened fixed-rate spreads by 15 basis points today. However, more changes may be coming depending on further movements in corporate spreads and pricing indications from life company lenders. Borrowers expect limited lending will be available from regional banks until there is more certainty in the market that bank distress has been contained.

As we approach quarter-end valuations, we expect muted changes in market replacement rates given the lack of liquidity in the market, suggesting widening of implied lending spreads assuming Treasury yields continue to hold or decrease. We will continue to monitor the markets, including discussions with both borrowers and lenders, and make appropriate adjustments as reactions unfold.

Interest rate hedging

With today’s decline in rates, we saw many clients come off the fence and execute elective hedges that they had been considering. This was particularly true of our clients looking to forward hedge expected future bond issuances and fixed-rate financings, but we saw activity across our client base. Bid-ask spreads and execution charges understandably widened as dealer banks dealt with volatile markets which made it more difficult for them to hedge their own risk. The overall price movements tended to be favorable for clients. The table below shows pricing grids for caps on 1-month Term SOFR today vs. one week ago (expressed as dollars on the loan amount hedged, paid up front). We continue to encourage clients to work with us to track pricing on pending future hedges, particularly upcoming interest rate cap extensions. Current volatility may present clients that are ready to trade quickly with the ability to opportunistically lock-in favorable pricing (as we saw today).

FX hedging

Movements in spot rates have been relatively modest compared to the swings in U.S. interest rates. Since Friday, EUR, GBP, JPY, and CAD gained 1-2% against USD. Currency option volatilities, though, have tracked the rise in macro uncertainty. G10, Latam, and APAC currency pairs have seen roughly 1/3-1 vega increase in (3-month ATM) option volatilities. Forward points have decreased in many cases due to reduced interest rate differentials, impacting the pick-up in certain currency pairs or worsening the drag in others. For example, if an investor were to hedge EUR back to USD on Thursday, March 9, they would have enjoyed a pick-up of roughly 1.9% p.a. That pick-up dropped to roughly 1.6% p.a. today.

Regulatory

We have a handful of clients with trades with Silicon Valley Bank and/or Signature Bank. We always advise our clients to discuss these situations with their legal counsel, but our assessment of the transition by the FDIC of these banks to successor “Bridge Banks” is that derivatives contracts (FX and interest rate) will be treated as Qualified Financial Contracts (QFCs) under the Federal Deposit Insurance Act and should continue to perform as usual.

Looking ahead

As volatile as market conditions have been year-to-date, today’s developments could act as a catalyst for increased market volatility in the near-term. Recent market volatility has been driven by the dueling narratives of a hawkish Fed committed to fighting persistent inflation and policy tightening that hindsight may show led us into a recession. The bank distress of the past few days – which can, in significant part, be tied back to higher interest rates – may have sensitized the market to the notion that a “hard landing” may be more imminent. This could drive even stronger market reactions to data releases and economic news, with Tuesday’s CPI print potentially providing an interesting counterpoint to the last two business days’ news.