COLUMN-U.S. bank failure places oil prices under pressure: Kemp

The Federal Reserve Bank of Chicago’s National Financial Conditions Index was only mildly restrictive prior to the SVB failure. Following the bank run, however, most institutions are likely to tighten lending standards and increase deposit rates as they attempt to fortify their balance sheets.

U.S. interest rate traders have cut their forecasts for rates following the failure of Silicon Valley Bank (SVB) and its takeover by government regulators on March 10. The run on SVB has made traders increasingly think concerns about financial stability will constrain the U.S. Federal Reserve's ability and willingness to increase rates further.

Futures prices imply the overnight interbank federal funds rate will be 4.00-4.25% in December 2023, below the current target of 4.50-4.75%. The forecast has been transformed in the three trading days since March 8, when futures prices implied interest rates were expected to continue increasing and end the year at 5.50-5.75%.

Oil prices have also dived as traders expect the implied weakening of economic activity to reduce the trajectory for petroleum consumption over the rest of 2023. Chartbook: U.S. financial conditions

YIELD CURVE INVERSION Banks engage in maturity and liquidity transformation, attracting short-term deposits and other highly mobile short-term borrowing to make longer-term loans and buy longer-term and often less-liquid assets.

Progressive inversion of the U.S. Treasury yield curve, which had become more inverted than at any time since 1981, is putting this business model under pressure. SVB may have been an outlier in terms of its risk management but extreme inversion is starting to put the entire sector under strain.

Responding to SVB's failure, the central bank promised to make available additional liquidity to banks and other deposit-taking institutions. By reassuring depositors, the central bank aims to prevent runs on other institutions and contagion through the financial system.

And by promising to buy high-quality assets at face value, the central bank is trying to forestall a fire sale that could depress valuations and become self-reinforcing. POLICY AND SUPERVISION

The central bank's intervention has highlighted the complex interaction between monetary policy and bank supervision. Policymakers say money policy and financial supervision are separate but in practice the two are inextricably linked.

Monetary policy works through yield curve inversion, changing the relationship between higher risk and lower risk assets, increasing pressure on borrowers, and unemployment, all of which raise the risk of bank failures. Tightening monetary policy after a period of easy money often causes the failure of one or more institutions that have made imprudent loans or are unable to adapt to changing conditions fast enough.

In turn, bank failures put pressure on monetary officials to consider cutting interest rates to provide relief for other institutions and prevent failure cascading throughout the credit system. Lowering overnight interbank interest rates and normalising the yield curve is the fastest and most comprehensive way to protect the banking system.

As a result, the U.S. central bank has often reduced interbank interest rates following a financial crisis, including the failure of Long-Term Capital Management in 1998 and Bear Stearns and Lehman Brothers in 2008. THE SUPERVISION CYCLE

To create more freedom for monetary policy, central banks try to toughen bank supervision, making banks more resilient to a period of high interest rates, financial stress or a business cycle downturn. But maintaining strict standards over time is hard because banks push back against regulations constraining risk-taking and profit-making.

There is a supervision cycle in which regulations are tightened immediately after a bank failure or other financial crisis and then gradually relaxed as memories fade. The interplay between the supervision cycle and the monetary policy cycle is a major source of financial and economic instability.

Supervision tends to become weakest late in the business cycle, just as monetary policy becomes tightest, contributing to financial fragility. Conversely, supervision tightens after a financial crisis, when monetary policy is most relaxed, hampering economic recovery.

SVB FAILURE AND RATES Until now, the U.S. central bank's campaign of interest rate increases has had a moderate impact on financial conditions, despite rates rising by 450 basis points in the course of a year.

While the cost of mortgages and corporate borrowing, tied to long rates, not short ones, has increased, the tightening of lending standards and credit availability has been modest. The Federal Reserve Bank of Chicago's National Financial Conditions Index was only mildly restrictive prior to the SVB failure.

Following the bank run, however, most institutions are likely to tighten lending standards and increase deposit rates as they attempt to fortify their balance sheets. Tougher lending standards will contribute to the business cycle slowdown already underway, mostly in manufacturing.

In one sense, tightening lending standards are likely to make the central bank's past interest rate increases more effective. The expectation that tighter lending standards will slow business and consumer spending is one reason traders expect the central bank will need to raise interest rates much less in future to bring inflation under control.

In another sense, however, evidence of increased financial fragility is likely to constrain the central bank's ability and willingness to raise interest rates as much as seemed likely. Traders likely anticipate the central bank may have to take more risk with inflation to safeguard financial stability.

The central bank's announcement it will provide additional liquidity to deposit-taking institutions is in part an effort to create more space to continue raising interest rates without sparking a wider banking crisis. But given the spillovers between monetary policy and supervision, the offer of additional liquidity is probably not enough to insulate monetary policy from financial stability considerations.

Overall, the SVB failure is likely to lead to tighter credit conditions, implying a lower path for interest rates in future, in part because economic activity is likely to be weaker. The implied weakness in economic activity explains why front-month Brent futures prices fell almost $4 per barrel (5%) at one point on Monday towards their lowest level in three months.

If the Federal Reserve's attempts to steady confidence and prevent an abrupt tightening of lending conditions succeeds, oil prices could reverse recent losses quickly. But if the SVB's failure causes a more widespread reassessment of lending standards and balance sheet strengthening, oil prices are likely to remain under pressure.

John Kemp is a Reuters market analyst. The views expressed are his own (Editing by Barbara Lewis)

(This story has not been edited by Devdiscourse staff and is auto-generated from a syndicated feed.)