The US banking system is facing new challenges as bond yields rise amid inflationary pressures and uncertainty about the Federal Reserve’s policy. The recent failure of a major US bank has triggered a wave of fear and volatility in the financial markets, raising questions about the stability and resilience of the banking sector.
Bond Yields Surge as Investors Seek Safety
One of the main indicators of the stress in the banking system is the surge in bond yields, which reflect the cost of borrowing for the government and other borrowers. Bond yields and prices move in opposite directions, so when investors demand higher yields, they are effectively selling bonds and driving down their prices.
The 10-year US Treasury bond yield rose past the 2% mark for the first time since the summer of 2019 on Thursday, after a key inflation figure rose to its highest level in nearly 40 years. The consumer price index (CPI) increased by 7.5% year-over-year in January, well above the market expectations and the Fed’s target of 2%. The core CPI, which excludes food and energy prices, rose by 5.8%, also a record high.
The rising bond yields reflect the investors’ concerns about the inflationary outlook and the Fed’s ability to contain it. The Fed has signaled that it plans to raise interest rates three times this year, starting from March, to combat inflation. However, some analysts believe that the Fed may have to act more aggressively and hike rates more than expected, which could hurt the economic recovery and weigh on the banking sector.
Banking Sector Faces Liquidity and Solvency Issues
The banking sector is also facing liquidity and solvency issues, as the rising bond yields have eroded the value of their bond portfolios and increased their funding costs. The banks rely on short-term borrowing from the money markets to finance their long-term lending activities, such as mortgages and business loans. However, as the short-term interest rates rise, the banks have to pay more to borrow money, which squeezes their profit margins and reduces their lending capacity.
The situation worsened last week, when Credit Suisse, one of the largest US banks, announced that it was filing for bankruptcy after suffering massive losses from its exposure to a hedge fund that collapsed due to a margin call. The hedge fund, Archegos Capital Management, had borrowed heavily from Credit Suisse and other banks to bet on risky stocks, such as ViacomCBS and Discovery. However, when the stock prices plunged, the banks demanded more collateral from Archegos, which failed to meet its obligations and triggered a fire sale of its assets.
The bankruptcy of Credit Suisse sent shockwaves across the financial system, as investors feared that other banks may also face similar losses or liquidity problems. The stock prices of many US banks fell sharply, while their credit default swaps (CDS), which measure the risk of default, spiked. The CDS of Credit Suisse soared to over 300 basis points on Friday, meaning that it would cost $300,000 per year to insure $10 million of its debt.
Government and Regulators Try to Restore Confidence
The government and regulators have tried to restore confidence in the banking sector by providing assurances and support. Treasury Secretary Janet Yellen said on Tuesday that the government is ready to provide further guarantees of deposits if the banking crisis worsens. She also said that authorities believe they have taken appropriate steps to stem liquidity problems in the sector, but will take more action if needed.
The Federal Deposit Insurance Corporation (FDIC), which insures deposits up to $250,000 per account, said that it has enough funds to cover any potential losses from bank failures. The FDIC also said that it is closely monitoring the situation and working with other regulators to ensure the safety and soundness of the banking system.
The Federal Reserve has also played a key role in stabilizing the banking sector by providing ample liquidity through its various lending facilities and asset purchase programs. The Fed has injected trillions of dollars into the financial system since the onset of the Covid-19 pandemic, buying Treasury bonds, mortgage-backed securities, corporate bonds, municipal bonds, and other assets. The Fed has also lowered its benchmark interest rate to near zero and offered cheap loans to banks and other financial institutions.
However, some experts warn that the Fed’s actions may have unintended consequences, such as fueling inflation and creating asset bubbles. They argue that the Fed should taper its asset purchases sooner rather than later and raise interest rates more gradually to avoid disrupting the markets and hurting the economy.
