The great recovery: how the markets have changed their tune after CS bailout

UBS may have saved Credit Suisse, albeit buying it a very cut down price with plentiful government guarantees, and promising to preserve Credit Suisse employees’ bonuses. However, it was the ECB and the European financial authorities who saved the market’s hide on Monday, after a wave of risk aversion gripped financial markets and European bank stocks suffered heavy losses. The ECB has said they stand “ready to respond as necessary” to preserve financial stability in the currency bloc, and the mood music has changed. This is akin to former ECB President Mario Draghi’s “whatever it takes” moment back in 2012 and could help to calm markets and the financial sector, after a turbulent 10 days. 

The Swiss authorities broke the unwritten rules of bank resolutions 

If we rewind 24 hours, the news about UBS “buying” Credit Suisse had only just broken, and investors were trying to ascertain the details. There were two areas of concern for investors: 1, the speed of the deal and the fact that rules had to be changed so that UBS shareholders didn’t get to vote on the deal. This was a risky road for the Swiss authorities to take, since it spread fear that investors would not be respected in the aftermath of the Credit Suisse debacle. It triggered a wave of investors selling their bank stocks because they had become inherently riskier. 2, The biggest gripe that the market had with the CS takeover, was how AT1 bond holders were treated. AT1’s are subordinated debts, whereby there is a chance of a bail in (rather than a bailout) if a bank receives government support. What is unusual in Credit Suisse’s case is that upon the announcement of the UBS deal, CS AT1 holders received a permanent write-down, which means that this category of bond holder lost all their money. This is unusual for two reasons: 1, Other European banks, do not state that AT1 holders will receive permanent write-downs, most receive partial or temporary write downs only, and 2, it meant that AT1 holders were lower down the claims hierarchy compared to shareholders, which is usually the other way round. 

The fact that Credit Suisse and UBS have changed the unwritten “rules” around AT1 bond holders, caused a major risk off event at the start of the Asian and European sessions. Why would anyone buy banking sector shares or credit, if they could see their stakes wiped out due to hasty bailouts? The other factor that caused concern was that Credit Suisse’s demise was due to a crisis of confidence and a liquidity issue, triggered by the collapse of SVB in the US the previous week. Credit Suisse did not collapse because of a credit event, and it did not have a questionable balance sheet, it also had decent capital ratios. Thus, the Swiss authorities may come to rue the haste with which they folded CS into UBS. 

Central banks restore credit market hierarchy after slipping up by the Swiss

However, within a few hours, calm has been restored and stock markets started to recover. The trigger was the Eurozone authorities and the ECB. They came out and expressed concern at what the Swiss authorities did with AT1 bond holders and assured the markets that holders of AT1 bonds in European banks would not suffer the same fate as Credit Suisse. This is important, since AT1 bonds are a key part of banking finance in Europe. Later in the day, the Bank of England came out to clarify the order in which shareholders and creditors should bear losses in a bank insolvency or resolution case. The BOE confirmed that holders of AT1 bond instruments rank ahead of common equities. Ultimately, we believe that the fact that the ECB and the BOE clarified the hierarchy of AT1 bondholders should give the European credit market a chance to recover and ultimately to thrive now that its position is known. 

There have been a couple of other factors that have also calmed the markets, global central banks pledged to provide more dollars to financial markets and hold daily rather than weekly auctions of dollars through to the end of April. However, the first auction on Monday saw very few bids for dollar liquidity, suggesting that there are no strains in global funding markets. This is a very good thing, and it could help to spur the current recovery in sentiment. The result is: rising 2-year Treasury yields, the 2-year government bond yield is now back above 3.9%, rising stocks, particularly banking shares, and a decline in the gold price, which had broken above $2,000 per ounce on the back of the CS turmoil, but is now back at $1,970 per ounce. 

Recovering credit markets, a good sign 

For the geeks out there, the credit markets recovered quickly on Monday, with European high yield debt recovering in line with stock markets. However, the collective sigh of relief from the market is also reflected in the ITRAXX Crossover index, that measures European, Asian, and Emerging market tradable credit default swaps. This index has recovered sharply, after large declines in recent days and weeks. After initially falling 15%, UBS’s share price is up 8%, as the market assesses that the takeover of CS, for $3bn, is a good medium term move that will make UBS the world’s largest wealth manager.

Fed to the rescue 

Looking ahead, the next focus is the Federal Reserve meeting and the Bank of England on Wednesday and Thursday respectively. The Fed is still expected to hike by 25 basis points, with Federal Funds futures pricing in a 71% probability. Interestingly, the market is relaxed at this prospect, most likely because they might shift to a more dovish tone, and a rate increase to 4.75-5% may end up being the terminal rate for the US. There is also a rising chance that the BOE could pause rate increases, as it was the first out of the block to raise interest rates in December 2021. The Fed and other central banks now must juggle dealing with inflation, and stabilising the global banking system, which is no mean feat. US medium-sized banks are still under pressure, which could hurt consumer and business sentiment, especially if lending levels fall. We still think that there is a sizeable chance that the Fed may not hike rates, especially if it feels like the market has done enough tightening for them. Overall, it’s only Monday afternoon, and it feels like it has been a long week already!