The size and speed of the tightening Fed policy we are currently enduring has been unprecedented. (Just 12 months in from the first interest rate hike and 450 basis points higher!) The potential financial spillovers from such a move are still simply a guessing game.
- We have seen specific and idiosyncratic risks manifest in some of the weakest segments of the economy – a select group of banks in the US and Credit Suisse have been the poster children.
- The risk: that the pressures facing these factions spread into a massive negative feedback loop, driven by a lack of confidence in the system.
- If these fears persist and their stresses begin to permeate outside of these specific areas, this negative feedback loop could easily take on a life of its own.
- Should central bankers prove effective in short-circuiting this doom loop, we will likely still see collateral damage.
We think the risks have shifted. Stronger growth and sticky inflation were forcing the Fed’s hand – one that risked a material tightening in order to arrest the inflation boogeyman. However, financial instability has suddenly done quite a bit of the Fed’s dirty work very quickly and this has altered the mood. This should be enough to warrant a slowing in the pace of tightening and a pause likely well below the terminal rate pricing just a few weeks ago, shifting the market’s focus from inflation worries to growth concerns.
So the question becomes: Have the risks to a recession materially increased as a result of the recent financial system wobbles? Let’s take a look. First of all, small banks had already begun to cut their lending and have seen the demand for loans decline. This was under way even before the Silicon Valley Bank situation began to metastasize. Big banks too.
Domestic Banks Reporting Demand for Loans (1/31/03–3/31/23)
Example: The loan supply/GDP multiplier is roughly 50% – for every drop worth $10 of loan supply, GDP is expected to contract by $5. (Estimates we’ve seen by economists put this multiplier at 30%–50%.) Credit extension in aggregate drops 50% in this scenario (small banks drop to 0% but big banks pick up 50%), so 50% of 2% (total credit supplied by small banks as a percentage of GDP) is 1%. If we assume the flow-through to the real economy is 50% (the loan supply/GDP multiplier), then 50% of 1% is 0.50%. So the hit to GDP could be 0.50%. Now take a peek at the Atlanta Fed’s GDPNow forecast – it’s calling for 1Q23 growth of around 2.50% with the recent range being 2%–3%. So, clip off 0.50% from 1Q GDP and 2.5% becomes 2.0%. This number falls short of a hard landing scenario.
Winners and losers
There will be winners and losers from the banking failure fallout. That we can be sure of. Big banks seem to be the winners, as depositors shift their money to the larger money centers as a means of flight to safety. But with such an influx of deposits – and recall that these banks had shunned deposits during Covid – is there an incentive to increase deposit rates? If so, would this likely help Net Interest Margins (NIMs)?
To be sure, even large banks are fighting against more attractive rates in Treasuries and money markets, but deposits can remain sticky for reasons other than rates – confidence is certainly one of them. And for smaller banks fighting to retain depositors, will they need to jack up short rates aggressively to keep these flows from fleeing? If so, would this likely hurt NIMs?
In the “Losers” column, we could see commercial real estate (CRE) and auto loans. Some 80% of CRE lending comes from small and medium-sized banks. With lending expected to slow and standards tightening, should we expect CRE to feel the pinch? Small banks have also seen an uptake in auto loan financing, accelerating during the Covid crisis.
As mentioned previously, maybe loan growth slows as a result of the fallout from the SVB debacle, but it certainly doesn’t seem to signal a hard landing is imminent. Many of the lending opportunities could easily be absorbed by larger institutions, with the exception of commercial real estate which appears to be a niche sweet spot for small banks.
At the end of the day, this is a confidence crisis. Short-circuit the negative feedback loop resulting from failing confidence in deposits and the fallout should prove to be contained.
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