Some commentators are now suggesting the US regional banking crisis is over. The latest victim of a short selling attack, PacWest Bancorp, saw its share price soar on Friday (5 May) and it opened this week (8 May) higher still. Goldman Sachs published data showing that the pace of deposit outflows has slowed since the crisis began in March and, of course, not a single depositor has lost money.
There is a scenario in which inflation falls back to the Federal Reserve’s 2% target without a recession, interest rates fall and the US banking system prospers. But I think that is highly unlikely. A more likely scenario would see a credit crunch, more wobbles in the banking system and a US recession – albeit probably mild – before the Fed delivers the big interest rate cuts already priced into the market.
So I do not think the banking crisis is over, and though the arguments are a little bit technical they reflect serious flaws in the US financial system. First, many of the powers the US authorities used so successfully in the global financial crisis (GFC) in 2008, such as extending deposit insurance, have since been rescinded by Congress. And so far, buyers have been found for failing regional banks – but there are limits to that process.
Second, the expansion of the Fed’s balance sheet as a result of quantitative easing (QE) has removed a key mechanism that in previous crises helped stabilise the system. Before the advent of QE, a financial crisis would see a flight from bank deposits into Treasury Bills, which would push their yield down relative to that on bank deposits, widening the so-called TED spread. As such, large depositors suffered a penalty for moving deposits from banks, and as fear of bank failure rose the TED spread would widen and the system could find an equilibrium. QE has put a stop to this. In order to prevent excess reserves at the Federal Reserve, which stem from QE, the Fed would tend to push the funds rate down towards zero. Instead, the Federal Reserve has had to pay interest on excess bank reserves at the target interest rate, short-circuiting the TED spread. So depositors no longer suffer a penalty from withdrawing funds from a troubled bank.
Leaving aside these technical issues, the fear among many US banks that they might be the next victim will cause them to be ultra cautious in their lending. Indeed, a significant tightening had already occurred before the failure of Silicon Valley Bank. The Senior Loan Officer Opinion Survey, released this week, shows a further serious squeeze back towards the levels seen in the worst days of the GFC. An important difference with the GFC, however, is that the mega banks have suffered little in this latest crisis; indeed, they may even prosper in the longer term as they pick up rivals on the cheap. But they are unlikely to pick up all the slack in terms of credit supply left by their weaker brethren and will surely further tighten the terms of any loans they do make.
Meanwhile, recent employment figures demonstrate that the US economy is some distance from recession. However, the lags in monetary policy are long and variable and the huge surplus savings left over from the Covid crisis have likely lengthened those lags. But those reserves now seem to have been spent in the US and the credit crunch, if it plays out as I expect, means that US recession will be here before the end of the year.
What does all this mean for equities and economies in the rest of the world? First, central banks have been raising rates almost everywhere, with credit conditions tightening as a result. But I do not expect banks in Europe and the UK to suffer the same continuing crisis. Credit Suisse really was an isolated case and the regulators in Europe are not as constrained as their US counterparts.
Recessions are not good news for risk assets. But the impending US recession is the most widely anticipated I can remember. Earnings estimates have already been cut and although the outlook for equities is not great, we at Columbia Threadneedle have taken a broadly neutral stance given that interest rates should fall quickly. Government bonds could well outperform and, as I explained last week, the US dollar looks set to weaken further. Another big week lies ahead with crucial economic data expected in the US, so we’ll have more clarity on where we are then.
