A handful of large, troubled U.S. regional banks — and maybe one really big European one — may well accomplish what the mighty Federal Reserve couldn't on its own: tightening the financial screws enough to slow down economic activity in a meaningful way.
- That, at least, is the takeaway from financial market moves since the federal seizure of Silicon Valley Bank less than one week ago.
Why it matters: Just a couple of weeks ago, we mused about why a series of Fed hikes have not affected the economy more. But now, there are early signs that banking troubles will constrict credit and damage confidence in ways that rate hikes alone have not.
- It is a fast-moving, highly uncertain situation in which Fed officials will have to rely more on gut instinct than backward-looking hard data.
- Should the Fed continue its long-telegraphed tightening campaign to bring down inflation, or conclude that a seize-up in lending conditions triggered by banking problems will do the job for them?
Between the lines: Stress in the financial system tends to have powerful effects on growth. Part of the reason rate hikes haven't slowed the economy more over the last year is that, while borrowing costs have been higher, credit has mostly remained readily available.
- That would change if the failures of SVB, Silvergate and Signature Bank (and troubles at several others) lead banks writ large to adopt greater caution, curtailing lending.
- Similarly, it could make buyers of corporate bonds more risk-averse, lending on less favorable terms and at higher interest rate premiums relative to safe assets.
- Even if there are no further bank failures, notes JPMorgan Chase's Michael Feroli, there could be an outflow of deposits from smaller banks that causes them to try to shrink their loan book; they could also constrain lending in anticipation of tighter regulation or a recession.
What they're saying: "Even prior to this shock, bank lending conditions had begun to tighten to levels that typically precede recessions," Matthew Luzzetti, chief U.S. economist at Deutsche Bank, tells Axios.
- "We anticipate this shock is likely to lead to further risk aversion that will accelerate the tightening through this channel, making a recession by year-end even more likely," he said.
By the numbers: Swings in the bond market are consistent with a story of tighter credit and a gloomier outlook for the remainder of 2023 than was the case a week ago.
- The two-year Treasury yield, 5.06% just eight days ago, was at 3.93% Thursday morning. That implies the Fed will soon be cutting its target rate from the current levels of around 4.6% — something it will only do if there is clear evidence of economic deterioration and falling inflation.
- Spreads between rates on riskier corporate debt and equivalent Treasuries have widened, as have measures of anticipated market volatility.
Yes, but: When markets are in turmoil, as they are this week, extreme volatility can reflect more a sense of momentary panic and shifts caused by large investors unwinding positions than any considered reassessment of the likely path of the economy.
- Moreover, this economy has proven strikingly resilient over the last year; even as the Fed has hiked, the stock market has swooned, while housing and tech faced real challenges. Perhaps underlying momentum is strong enough to handle a banking panic, too.
What to watch: A range of institutions publish a financial conditions index to capture all this in a single number. We'll be paying attention to what they show.
- Also, the Fed releases every Friday afternoon a report on the assets and liabilities of American commercial banks, known as the H.8 report. It will be worth paying special attention to in the coming weeks.
The bottom line: One week ago, it looked like the open questions for the economy would be answered with data on jobs and inflation. Now we are in a murkier, more uncertain world with greater risks of real economic pain.
