In the post-pandemic world, investors have largely been living in an economy and market conditions that are upside down. A good jobs report and historically low unemployment rate send the market lower, while the possibility of a recession puts some experts and analysts into a more bullish stance.
The reason is that a tight labor market and a strong economy have fueled inflation, while a recession might force the Fed to cut interest rates, which would trigger more of a risk-on environment for stocks.
This banking crisis that we are now in has led to a similar backward mindset: It could significantly slow the economy later this year and even tip it into a recession, but that also may force the Fed, which has gotten more hawkish recently, to finally end its intense rate-hiking campaign and maybe even cut interest rates.
A tightening of credit
Prior to the collapses of Silicon Valley Bank (a subsidiary of SVB Financial) and Signature Bank, the Fed had been contemplating a 0.50-percentage-point hike at its recently completed meeting in March but only ended up raising interest rates by a quarter point. Recent data suggests the labor market remains strong while consumer prices are still too high.
But after several banks collapsed, largely due to deposit runs, banks are going to be more nervous about their deposits and how sticky any of these really are after this intense interest rate-hiking campaign, where three-month U.S. Treasury bills are currently yielding 4.65%. This will likely lead banks to try to keep their balance sheets much more liquid, not go too long on bonds or loans, and slow lending so they are not too leveraged if/when any nasty surprises crop up.
"A very rough estimate is that slower loan growth by mid-size banks could subtract a half to a full percentage-point off the level of GDP [gross domestic product] over the next year or two," economists from JPMorgan Chase wrote in a recent research note. "We believe this is broadly consistent with our view that tighter monetary policy will push the U.S. into recession later this year."
Economists at Goldman Sachs reduced their estimates for fourth-quarter U.S. GDP by 0.3 percentage points, which brings their forecast down to 1.2% growth year over year. Even Fed Chair Jerome Powell said at a recent press conference that a tightening of credit by the banking system is "the equivalent of a rate hike, or perhaps more than that."
Don't forget about credit normalization
Goldman also noted that banks with less than $250 billion in assets originate half of all U.S. commercial and industrial loans, 60% of mortgages, 80% of commercial real estate, and 45% of consumer loans.
The other thing to consider is that credit quality in the banking system has been very healthy over the last few years, showing only minimal cracks. However, most have been waiting for normalization. Bank executives have already cited problems they are seeing in office space.
Additionally, when certain assets and liabilities of Signature Bank were sold to New York Community Bancorp, many of Signature's assets were left in the hands of the Federal Deposit Insurance Corporation (FDIC). Christopher Whalen of Whalen Global Advisors called $11 billion of Signature's multifamily loans left with the FDIC "toxic waste."
These loans are tied to multifamily apartments with rate caps and reportedly high debt-to-value ratios. Now, NYCB also probably didn't want these loans because of concentration risk and it wanted to get its very high loan-to-deposit ratio down, but news like this is not going to instill confidence. Credit also takes time to deteriorate and many leases and mortgages have not been renewed or expired yet. The Wall Street Journal, citing data from Trepp, reported recently that $270 billion of commercial mortgages will expire at the end of the year.
How likely is a rate cut?
There is still a lot of uncertainty in the air, but a significant slowdown in lending would not be good for the economy and could lead the Fed to cut interest rates, especially if the economy tips into a recession.
Lower lending rates increase borrowing activity, and I'm sure banks would be more willing to lend if shorter-term interest rates, which is what they borrow at, were actually lower than longer-term interest rates, which is what banks typically lend at.
Also, keep in mind that a good portion of the Fed's previous rate hikes are still working their way through the economy and should continue to slow it down in the months ahead. For the market, this may end up being good news because not too long ago many believed that the Fed may take interest rates as high as 6%.
Now, many traders are pricing in a rate cut as soon as July, which is earlier than they had been expecting heading into 2023 and could lead to a better back half of the year for the market.