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A new narrative has gripped the markets. As a result of the blows suffered by US banks and Credit Suisse, economists and analysts are saying banks will now be wary of lending, especially the regional banks that account for a substantial chunk of credit. That could result in a credit crunch, which will slash growth in the US. Moreover, since regional banks lend predominantly to smaller businesses, the credit crunch will affect these smaller firms. The upshot is that the odds of the US economy tumbling into a recession have risen sharply in the past couple of weeks. Therefore, goes the argument, the US Fed should not exacerbate the situation by raising its policy rate today. Some, like Elon Musk, have called for a rate cut. Nomura has predicted a 25 basis point rate cut and an end to quantitative tightening, to offset financial instability.
Indeed, a recent study published at NBER says that even if 10 percent of uninsured depositors withdraw their money, 66 banks, accounting for $210 billion of assets, would fail in the US.
There are several reasons why banks may decide to go slow on lending. One, they might prefer to build up a buffer with which they can meet any withdrawals from their deposits. Two, if some depositors panic and withdraw deposits, banks will have to crimp their lending. Three, they may not want to invest in corporate or even government paper that will go down in value as interest rates rise. Four, many small banks are exposed to real estate, which is usually hurt when interest rates rise. Five, they may want to increase their capital adequacy.
Goldman Sachs economists say the incremental tightening in lending standards that they expect from small bank stress would have the same impact on growth as roughly 25-50 basis points of rate hikes. Others have come up with even higher estimates — Torsten Slok, economist at Apollo Global Management, says the banking crisis is equivalent to 150 basis points of rate hikes. In short, the argument is that since the banking crisis has already tightened financial conditions considerably, the Fed need not continue with its interest rate hikes.
But is this narrative correct, or is it an over-reaction to the recent panic? US Treasury Secretary Janet Yellen has said they would intervene to protect depositors at smaller banks if there is a risk of contagion. If the panic was as bad as made out to be, how is it that bond yields are rebounding so soon? Even if we assume that is only a relief rally, the fact remains that spreads for US high-yield bonds are still below where they were in July last year and nowhere near the levels they reached at the time of the COVID crisis in early 2020, to say nothing about the heights scaled during the Global Financial Crisis.
Moreover, the fall in deposits at US banks has been going on for quite a while now, ever since the Fed started raising interest rates. It could be argued that the reason why Silicon Valley Bank failed was essentially because its liabilities were too concentrated, focused on venture capital that was a big casualty of Fed tightening.
On the asset side, rating agency S&P Global has said that they "view the risks from unrealised losses as manageable" and that "most banks have the capacity to hold their (non-trading) fair-valued assets to maturity, and in doing so neutralise the impact of unrealised losses over time".
And then, of course, there is the fact that inflation, particularly core inflation, is well above the Fed’s target.
There is also the precedent of the European Central Bank hiking its policy rate by 50 basis points in the midst of the Credit Suisse crisis. And the Bank of England eased liquidity to tackle its liquidity crisis, but that didn’t prevent it from continuing to hike rates.
That said, Jerome Powell will have to tread a fine line, not only when deciding on whether to hike or not to hike, but how to soothe the fears about banking contagion. Our columnist Ajay Bagga says the Fed is likely to deliver a significant policy messaging pivot, aimed at calming market worries. After all, as the Bank of America survey of fund managers found, the biggest tail risk is apparently a credit risk event in US shadow banks.
The CME Fedwatch tool says Fed Fund futures are pricing in 89 percent probability that the Fed will hike by 25 basis points today. But then, these futures have been all over the place, with the probability of a 25 basis point hike ranging from 73 percent a day ago to 54 percent a week ago to 76 percent a month ago. It may very well change again -- and rapidly.
Some have said the Fed pausing now will reflect upon its credibility. That should not worry the central bank too much. It can always retort with the quote often attributed to John Maynard Keynes: “When the facts change, I change my mind. What do you do, sir?”
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Moneycontrol Pro
Manas Chakravarty
