From ‘no landing’ to crash landing?


Until approximately, uh, last Thursday, the chatter in macroeconomic circles was no longer just whether the US economy was facing a hard or soft landing: “no landing” was the hot new prediction.

US economic data was proving remarkably impervious both to the physical pain of aggressive interest rate increases and the more psychological anguish of bad vibes. The US labour market just DGAF, it seemed.

The collapse of Silicon Valley Bank and the wider financial ructions it has triggered has now radically altered the narrative again. For example, Apollo’s Torsten Sløk says he has shifted from Team No Landing to Team Hard Landing. His emphasis below.

When the facts change, my view changes. A financial accident has happened, and we are going from no landing to a hard landing driven by tighter credit conditions, Small banks account for 30% of all loans in the US economy, and regional and community banks are likely to now spend several quarters repairing their balance sheets. This likely means much tighter lending standards for firms and households even if the Fed would start cutting rates later this year. With the regional banks playing a key role in US credit extension, the Fed will not raise interest rates next week, and we have likely seen the peak in both short and long rates during this cycle.

Here’s a chart underscoring his point.

BlackRock’s Larry Fink raised a similar point in his annual letter to investors earlier this week.

While it was still unclear whether the SVB debacle would cascade into a big fat new S&L Crisis, “it does seem inevitable that some banks will now need to pull back on lending to shore up their balance sheets, and we’re likely to see stricter capital standards for banks”, he wrote.

Jan Hatzius’s team at Goldman Sachs has just published a report digging into the subject in a bit more depth. Here are is the bullet-pointed abstract. FTAV’s emphasis below:

— US policymakers have taken aggressive steps to shore up the financial system, but concerns about stress at some banks persists. Ongoing pressure could cause smaller banks to become more conservative about lending in order to preserve liquidity in case they need to meet depositor withdrawals, and a tightening in lending standards could weigh on aggregate demand.

— Small and medium-sized banks play an important role in the US economy. Banks with less than $250bn in assets account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending.

— Any lending impact is likely to be concentrated in a subset of small and medium-sized banks. While the two banks taken into receivership account for just 1% of total bank lending, the lending shares are 20% for banks with a high loan-to-deposit ratio, 7% for banks with a low share of FDIC-insured deposits, and 4% for banks with a low retail share of deposits.

— The macroeconomic impact of a pullback in lending will remain highly uncertain until the extent of the stress on the banking system becomes clear. We estimate it using two approaches. Our accounting approach assumes that small banks with a low share of FDIC-covered deposits reduce new lending by 40% and other small banks reduce new lending by 15%. This implies a 2.5% drag on the total stock of bank lending, which economics studies suggest would result in a roughly ¼pp drag on 2023 GDP growth. Our statistical approach expands our financial conditions growth impulse model to include bank lending standards, which we assume will tighten substantially further, and implies a drag on GDP growth of ½pp beyond that already implied by the lagged impact of the tightening in recent quarters.

We have lowered our 2023 Q4/Q4 GDP growth forecast by 0.3pp to 1.2% to incorporate these estimates of tighter lending standards, reflecting in part a larger downgrade to investment spending.

— Unless bank stress significantly changes the outlook, the Fed’s goal for the year will be to keep demand growth below potential in order to keep the rebalancing of supply and demand on track. Tighter bank lending standards help to limit demand growth, sharing the burden with monetary policy tightening. Our analysis implies that the incremental tightening in lending standards that we expect from small bank stress would have the same impact on growth as roughly 25-50bp of rate hikes would have via their impact on market-based financial conditions.

Goldman Sachs has been one of the most optimistic banks on Wall Street, but even its confidence seems to be shaken. Separately. the bank’s economics team lifted its odds on a US recession over the next 12 months from 25 per cent to 35 per cent.

It’s a fascinating situation. The “normal” trigger for banks reining in lending is credit risk: a weaker economy causes more loans to go bad, and more bad loans spurs banks to cut back lending, weakening the economy further.

But this is fundamentally (so far at least) about interest rate and funding risk. So the dynamics might be very different.