While the situation remains fluid and uncertain, the problems appear idiosyncratic than systemic.
- Stress in the U.S. banking sector is idiosyncratic rather than systemic, but market uncertainty will remain elevated.
- Credit conditions will continue to tighten, raising not only the probability of recession, but potentially its severity.
- We recommend a defensive bias in portfolios, moving higher up the quality spectrum in credit and the capital stack in bonds.
The U.S. Federal Reserve (Fed) hiked interest rates for the ninth consecutive time at its March meeting, raising the fed funds rate by 475bps in the past year. The latest rate hike came against a backdrop of financial turmoil and still high, but declining, inflation. The Fed acknowledged the potential risks to the economic outlook stemming from the upheaval in the banking sector, and adopted a more dovish tone. But given the uncertain inflation outlook, the Fed has not ruled out further rate hikes.
While the Fed remains highly data dependent, the market is not, and has swiftly moved to price in cuts from mid-year given expectations of tighter credit conditions and weaker growth.
In this note, we consider the risks to U.S. economic outlook and the indicators to watch when assessing a potential credit crunch.
Is the U.S. heading for a credit crunch?
The tightening of bank lending standards began as the Fed started to raise rates but became more acute in the final quarter of 2022. The expectation is that lending standards will continue to rise as the banks are increasingly scrutinised for adequate levels of capital, liquidity and asset quality. However, it is too early to determine if this will manifest itself as an outright credit crunch in the broader economy.
So far the actions by the Fed, U.S. Treasury and Federal Deposit Insurance Corporation (FDIC) appear to have reduced the most recent stress and banks are making use of the new liquidity provisions. Based on the data through March 15, borrowing at the newly established Bank Term Funding Program (BTFP) increased but was offset by the decline in borrowing at the Fed’s deposit window, leaving aggregate borrowing from these Fed facilities little changed based on data available. This suggests banks are so far actively managing deposit outflows without needing to heavily rely on liquidity from the Fed. Overall, the market concerns with regards to deposit outflows are relatively localized, contained and manageable.
Small banks account for approximately 40% of lending in the U.S., a figure that has steadily increased in the past decade. As banks focus on balance sheet strength and the quality of their lending, the flow of credit likely will be restricted. The potential for increased regulatory oversight on regional banks may also further limit credit growth.
Exhibit 1: Small domestic commercial bank loans
Share of total domestic bank loans
Continued tightening in lending standards will impact household and business financing, creating a drag on economic activity. But without a more sustained systemic risk to the financial system and full-blown banking crisis, the depth of any recession in the U.S. may still be relatively shallow and short in duration. However, the risk to something meaningfully worse have risen at the margin should the current shocks continue to reverberate through the financial system.
Exhibit 2: Lending standards have tightened
Share of respondents tightening standards
What to watch?
A potential reduction in liquidity and restriction in credit within the economy can come about in different ways. But for signs of stress, the markets will be focused on:
- Signs of greater depositor outflows or a sharp increase in the use of liquidity facilities, which may point to signs of stress or the inability of banks to manage liquidity issues.
- In prior episodes, liquidity stress in the U.S. financial system has been measured by the difference between 3-month Forward Rate Agreement (FRA) and the Overnight Indexed Swap (OIS) spread. Large spikes in this metric would signal that banks may be unwilling to lend to each other, exacerbating the credit squeeze in the economy.
- Broader measures of financial stress, such as financial conditions indices. Financial conditions eased in 2022, perhaps at the annoyance of the Fed, and have reversed this move in 2023, but are not yet at extremes.
While the situation remains fluid and uncertain, the problems appear idiosyncratic than systemic. Maintaining confidence is crucial and central banks need to demonstrate the ability to handle the challenges within the banking sector. This should greatly reduce the probability of meaningfully higher interest rates.
The good news is the underlying financial system is stronger than heading into the global financial crisis given the increase in regulation.
The latest Fed decision and banking sector stress in the past weeks reinforce our view of taking a more defensive approach in asset allocation, focusing on high quality fixed income. This includes developed market government bonds and high-grade U.S. corporate credit.
In equity markets, the relative outperformance of the Chinese economy as reopening continues provides a window of opportunity for both Chinese equities and Asian companies that are less dependent on exports.
While in developed markets, the focus is on companies with strong balance sheets and pricing power that will help them navigate a slower growth environment.