The stress in the US banking sector poses a dilemma for the US Federal Reserve. Core inflation remains high and is far from the Fed’s target level. This suggests that policy rates need stay at current, elevated levels for longer than the market expects. Were it not for regional banking stress, markets would likely be pricing in a terminal rate for fed funds closer to 6%.
However, it is exactly the high policy rates, in combination with poor regional bank balance sheet management, that has resulted in several bank failures already. Credit growth for small- and medium-sized enterprises is likely to slow. While this should contribute to a necessary slowdown in economic growth and thus inflation, the latest US non-farm payrolls data showed that the labour market has remained tight.
Before the failure of some regional US banks, central bank rates were seen peaking at 5.5-6%. Market pricing has now moved to predicting almost 150bp of cuts over the next 12 months. In Europe, the ECB’s peak rate is expected to be later than the Fed’s, at around 3.75%.
Limited bank stress, but ‘macro-significant’
Arguably, the bank stress episode has brought forward the timing of recession via its impact on lending, but we believe the Fed will be reluctant to cut rates as long as core inflation remains far above its 2% target. With wage-driven inflation being sticky, any Fed cuts look unlikely until late 2023 at the earliest. In our view, the magnitude of a 2024 cutting cycle should be limited.
We believe that regional banking problems are not systemic, though they are still ‘macro-significant’. Bank deposit outflows to money market funds have slowed. Bank earnings will likely be challenged by the need to raise the rates paid on deposits and an increased burden from tougher regulations. The provision of credit can be expected to contract further.
While it is difficult to calibrate, banks’ tightening of credit standards and the hit to animal spirits are likely to have an impact equivalent to a couple of Fed interest rate rises. Tighter credit conditions will likely to help bring forward a recession that we had been anticipating in late 2023/early 2024.
Expect a further slowdown
Growth for now, however, is resilient. Institute for Supply Management surveys of manufacturing and services rose in April. At the same time, open job positions have fallen back. The latest labour force participation rate was unchanged, while the rate of wage gains increased. We conclude that the labour market remains tight, but the direction of travel is towards a rebalancing.
We believe the latest Fed rate hike is the last in the currenct cycle. The stress in the regional bank segment is sufficient to prevent further increases, but insufficient to prompt the central bank to pivot to cuts with core inflation well above target.
In our view, real (inflation-adjusted) yields need to be in restrictive territory for some time, although we have lowered our targets.
An ‘immaculate disinflation’ – whereby wage pressures moderate simply through the removal of excess job openings, without significant actual job losses – is wishful thinking. To reduce wage pressures, the Fed must still engineer an increase in the unemployment rate, which will require a period of restrictive conditions.
However, the banking sector anxiety suggests that the Fed’s aggressive tightening is now having a significant impact, with some institutions in the credit intermediation (and monetary policy transmission) process coming under stress. Investor concerns have been focused on asset classes and institutions that may be vulnerable to higher rates.
Something has broken
Many investors have taken the view that the Fed will likely keep policy in restrictive territory ‘until something breaks’ – with that ‘something’ being the labour market or part of the financial system. It has turned out to be the latter.
The credit contraction that the Fed has been looking to engineer could yet turn into a credit crunch. A candidate for potential trouble is the commercial real estate sector, which suffered from the pandemic and where regional banks and private equity have considerable exposure.