Credit is the lifeblood of the economy, and the credit system just had a heart murmur.

After a spate of scares and hurried rescues in the banking system, financial markets have had a week to calm down and take a deep breath.

The liquidity issues at the banks under duress do not appear to be that widely shared. The U.S. Federal Reserve’s Bank Term Funding Program was an aggressive response to shore up confidence. Central bank officials have all communicated calm vigilance. And, following some initial confusion, U.S. Treasury Secretary Janet Yellen has firmed up her language on potential deposit insurance.

As our commentary on the episode suggests, we consider it to be less severe than the troubles of 2007 – 08. Nonetheless, with many banks under water in oversized government bond portfolios and highly exposed to problematic commercial real estate lending, we may not have seen the last of the drama—and even if we have, the crisis may leave some lasting damage to the economic outlook.

What Caused This Crisis?

To appreciate the challenge facing central banks, it’s worth recounting how this crisis started.

The enormous fiscal and monetary stimulus provided to mitigate the effects of the COVID-19 pandemic created a deposit windfall for banks on the order of $5 trillion. With few loan growth opportunities, they invested those deposits in U.S. Treasuries, municipal bonds and mortgage securities, all at historically low interest rates. Then came inflation and an unprecedented speedy rate-hike cycle by the Fed, which pushed Treasury yields up and led depositors to seek higher interest from money market funds, forcing some banks to liquidate these investments at significant losses.

As we feared, such a brutal turn in monetary policy was likely to break something.

A month ago, central banks faced a dilemma: how to fight inflation without undue damage to the economy and jobs. Now they face the full “trilemma”: how to achieve those two objectives while also stabilizing the banking system.

What Will Be the Long-Term Costs?

Assuming, for now, that the banking sector is stabilized, the more significant question is what happens to the availability of credit.

Consumers and businesses can barely function without credit: Tight lending and credit standards slow economic activity, while too-loose credit standards can fuel the opposite and create other problems—remember 2008?

Higher policy rates, the inverted Treasury yield curve and a weakening economy have already tightened conditions.

The Fed and the European Central Bank regularly ask banks whether they are loosening or tightening credit standards, and by taking away the percentage that are loosening from the percentage that are tightening, they report the net percentage of banks that are tightening. The Fed’s latest Senior Loan Officers’ Opinion Survey (completed before the Silicon Valley Bank problems) saw the net percentage of institutions tightening credit standards for commercial and industrial loans rise from -14.5% in the first quarter of 2022 to 44.8% in the first quarter of this year. For commercial real estate loans, it went from -10.3% to 69.2%. In Europe, the equivalent figure rose from 2% to 26% through 2022.

But we worry that the recent banking problems will result in lenders pulling back even more aggressively. Economists have estimated that the impact of the recent crisis is already equivalent to a 25- to 50-basis-point Fed rate hike.

Bailing out Silicon Valley Bank and Signature Bank, despite them not being obviously systemically important, will continue to generate costs, and Congress will likely ensure that these are ultimately shouldered by the banking industry. To stem deposit withdrawals, customers may need to be compensated with higher rates. Investors in bank capital may demand a higher premium against the risk of being “bailed in” during a rescue.

Tighter regulation is also likely. If the U.S. Federal Deposit Insurance Corporation (FDIC) now effectively guarantees all $18 trillion of U.S. deposits (rather than just the $11 trillion that sit below the $250,000 threshold), it seems likely that significant new banking regulation will follow to protect taxpayers. At the very least, there are likely to be demands for more loss-absorbing capital and short-term liquidity, and a debate about how many smaller institutions in the U.S.’s highly fragmented banking system should be subject to those demands.

Even if only some of this happens, it will translate into higher costs and lower earnings for the banking sector, higher fees and tighter terms for its customers, and potentially less capacity and appetite to lend.

Near-Term Focus

Some of these implications of the crisis will play out over months and years. In the meantime, we think investors should focus on that central bank trilemma.

For all the reasons described above, banks under stress are likely to tighten credit conditions faster and further than policymakers intended. And yet, right now, European and U.S. consumer prices, jobs data, and corporate and consumer surveys remain surprisingly resilient.

If those conditions persist for any length of time, how will central banks respond? Can they afford to wait and hope that tighter credit conditions eventually start to bite into demand? Do they gamble on more aggressive hikes, despite the evident risks to financial stability and the flow of credit? Or—our base case—do they hold at the current level and simply commit to it for longer?

None of those outcomes would be particularly positive for corporate earnings and the economy. Credit is its lifeblood, and it needs to flow at an appropriate rate. That is why, in our view, the approaching end of the hiking cycle may be the time to start planning a return to risk assets, but not yet the time to execute it.

In Case You Missed It

  • S&P Case-Shiller Home Price Index: January home prices decreased -0.58% month-over-month and increased +2.55% year-over-year (NSA); -0.43% month-over-month (SA)
  • U.S. Consumer Confidence: +0.8 to 104.2 in March
  • Eurozone Consumer Price Index (Flash): +6.9% year-over-year in March
  • U.S. Personal Income and Outlays: Personal spending increased +0.2%, income increased +0.3%, and the savings rate rose to 4.6% in February

What to Watch For

  • Monday, April 3:
    • ISM Manufacturing Index
  • Tuesday, April 4:
    • Eurozone Producer Price Index
    • JOLTS Job Openings
  • Wednesday, April 5:
    • ISM Services Index
  • Friday, April 7:
    • U.S. Employment Report

    Investment Strategy Group