Torsten Slok would have answered your question a week ago about how the economy would fare in the year ahead. He said he expected a no-landing scenario whereby there was no landing. Federal Reserve This would reduce inflation and not trigger a downturn.
After the collapse of three US bank branches in just a few days, all that changed was now. The chief economist of Apollo Global Management now says he’s bracing for a hard landing. He joined the What’s up Podcast to discuss his shifting views.
These are some highlights from the conversation. They have been condensed, edited and clarified. Click here Listen to the complete podcast on the Terminal or subscribe to Apple Podcasts, Spotify, or any other place you like to listen.
Q: You changed your view of seeing a no-landing scenario to a hard-landing one — tell us about this.
A: It was a debate that raged up until recently about why the Fed raises rates and the economy is not slowing down. How is it possible that the consumer is doing so well? A very important answer was that there was still plenty of savings in the income distribution. This meant that many households still had a lot of savings to go after the pandemic. The debate about why the economy isn’t slowing down was ongoing up to recently. And call that what you want, but that’s what we have called the no landing. This was the reason inflation has remained within the range of 5% to 6% and 7%. That’s why the Fed had to raise rates.
What happened, of course, here with Silicon Valley Bank was that suddenly out of the blue, at least for financial markets, really nobody — and I think that’s safe to say at this point — had seen this coming.
As a result, we all had to go back and rethink our plans. What is the significance of regional banks? How important is the banking sector for credit extension? According to data from the Fed, roughly a third (33%) of assets in the US banking industry are located in small banks. Here, a small bank can be defined as any bank number 26-8,000. Large banks are ranked from one to 25 in terms of assets. So that means that there’s a long tail of banks. Some are very large, but they shrink the farther you go. The key question for today’s markets is: How important are small banks now that they are having problems with deposits, funding costs, dealing with issues regarding their credit books and also with stress testing on smaller banks?
So this episode with the Silicon Valley Bank, markets are doing what they’re doing and there’s a lot of things going on, but what is really the major issue here is that we just don’t know now what is the behavioral change in terms of lending willingness in the regional banks. And given the regional banks make up 30% of assets and roughly 40% of all lending, that means that the banking sector has now such a significant share of banks that are now really at the moment thinking about what’s going on. And the risk with that is that the slowdown that was already underway — because of the Fed raising rates — might now come faster simply because of this banking situation. So that’s why I changed my view from saying no landing, everything is fine to now saying, well, wait a minute, there is a risk now that things could slow down faster because we just need to see over the coming weeks and months ahead, what is the response going to be in terms of lending from this fairly significant part of the banking sector that is now going through this turbulence we are seeing.
Q: We haven’t really seen any deterioration in creditworthiness yet. Is it possible that the curtailing credit supply will result in similar outcomes? Or is there a reason to think it’ll be different? Is it possible that we will see another drop in credit quality?
A: I started my career at the IMF in the 1990s, and the first thing you learn is that a banking crisis and a banking run normally happen because there are credit losses on the bank’s books. In 2008, we saw this. This was evident in 2008. These were very liquid losses. This couldn’t just be sold very quickly. This is quite a different situation. In a strong economy, we have never experienced a banking crisis. The irony is that this is the most liquid asset, Treasuries.
So that’s why if 10-year rates, let’s say that they go down to say, 2.5% or even 2%, that will be helping incredibly on the banks’ balance sheets because it is the liquid side of the balance sheets that have, at least in this episode, been the main problem in terms of what the issues are. So that’s why the fear is that if we now have not only the lagged effects of the Fed hiking rates already slowing the economy, but if you now have a magnified effect that the slowdown might come a bit faster, then of course we do ultimately also need to look at what does that mean for credit losses, for everything that banks have on their balance sheets.
Q: What everybody in the market is saying is that they were waiting for the moment the Fed “broke” something and now something has broken. What are you expecting from this Fed meeting?
A: Looking at the Fed meeting today, the challenge is that there are risks for the Fed’s financial stability. If we had spoken about this a week ago, then I would’ve said they’re going to go 50. But today, it is suddenly the case that the top priority — which we thought until recently was all inflation — has been replaced and put into the back seat of the car. Financial stability is now the number one priority. The Fed must ensure that financial stability is the number one priority. If that is the case, credit will flow to consumers, corporates, residential real estate, and commercial real estate. You can also be at risk of a more difficult landing if it is not. So that’s why financial stability being the top risk would lead me to the conclusion that they can always raise rates later if this does turn out to be like Orange County and LTCM. The biggest risk to this meeting at the moment is that they don’t feel secure enough in their financial system to raise rates again.
— With assistance by Stacey Wong