Banking Crisis Hastens End Of Fed Tightening Cycle
Authored by Simon White, Bloomberg macro strategist,
The 25 basis points rate hike expected from the Fed this week could be the last for some time, as stresses in the financial sector cause bank credit to contract.
The crisis-lite in the banking sector, triggered by the Fed’s rapid run of rate hikes over the last year, looks set to cause the balance sheets of US lenders to shrink as the tighter conditions force regional banks to rein in lending.
The tightening will be more than enough to persuade the Fed to step back from its current policy stance, leading to an earlier-than-expected end to rate hikes and a premature curtailment of QT as tighter credit conditions coincide with a weakening job market.
The expected tightening will come in spite of the Fed’s new liquidity facility (the BTFP). To understand why, note that not all reserves are alike. In short, reserves are likely to migrate from smaller banks, where active lending ensured they were of higher velocity, to larger banks who do not want or need them.
The economy’s recent resilience has been driven by the fact that the aggregate balance sheets of US banks have barely contracted. But this trend has been masking the reality that, while smaller banks’ assets were continuing to grow, those of large banks have fallen over the last year.
Both small and large banks have continued to lend, but activity by the larger banks has on balance been neutralized as they have also been shedding duration risk by selling Treasury and agency bonds. Non-bank buyers have been acquiring the securities, meaning total deposits held in the banking system have fallen. Bank deposits are a higher-velocity “use” of reserves and therefore, when they fall, total velocity falls, posing a headwind for the economy.
Small banks are under stress, and are likely to continue to remain so, given their exposure to real estate lending, especially for commercial property. We can see this in the chart below, which shows the 99th and 75th percentile of rates traded in the fed funds market. It is almost certainly the more distressed smaller banks who are paying 15 bps above the top end of the fed funds target range to borrow reserves.
The BTFP facility will be of limited help as smaller banks have a higher proportion of assets that can’t be shifted onto the Fed’s balance sheet.
The FDIC may have eased the risk of bank runs for now, but small banks’ liquidity problems mean they will face further turbulence. The crisis may be in abeyance, but it has further to run.
Small banks are therefore likely to significantly rein in their lending. Larger banks too: the chart below shows that a greater number overall of banks are tightening lending standards, which will lead to fewer loans being made.
Even if larger banks pick up the slack in credit, they are likely to continue shedding duration risk - as they typically do when rates have risen - meaning the impact of any lending they do could have a lesser impact on economic momentum.
The overarching issue is that deposits will now migrate from the higher-velocity world of smaller, regional banks to the lower-velocity sphere of larger banks, which are already saturated with them.
The larger US banks, especially the big four, have been turning away deposits in recent years. After a temporary halt through the pandemic, central-bank reserves once again attract a capital charge of 3%.
Big banks are drowning in reserves, which is why they have kept their deposit rates so low. This is also why this crisis is different from 2008 — back then, nobody wanted to lend, while today, the biggest players don’t need to borrow. Cue LIBOR-OIS being sub 10-bps wide despite the biggest banking crisis since Lehman.
If big banks didn’t want deposits before SVB’s collapse, they’re unlikely to want them now. Indeed, if most of the new reserves created last week ended up at the big-four US banks, their reserves-to-asset ratio would be at an almost 20-year high.
Big banks will raise their deposit rates (perhaps under political pressure), but only slowly and reluctantly. And they may politely point new depositors in the direction of higher-yielding money-market funds. Yes, these are uninsured, but the yield pick-up is significant and, lest we forget, the US government underwrote MMFs in 2008.
So money-market funds are likely to be the ultimate beneficiary of Fed-intermediated small-bank deposit flight. And as bill yields are back below the Fed’s RRP rate, much of the deposit flow could wind up in the RRP facility.
The net effect of the banking crisis will be to turbo-charge QT. The BTFP does not address the distributional issue with reserves, and is only likely to help channel them from higher-velocity uses to the effectively zero-velocity RRP facility.
Bank credit is one side of the coin; corporate and private credit is the other. But credit is tightening across the economy.
This means considerably tighter financial conditions and much higher recession risk, while inflation pressures should ease (for now). So the Fed got what it wanted, but probably not in the way it would have wished