The mass credit rating downgrades in the US banking sector yesterday are a further cause of concern. Moody’s has cut the outlook for the US banking system to negative from stable and placed six US lenders on review for downgrade. The S&P also placed First Republic on Negative Creditwatch.
The other key indicator to track will be the financial conditions in the US, which have tightened the most for this cycle mostly due to the widening in credit spreads. This can be significantly more impactful for growth outlook or the outlook for the equity markets rather than a large interest rate hike which takes time to trickle down to the economy.
Even if the Fed stays focused on inflation in the near-term, the longer-run path is now quite uncertain. Growth concerns have risen with banks likely to tighten lending standards which could have a larger and quicker impact on the real economy compared to a rate hike. But with inflation still remaining uncomfortably high, and potentially boosted further by China reopening and the Fed’s added liquidity measures, this means we might be now heading towards Stagflation.
Another key thing to consider is that corporate margins could squeeze further, and the impact may be invariably larger for the smaller enterprises (best represented by RUSSELL 2000) as bank failures dent sentiment. The NFIB survey released yesterday also indicated that inflation remains the biggest problem for small enterprises in February in the US.
So in a way, rising risks of growth slowdown could bring yields lower, but the risk premium is likely to rise. Near-term yields could remain highly volatile as growth, inflation and market risk dynamics are interpreted. But flight to quality will likely prevail as we are getting into a tougher economic environment.