A whole new world of higher interest rates

The recent market stress and the ongoing pressure facing smaller US banks appears eerily similar to the Savings and Loan (S&L) crisis in the United States, which occurred between 1986 and 1995, and resulted in the failure of nearly a third of the 3,234 savings and loan associations. It was partly a duration crisis. Savings and loan associations were competing with government sponsored enterprises to balance 30-year fixed rate mortgages, which have no place on a balance sheet due to inherent duration mismatch with funding. This may remind us of the First Republic $98bn mortgage book. Back then, like today, the pace of rate hikes harmed the profitability of banks and left some, especially small ones, vulnerable to flighty deposits. The current Silicon Valley Bank’s failure was about the bonds they hold, but the broader issue also includes rate mortgages they have in their balance sheet. All of this is repairable.

So far, policymakers have moved quickly to get a handle on the situation. They resorted to old, efficient tricks from previous episodes of financial stress to provide liquidity to the market – meaning access to emergency lending and USD swap lines to boost dollar liquidity. The latest tool serves as a backstop for the financial sector: any big bank globally that can post good collateral at the Bank of England, the Swiss National Bank, the European Central Bank or the Bank of Japan can get dollars from its central bank (which gets dollars from the US Federal Reserve) any day of the week. This is like a global discount window for dollars aimed to avoid dollar shortage in the system. In the previous crisis, these mechanisms helped bring stability back after a while, and one can expect this to happen once again. But this liquidity backstop – which is in no way comparable to Quantitative Easing – won’t go to the real economy. That’s what should worry us.

Higher risk of a US recession

When we published our forecasts for 2023, we were not among the recession camp, as the level of credit entering the economy was not consistent with a recession. In Q4 2022, Commercial and Industrial lending – a key barometer of economic growth - was up at a stunning 11.5% year-over-year rate. In real terms, it was at 5.05%– see below chart. Our baseline was that the economy was heading for a period of quickly oscillating expansions/contractions, growth perhaps easing and unemployment rising but still low. Most companies were not ready to give up the employees whom they had so much difficulty hiring (thus raising the risk of job zombification). For most market participants, it was probably harder to address than the standard recession playbooks.

But things are about to change. US banks short on cash have borrowed large amounts of money from the US Federal Reserve ($300bn in the week ending March 19, for instance). We don’t believe a lot of those bank reserves will be lent out, unfortunately. The main macro risk from the current market stress is that banks will slow credit growth. Why does that matter? In a highly leveraged economy like ours, a constant inflow of credit is needed to generate growth. In the United States – where capital markets play a key role for credit generation – banks still represent around 40% of private credit. And for SMEs – which have a particularly large macro footprint – bank tightening is a big deal. We still think it is too early to call for a US recession – we lack macro data to back this call. But the new dynamic risks bringing an eventual recession sharply forward.

What’s next to pay attention to?

It will take weeks or perhaps months to better assess the exact macroeconomic situation. The level of uncertainty is unusually high. In the interim, we should monitor commercial mortgage-backed securities and broader credit spreads, especially in the United States. Interbank lending conditions are certainly not of much use, at least in the short-term and after the backstops implemented. The stresses will be very hard to monitor in real time. We also guess that central bankers will keep communication channels wide open with the banking industry to make sure there is no market stress emerging. In our view, there is no material risk of rolling bank runs – this is clear. But market participants need to focus on the impact of the unfolding market stress on broad lending conditions and the deeper structural weaknesses among smaller banks, especially with respect to commercial property. This is a potential elephant in the room in the United States. Banks smaller than the top 25 largest account for a massive 67% of commercial real estate lending. According to the International Monetary Fund, there are $2trn of loans to the commercial real estate sector in the smaller US banks. The problem is that Covid has changed the world of work. About 50% of employees haven’t gone back to the office full time and, as leases come up for renewal, the risk is high that many will not be renewed, thus leaving a long tail of non-performing loans on the books of the banks (especially the smaller banks).

In Europe, there are issues too – however, less acute for now. Higher interest rates and lower affordability in the real estate sector are also destabilising the financial and macro landscape. We are beginning to see the consequences of the exit from negative rate policy, noticeably in countries where mortgage loans are fixed at variable rates (which is basically most of Europe). In Greece, foreclosure filings are on the rise (especially since the Supreme Court has allowed private investment funds established abroad to buy property and resell it – thus fueling property speculation). In Sweden, the residential property market is going through one of the worst drops globally – with 16% of home values wiped out in the past year, after higher rates fed into variable mortgages. This is not over yet. The Swedish central bank, the Riksbank, is expecting the decline to reach 20% from the peak a year ago. In the United Kingdom, mortgage approvals are sinking due to higher rates. According to the Office of National Statistics, the monthly cost of a new mortgage rose by 61% in the year to December 2022 for the average semi-detached house. This keeps increasing. It is still too early to assess the exact macro implications of all of this. It will become clear not in a matter of weeks, but over months. What is sure is that it does not bode well and that the macroeconomic outlook is getting more worrying than it was just weeks ago.