Six key things to know about the financial world right now

The message from US Treasury Secretary Janet Yellen has been seen as rather conflicting on the potential treatment of uninsured non-systemic bank deposits, creating substantial uncertainty among depositors and in financial markets. According to Yellen, the US could take similar steps to guarantee deposits at smaller banks to protect the banking system, but no blanket insurance on deposits is being considered at the moment.

In Europe, Credit Suisse was forced to merge with its stronger domestic rival, UBS. We consider that the problems of Credit Suisse are more company specific and started long before the US events. Its position considerably deteriorated in the fourth quarter of last year, when it suffered from substantial client fund and deposit outflows, which gained more speed after the general market sentiment weakened.

Most European banks are impacted by these events mainly via the more cautious market sentiment. Debt risk premiums widened, and the sharp swings in financial markets closed the primary bond markets. While bond markets have now opened up to a limited degree, wider spreads make it more expensive for banks to fund their operations, the impact of which will come through only slowly as banks advance with their funding programmes.

The decision of the Swiss authorities to wipe out the Credit Suisse AT1 debtholders resulted in the AT1 market being severely hit. It is doubtful that banks will be able to issue new AT1 anytime soon, increasing the likelihood of outstanding AT1 notes being extended. We consider that the recent events in the banking sector have resulted in substantially increased uncertainty, which is likely to continue to be reflected as substantial short-term volatility in credit markets. We expect bank spreads to be negatively impacted in general and also in the longer term, whether in bank capital or in bank senior debt, as bank investors factor in more uncertainty regarding resolution practices.

This is neither lehman 2.0 nor savings and loans re-run from the 80s

So far, the problems have been concentrated in US regional banks and one specific weaker entity in Europe. The European issue has been more or less addressed by prompt interventions by the Swiss government and central bank. In the US, the problems are concentrated in non-systemic banks, while larger banks may actually have benefited from new deposit inflows and business attracted by their systemic status. This makes the likelihood of a wide systemic crisis quite limited. We consider that stabilisation of deposit developments in the US would be key for a more pronounced stabilisation in bank credit spreads too. So far, no institution under pressure has played a similar role in the global banking industry as Lehman Brothers did. While it cannot be excluded that other institutions are suffering from the same symptoms as those under pressure in recent weeks, a cascading effect as experienced during the 2007-09 crisis does not look likely.

We’re still in the early stages, so the range of possibilities,  along with further developments, is wide. In the US, even if the problem seems to have been contained so far, the full impact of recent events is still to unfold. Banks were already tightening lending standards markedly (adjusting terms of borrowing, covenants, size of credit lines, maximum maturity lengths, etc., as highlighted by the Federal Reserve’s Senior Loan Officer survey). The risk now is that lending conditions will tighten even further as small and regional banks see their deposit base shrink and regulators recognise that they need to take a more proactive approach, making banks even warier.

Small banks (less than $250bn of assets) account for 43% of all commercial bank lending in the States, up from 30% in 2008, so they have become more important for the US economy. If they pull back, it is doubtful that large banks can completely fill the void. Moreover, small banks account for more than two-thirds of all outstanding commercial real estate lending and more than a third of all outstanding residential real estate lending. Should price falls for these assets accelerate, the balance sheet position of the small and regional banks could look even more strained and intensify the turmoil.

Your concerns about Europe

Since the financial crisis and the euro crisis, large European banks have been subject to much stricter regulation than before. The Single Supervision Mechanism, together with national financial supervisors, has clearly improved transparency, stress tests and supervision. Also, the Single Resolution Mechanism should help break the doom loop between sovereigns and banks that played such a prominent role during the euro crisis.

More generally speaking, the European banking system is supported by strong capital and loss-absorption buffers. These offer banks room to absorb the impact of the weakening of credit quality. Banks are also required to meet stringent requirements on liquidity (LCR) and longer-term funding (NSFR). These factors make the system generally well protected against negative shocks.

European banks have raised a record-breaking amount of debt across covered bonds to unsecured debt from capital markets this year, that is before the latest chain of negative events started to unfold. This makes banks better positioned to weather the closure of primary debt markets for now. That being said, the bulk of the funding that the European Central Bank has offered to banks via its TLTRO-III programme matures in only three months’ time in June. Also, the collateral relief measures offered to banks during the Covid-19 crisis are set to tighten further in tandem. If we experience further disturbances in bank funding markets, the ECB may choose to offer banks access to additional liquidity, potentially restarting (T)LTROs and/or lowering collateral requirements again.

Tightening lending standards

In the eurozone, financial stress has only increased moderately so far. The ECB’s own index of systemic stress increased in the first days after the market turmoil, but only to levels last seen around the turn of the year. The war in Ukraine and the start of the hiking cycle caused stress to jump significantly more than what we’ve seen so far. Credit conditions were already being tightened on the back of recessionary concerns and higher rates.

Before the events of the past couple of weeks, credit conditions were already being tightened on the back of recessionary concerns and higher rates. The ECB’s bank lending survey also suggested that banks were expecting to further tighten standards in the months ahead, on top of which comes the impact of the current banking turmoil. With CDS spreads for banks widening, funding costs will increase and could eventually lead to even tighter lending conditions.

For the US, the Senior Loan Officer survey from the Federal Reserve is the most obvious indicator to follow, but there are other data points, such as The National Federation of Independent Businesses’ Small Business Optimism Index. It has a sub-component titled “availability of loans versus 3M ago” and “expected credit conditions over next 3M”. This is starting to tentatively deteriorate. There is also monthly data regarding lending to commercial and industrial companies, and it fell month-on-month in February, the first monthly decline since September 2021. That said, it is still up 12% year-on-year and by 20% on 2019 levels, but this is something we will be keeping a very close eye on.

The combination of higher rates, less credit availability and weakening business sentiment suggests the risks are to the downside. On the consumer side, we know mortgage applications for home purchases have more than halved. Consumer credit numbers are still coming in reasonably hot, but the rising default rates on car loans are a signal that all is not well. The latest consumer sentiment data suggests the appetite to buy ‘big ticket items’ such as cars, houses and household appliances is waning, so we would expect consumer borrowing to slow, especially if households get spooked that their savings aren’t safe.

ING’s base case for the economy

Our existing base case was already more cautious than consensus and factored in the adverse impact of the rapid monetary policy tightening so far. It was clear that at some point, something would break, be it something in the real economy or in financial stability. In any case, recent developments have strengthened our base case scenario of a recession in the US and subdued growth in the eurozone. Where previously the risks were clearly skewed to more resilient growth and higher central bank rates, it’s now more symmetric.

Until last month, the main drivers of the different scenarios had been energy prices and monetary policy, while now it’s credit conditions or lending standards as well as the health of corporate balance sheets which determine the different scenarios.

The prospects of a technical recession have increased again in the eurozone on the back of even tighter credit conditions. While risk-free interest rates have actually dropped, bank lending rates are likely to increase further, potentially hampering investment. Corporates tapping bond or equity markets could be an alternative for bank funding, but given the eurozone’s high reliance on banks, this is still unlikely to be a big game-changer. Some financial stress could actually help bring down inflation faster than expected but too much financial stress would push the eurozone into recession. Up to now, risks of a return of the euro crisis have remained muted. However, in the case of longer-lasting financial stress, the likelihood of yet another euro crisis clearly increases.

In the US, higher borrowing costs and reduced access to credit mean a greater chance of a hard landing for the US economy. This will help to get inflation lower more quickly than would otherwise have happened. Rate cuts, which we have long predicted, are likely to be the key theme for the second half of 2023, and we are favouring 100bp of easing in the fourth quarter of this year.

The focus on central banks

Central banks have pretty much unanimously adopted the mantra that financial stability and monetary policy can be treated independently and that policymakers have different tools for different problems. It’s true that the likes of the Federal Reserve and European Central Bank have become more nimble in creating and implementing tools to unblock specific areas of the financial system, exemplified in March 2020, where they eased challenges facing money market funds; also in the UK late last year by the temporary buying of government bonds to stabilise LDI pension funds. Central banks, chiefly the Fed, have already been quick off the mark with new schemes addressing the current market issues. But the difference between now and previous episodes of market stress is that the primary cause is the higher interest rate environment itself. And that ultimately makes it hard to disentangle the financial stability issues from future monetary policy decisions.

As Fed Chairman Powell mentioned after the March FOMC Fed rate decision, tighter credit conditions and declining bank lending would have a similar impact as rate hikes would. Essentially, this means that central banks will be monitoring closely whether tighter financial conditions are already being achieved thanks to banks becoming more cautious due to the current turmoil. If that is the case, central bank peak rates may be reached earlier as commercial banks are doing the work for them.

If nothing else, it’s now clear that rate hikes are having an impact and that policy is generally fairly restrictive. While central bank doves were initially slow to move away from “transitory” inflation predictions during Covid-19, something similar may be true of the inflation hawks today. Recent events are likely to see policymakers become more vocal about the increasingly two-sided risks to growth as interest rates ratchet higher.

For the Fed, we expect a final 25bp hike in May, leaving the Fed funds range at 5-5.25%. The feedback loop from financial stresses onto the broader economy is significant via both higher borrowing costs and less credit availability. With the risk of a hard landing increasing, which should weigh on inflation, we expect the Fed to cut rates by perhaps 100bp in the fourth quarter. This would take the Fed funds target rate range to 4.00-4.25%. We then expect rates to head to 3% in 2024.

For the ECB, the latest financial stresses also mark the start of the final phase of rate hikes. Things would have to get worse for the ECB not to hike again in May, but this time a 25bp rate hike looks like the most plausible option. After a final rate hike by another 25bp in June, Europe’s central bank is likely to move into a ‘wait-and-see’ stance. With core inflation still stubbornly high, we cannot see the ECB cutting rates before the second half of 2024.