If you had asked Torsten Slok a week ago how the economy was going to fare this year, he would have told you that he expected a no-landing scenario, in which Federal Reserve tame inflation without triggering a slowdown.
But everything changed following the collapse of three American banks in a few days. The chief economist of Global Apollo Management now says he is preparing for a hard landing. He joined the What goes up podcast to discuss his change in perspective.
Here are some highlights of the conversation, which have been condensed and edited for clarity. Click on here to listen to the entire podcast on La Borne, or subscribe below on Apple podcasts, Spotify or wherever you listen.
Q: You changed your vision from a no-landing scenario to a hard-landing scenario – tell us about that.
A: Until recently, the debate was, well, why doesn’t the economy slow down when the Fed raises rates? Why is the consumer still doing so well? And a very important answer to that was that, well, there were still a lot of savings left in the income distribution, that households still had a lot of savings after the pandemic. And until recently, the debate was why isn’t this economy slowing down? And call it what you want, but that’s what we called no-landing. And that is why inflation has continued to be around 5%, 6%, 7%. This is why the Fed had to raise its rates.
What happened, of course, here with Bank of Silicon Valley was it suddenly out of the blue, at least for the financial markets, really no one – and I think it’s safe to say at this point – had seen it coming.
And as a result of that, all of a sudden, we all had to go back to our drawing boards and ask ourselves, OK, but how important are regional banks? How important is the banking sector in terms of lending? In the Fed data, you’ll see that about one-third of US banking sector assets are in smaller banks. And here, a small bank is defined as bank number 26 in 8,000. A large bank is ranked number one out of 25 based on assets. This therefore means that there is a long queue of banks. Some of them are quite large, but the further you go, the smaller they become. And the key question for the markets today is how important are the smaller banks that are now facing issues with deposits, funding costs, issues with what this might mean for their credit portfolios, and also issues with what it means if we now also have to stress test some of these smaller banks?
So this episode with Silicon Valley Bank the markets do what they do and there’s a lot going on but what’s really the major problem here is we just don’t know now what the change is behavior in terms of willingness to lend in regional banks. And given that regional banks account for 30% of assets and around 40% of all loans, that means the banking industry now has such a large chunk of banks that are currently thinking about what’s going on. And the risk with that is that the downturn that was already underway – due to the Fed raising rates – could now happen more quickly simply because of this banking situation. That’s why I changed my perspective from saying no landing it’s fine to saying now, well wait a minute there’s a risk now that things will slow down faster because we just need to see over the coming weeks and months what the response will be in terms of lending from this fairly large part of the banking sector that is currently going through the turmoil that we are seeing.
Q: We haven’t seen any deterioration in creditworthiness yet. Will it play out the same way with regard to the reduction in credit supply? Or is there a reason to think it will be different? And is it possible that we will have yet another shoe dip with deteriorating credit quality in the future?
A: I started my career at the IMF in the 1990s, and the first thing you learn is that a banking crisis and bank run normally happens because there are credit losses in bank books. We saw it in 2008. If you go back to the 1990s, you saw it with the savings and loans crisis. And these are very illiquid losses. It couldn’t be sold very quickly. It’s very, very different. We have hardly ever had a banking crisis in a strong economy. And the irony of this is that it was actually the most liquid asset, treasury bills, that turned out to be the problem.
That’s why if the 10-year rates, let’s say they go down to 2.5% or even 2%, that will help banks’ balance sheets enormously, because it’s the liquid side of the balance sheets that has, at least in this episode, was the main issue in terms of what the issues are. That’s why the fear is that if we now have not only the lagged effects of the Fed rate hike that are already slowing the economy, but if you now have an amplified effect that the downturn might come a little faster, so of course we do that ultimately also have to look at what that means for credit losses, for whatever banks have on their balance sheets.
Q: What everyone in the market is saying is that they were waiting for the Fed to “break” something and now something has broken. So what do you expect from the Fed meeting?
A: The challenge today, ahead of the Fed meeting, is that there are risks to the financial stability of the Fed. If we had talked about it a week ago, I would have said they were going to go to 50. But today it suddenly happened that the top priority – which until recently we thought was inflation – has been replaced and put in the back seat of the car. From now on, the top priority is financial stability. And when the top priority is financial stability, the Fed needs to be absolutely sure that the financial system is stable and the financial markets are calm, and therefore credit goes to consumers, businesses, residential real estate , commercial real estate, with the idea that if you don’t, then you obviously risk having a much harder landing. That’s why financial stability being the main risk would lead me to the conclusion that they can always raise rates later if it turns out to be like Orange County and LTCM. But right now, surely the biggest risk of this meeting is that the financial system needs to be stable for them to feel comfortable before they can even start thinking about raising rates again.
— With help from Stacey Wong