Black clouds over the USA! Economists predict a deep recession

Just a few weeks ago, economists were convinced that the global economy was moving forward. Now they predict a deep recession is coming - as a knock-on effect of the collapse of several major banks, from Silicon Valley Bank to Signature Bank, as well as a chaotic implosion Credit Suisse.

Banking crises are almost never resolved in weeks or months. Their consequences can last for years, if not decades, setting off a chain of events along the way. As such, traders are convinced that recent events are just the tip of the iceberg. There is overwhelming evidence that the global banking crisis was triggered as a direct consequence of soaring interest rates and liquidity risks. However, this crisis could become even bigger as it is rapidly turning into a 'global credit crisis'.

This may just be the beginning!

We are still in the early stages, so the range of possibilities is wide as the situation develops further. In the US, even if the problem appears to be under control for now, the full effects of recent events are yet to be revealed. Banks had already significantly tightened credit standards (by adjusting the terms of taking out loans, the size of credit lines, maximum maturity periods, etc.).

There is now a risk that lending conditions will tighten further as small and regional banks see their deposit base shrink and regulators find they need to take a more proactive approach, making banks even more cautious.

Small banks (less than $250 billion in assets) account for 43% of all commercial bank lending in the US, up from 30% in 2008, thus increasing their importance to the US economy. If they pull out, it is doubtful that the big banks will be able to fill the void completely. In addition, small banks account for more than two-thirds of all CRE loan defaults and more than one-third of all residential loan defaults. If the decline in the prices of these assets accelerates, the balance sheet position of small and regional banks may look even more strained, adding to the turmoil.

Are we headed for a credit crisis?

For the US, the most obvious indicator to follow is the Senior Loan Officer Survey by Federal Reserve, but there are other figures as well, such as the National Federation of Independent Businesses' Small Businesses Index. This index includes a component entitled "credit availability compared to 3 months ago" and "expected credit terms over the next 3 months". This is starting to timidly worsen. There are also monthly data on loans to commercial and industrial companies, and those in February fell month-on-month, which was the first monthly decline since September 2021. Admittedly, this is still an increase of 12% year-on-year and 20% from 2019 levels, but it is something we will be watching very closely. On the consumer side, we know that home mortgage applications have fallen by more than half.

Consumer credit data is still quite warm, but rising car loan default rates are a signal that all is not well. Recent consumer sentiment data suggest that the appetite to buy "big items" such as cars, homes and household appliances is waning, so we could expect the pace of consumer credit to slow down, especially if households fear their savings are unsafe .

Everything is in the hands of the Fed

Central banks have almost unanimously adopted the mantra that financial stability and monetary policy can be treated independently, and that policy makers have different tools to solve problems. It is true that institutions such as the Federal Reserve and the European Central Bank have become more agile in creating and implementing tools to unblock specific areas of the financial system, exemplified in March 2020 when they eased the challenges faced by money market funds. Central banks, including primarily the Fed, quickly began to introduce new programs responding to current market problems. However, the difference between the current and previous episodes of market stress is that the higher interest rate environment itself is the root cause. And this ultimately makes it difficult to separate financial stability issues from future monetary policy decisions. As Fed Chairman Powell mentioned after the March decision FOMC on rates, a tightening of credit conditions and a decline in bank lending would have a similar effect to rate hikes.

Essentially, this means that central banks will be closely monitoring whether financial conditions have already tightened as banks have become more cautious due to the current turmoil. If this is the case, peak central bank interest rates may be reached sooner because commercial banks do the work for them. In the US, higher borrowing costs and less access to credit mean a greater chance of a hard landing for the US economy. This, in turn, will help bring inflation down faster than it would otherwise. The consensus of analysts' expectations at Bloomberg suggests that inflation remained stable in March at around 6% for headline data and around 5,5% for core data, with a slight improvement on a monthly basis for both data.

However, we know that the inflation path is at risk because OPEC is actively fighting the fall in oil prices, which in the coming months will have an impact on the increase in inflation. A barrel of oil has jumped almost 30% since the second half of March - as energy investors downplayed banking tensions and OPEC cut production by more than a million barrels a day. The good news is that the oil rally is bound to end around $80/$82 as weak economic data and rising concerns about recession will likely provide solid resistance to the OPEC rally. The 3,7 million barrel drop in US crude inventories published yesterday barely found buyers above the $80 level. So, chances are that the barrel could return to $75/76 in the short term.

While dovish central banks were initially slow to move away from “interim” inflation forecasts during Covid-19, something similar may be true of inflation hawks today. Recent developments are likely to make policy makers louder about the increasingly mutual risks to growth as interest rates rise.

As for the Fed, a final 25 bp hike is possible in May, which will put the interest rate range at 5-5,25%. With the growing risk of a hard landing, which should weigh on inflation, the Fed is expected to cut rates by around 100 bps in the fourth quarter. Thus, the target Fed rate would be in the range of 4,00-4,25%. Then in 2024, rates will move towards 3%.