(Bloomberg) – If you had asked Torsten Slok a week ago how the economy would fare this year, he would have told you that he expected a no-landing scenario, in which the Federal Reserve would tame inflation without trigger a downturn.
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But everything changed after the collapse of three US banks in a matter of days. The chief economist at Apollo Global Management now says he is preparing for a hard landing. He joined the What Goes Up podcast to discuss his changing views.
Here are some highlights of the conversation, summarized and edited for clarity. To listen to the full podcast on Terminal, click here, or subscribe below to Apple Podcasts, Spotify, or wherever you hear it.
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Q: You changed your view of seeing a no landing scenario to a hard landing scenario – tell us about it.
A: The debate up until recently has been why doesn’t the economy slow down when the Fed hikes rates? Why are consumers still doing so well? And a very important response to that was that across the income distribution there was still a lot of savings left, that households had a lot of savings left after the pandemic. And until recently, the debate was why isn’t this economy slowing down? And call that what you will, but that’s what we called the non-landing. And that’s why inflation stayed in the 5%, 6%, 7% range. So the Fed had to raise interest rates.
Of course, what happened here at Silicon Valley Bank was that suddenly, out of the blue, at least for the financial markets, really nobody – and I think you can say that at this point – saw this coming.
And then we all suddenly had to sit back at the drawing board and think, ok, but how important are the regional banks? How important is the banking sector in lending? Fed data shows that about a third of the US banking sector’s assets are held by small banks. And here a small bank is defined as bank number 26 to 8,000. A large bank is number one to 25 by assets. So that means there is a long tail of banks. Some of them are quite big, but the further out you go, the smaller they get. And the key question for today’s markets is how important are the small banks that are now having problems with deposits, with funding costs, with problems with what this might mean for their loan books, and also with problems with what it means if we now have to stress test some of these smaller banks as well?
So in this episode with Silicon Valley Bank, the markets are doing what they’re doing and a lot of things are happening, but what’s really the main problem here is that we just don’t know now what the change in behavior in relation to them is Lending readiness of the state banks. And given that regional banks account for 30% of assets and about 40% of all lending, that means the banking sector now has such a significant chunk of banks that are really concerned about what’s going on right now. And the risk here is that the slowdown that was already underway – because of the Fed’s rate hikes – could now be accelerating simply because of this banking situation. That’s why I’ve changed my mind from saying “no landing” to saying “everything is fine” to now saying “wait a minute, there’s a risk now that things could slow down faster because we’re just looking at the have to wait weeks and months to come,” what’s going to be the reaction in terms of lending from this fairly significant part of the banking sector that’s going through this turbulence now that we’re seeing.
Q: We haven’t seen any real credit deterioration yet. Will the credit crunch be similar? Or is there any reason to believe it will be different? And is it possible that as credit quality deteriorates, we will drop another shoe in the future?
A: I started my career at the IMF in the 1990’s and the first thing you learn is that a bank crisis and run-in usually happens because there are loan losses on the bank’s books. We saw that in 2008. If you go back to the 1990s, you saw that in the savings and credit crunch. And those were very illiquid losses. That just couldn’t be sold very quickly. That is very, very different. Basically, we have never had a banking crisis in a strong economy. And the irony of this situation is that it was indeed the most liquid asset, Treasuries, that turned out to be the problem.
So if the 10-year rates go down to, say, 2.5% or even 2%, that’s going to help banks’ balance sheets incredibly, because it’s the liquid side of the balance sheets. At least in this episode, the main problem was what the problems are. So there’s a concern that if we now not only have the lagged effect of the Fed’s rate hikes already slowing the economy, but if you now have an amplified effect that the slowdown might come a little quicker, then of course eventually we do also need to look at what that means for loan defaults, for whatever banks have on their balance sheets.
Q: What everyone in the market is saying is that they have been waiting for the moment when the Fed “broke” something and now something has broken. So what do you expect from the Fed meeting?
A: Today’s challenge ahead of the Fed meeting is that the Fed faces some risks to financial stability. If we had talked about this a week ago I would have said they were turning 50. But today, suddenly, the number one priority – what until recently we thought was just inflation – has been replaced and put in the back seat of the car. Now the top priority is financial stability. And if financial stability is a top priority, the Fed needs to be absolutely certain that the financial system is stable and financial markets are calm, and therefore credit is flowing to consumers, businesses, residential and commercial real estate, with the thought that when it isn’t, you will is the case, you run the risk of suffering an obviously much harder landing. For this reason, financial stability as the main risk would lead me to conclude that if it turns out to be Orange County and LTCM, they can always raise rates later. But for now, surely the biggest risk with this meeting is that the financial system needs to be stable for them to feel comfortable before they can even consider raising rates again.
–Assisted by Stacey Wong.
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