If you had asked Torsten Slok a week ago how the economy was going to be this year, he would have told you that he was expecting a no-landing scenario, whereby the Federal Reserve would control inflation without triggering a recession.
But everything has changed after the collapse of three US banks in a matter of days. Apollo Global Management’s chief economist now says he’s bracing for a hard landing. he joined what goes up podcast to discuss his changing views.
Here are some highlights of the conversation, condensed and edited for clarity. Click here to listen to the full podcast on Terminal, or subscribe below on Apple Podcasts, Spotify, or wherever you listen.
Q: You changed your approach of looking at a no-landing scenario to a hard-landing — tell us about it.
A: Until recently the debate was, well, why isn’t the economy slowing down when the Fed is raising rates? Why is it that consumer is still doing so well? And a very important answer to that was that, there was still a lot of savings left in the income distribution, that there was still a lot of savings left with households after the pandemic. And till some time ago the debate was going on that why this economy is not slowing down? And call it what you want, but this is what we called No Landing. And that was the reason why inflation remained in the range of 5%, 6%, 7%. So the Fed had to raise rates.
What happened, of course, here with the Silicon Valley bank was suddenly out of the blue, at least for the financial markets, nobody really — and I think it’s safe to say at this point — had it coming.
And as a result of that, all of a sudden we had to go back to our drawing boards and think, okay, but what’s the point of regional banks? What is the importance of the banking sector in terms of credit expansion? In the Fed’s data, you’ll notice that about a third of the assets in the US banking sector are in smaller banks. And here a small bank is defined as bank number 26 to 8,000. A large bank number ranges from one to 25 depending on the property. So this means that banks have a long tail. Some of them are quite large, but they get smaller the further out you go. And the key question for the markets today is how important are the smaller banks that are now facing deposit pool issues, with funding costs, are facing issues that could matter to their credit book, And also facing issues that what does it mean if we now have to stress test some of these smaller banks as well?
So this episode with Silicon Valley Bank, the markets are doing what they’re doing and a lot of things are going on, but really the key issue here is we don’t know yet what the behavioral change is in the regional banks. Willingness to lend And given that regional banks account for 30% of assets and about 40% of lending, it means that the banking sector now has such a significant portion of banks that they’re really wondering what’s going on at the moment. And with that comes the risk that a recession that was already underway – due to the Fed raising rates – could now come faster because of this banking situation. So I changed my mind to not landing, now everything is fine, wait a minute, now there is a risk that things could slow down sharply because we need to look at the coming weeks and months, banking sector What is going to be the reaction in terms of lending from this very significant segment that is now going through this turbulence that we are seeing.
Q: We haven’t really seen any credit degradation yet. Would it work in a similar way to reducing the supply of credit? Or is there any reason to think it would be different? And is it possible that we may face another downgrade with further deterioration in credit quality?
A: I started my career at the IMF in the 1990s, and one of the first things you learn is that banking crises and banking runs normally happen because bank books have credit losses. We saw this in 2008. If you go back to the 1990s, you saw the savings and loan crisis. And these were very illiquid losses. It couldn’t be sold very quickly. it’s very different. We basically never had a banking crisis in a strong economy. And the irony of the situation is that it was actually the most liquid asset, namely Treasuries, that turned out to be the problem.
So if 10-year rates, let’s say, go down to 2.5% or 2%, it will help incredibly on the balance sheets of the banks because that’s the liquid side of the balance sheet, which is, at least in this link In, the main problem has been in terms of what are the issues. So the fear is that if we not only have the already economy-slowing effects of the Fed hiking rates, but if you have a bigger effect now that the recession might accelerate a little bit, surely we eventually do as well. We need to see what this means for credit losses, for everything that is on the balance sheet of the banks.
Q: Everyone in the market is saying they were waiting for the moment the Fed “broke” something and now something has broken. So what are you expecting from the Fed meeting?
A: The challenge ahead of the Fed meeting today is that there are some risks to financial stability for the Fed. If we had talked about this a week ago, I would have said that he would be 50 years old. But today, it is suddenly the case that the topmost priority – what we considered until recently to be merely inflation – has been shifted and put in the back seat of the car. Now the top priority is financial stability. And while the top priority is financial stability, the Fed must be absolutely sure that the financial system is stable and the financial markets are calm, and therefore, that credit is flowing to consumers, corporates, residential real estate, commercial. real estate, with the idea that if it isn’t, you’re obviously at risk of having a very hard landing. So financial stability being the biggest risk would lead me to conclude that if it turns out like Orange County and LTCM they can always raise rates later. But for the time being, the biggest risk at this meeting is certainly that the financial system needs to be stable enough for them to feel comfortable before they can start thinking about raising rates again.
— with assistance from Stacey Wong
Orignal Post From: Bank crisis will hit US hard, says Apollo chief economist: ‘I changed my mind’