(Bloomberg) — If a week ago you asked Torsten Slok about the state of the economy this year, he would tell you he was expecting a no-landing scenario whereby the Federal Reserve will tame inflation without causing a recession.
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But that all changed after the collapse of three US banks in just a few days. Apollo Global Management’s chief economist now says he’s preparing for a hard landing. He joined the What Goes Up podcast to discuss his changing perspectives.
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.
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Q: You changed your opinion on the no-landing scenario to the hard-landing scenario — let us know about this.
A: The debate until recently was why didn’t the economy slow down when the Fed raised rates? Why are consumers still doing so well? And a very important answer to that is, there is still so much savings left in the income distribution, that households still have plenty of savings post-pandemic. And until recently, the debate was why isn’t this economy slowing down? And call that what you want, but that’s what we’ve called no landing. And that is the reason why inflation continues to fluctuate between 5%, 6%, 7%. That’s why the Fed has to raise interest rates.
Of course, what happened here with Silicon Valley Bank was that all of a sudden it happened, at least for financial markets, really nobody – and I think that’s safe to say. this moment – saw this coming.
And as a result, all of a sudden we all had to go back to our drawing board and think, OK, but what is the importance of regional banks? What is the importance of the banking industry in extending credit? In the data from the Fed, you will find that about a third of the assets in the US banking sector are in small banks. And here a small bank is identified as bank number 26 to 8,000. A large bank is ranked from 1 to 25 by assets. So that means there is a long tail of banks. Some of them are quite large, but the further away they get, the smaller they get. And the important question facing the market today is, small banks are currently facing problems with deposits, funding costs, facing issues of that can mean something like How about their credit books and also face the problems of what it means if we now also have to do stress testing on some smaller banks?
So this episode with Silicon Valley Bank, the markets are doing what they’re doing and there’s a lot going on, but the real problem here is that we don’t know now what behavior change is. What is willing to lend at regional banks. And given that regional banks account for 30% of assets and about 40% of total lending, that means the banking industry now has a significant percentage of banks that are really thinking about what’s going on right now. go out. And the risk with that is that the slowdown already in place – due to the Fed raising interest rates – could now come faster just because of this banking situation. So that’s why I changed my stance from saying don’t land, everything’s fine to saying, wait a minute, there’s a risk that things could slow down faster because we just see in the coming weeks and months what the reaction will be to lending from this rather important part of the banking sector that is currently experiencing the turmoil we are witnessing.
Q: We haven’t really seen any deterioration in creditworthiness yet. Will it play out the same way when cutting the credit supply? Or is there a reason to think it would be different? And is it possible that we still have another slippage with deteriorating credit quality?
A: I started my career at the IMF in the 1990s, and the first thing you learn is that banking and banking crises are often caused by credit losses on a bank’s books. We saw that in 2008. If you go back to the 1990s, you will see it in the savings and loan crisis. And these are very illiquid losses. This cannot be sold very quickly. That is very, very different. Basically, we’ve never had a banking crisis in a strong economy. And the irony of this situation is that it is the most liquid asset, namely Treasury bonds, that turns out to be the problem.
So that’s why if 10-year rates, let’s say they drop to about 2.5% or even 2%, that would help banks’ balance sheets a lot because since that’s the liquidity side of the balance sheet, at least in this volume the main issue is what the problem is. So that’s why people fear that if we now not only have the late effects of the Fed rate hike slowing the economy, but if you now have a If the slowdown can come a little faster, then of course we do in the end. need to consider what that means for credit losses, for everything banks have on their balance sheets.
Q: What everyone in the market is saying is that they’ve been waiting for the moment when the Fed “breaks” something and now something has broken. So, what are you expecting from the Fed meeting?
A: The challenge today, for the Fed meeting, is that there is some risk to the Fed to financial stability. If we had talked about this a week ago, I would have said that they would go up to 50. But today, suddenly came the top priority case – which until very recently we thought was inflation. – was replaced and put in the back seat of the car. Now the top priority is financial stability. And when financial stability is a top priority, the Fed needs to be absolutely sure that the financial system is stable and financial markets are calm, and so that credit is flowing to consumers and businesses. , residential real estate, commercial. real estate, with the idea that if that’s not the case, then you run the risk of landing clearly much more difficult. So that’s why financial stability is the top risk that would lead me to conclude that they can always raise rates later if this happens like Orange County and LTCM. But for now, the biggest risk in this meeting is certainly that the financial system needs to be in order for them to feel comfortable before they can start thinking about raising rates again.
–With support from Stacey Wong.
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