If you had asked Torsten Slok a week ago what the economy would do this year, he would have told you that he expected a no-landing scenario, where the Federal Reserve would manage inflation without triggering a recession.
But that all changed after the collapse of three US banks in a matter of days. Apollo Global Management’s chief economist now says he’s prepared for a hard landing. He participated in it What’s up podcast to discuss changing views.
Here are some highlights from the conversation, which have been condensed and edited for clarity. Click here to listen to the full podcast in Terminal, or subscribe below on Apple Podcasts, Spotify or wherever you listen.
Q: You changed your view of the no-landing scenario to a hard-landing – tell us about that.
A: The debate so far is, why doesn’t the economy slow down when the Fed raises rates? Why do consumers still feel good? And the very important answer is, there’s still a lot of savings left in the income distribution, households still have savings left after the pandemic. And to this day, the debate why this economy is not going down? And call it what you want, but it’s called no landing. And this is the reason why inflation continues to be in the range of 5%, 6%, 7%. That’s why the Fed needs to raise rates.
What happened, of course, here with Silicon Valley Bank something suddenly came out of the blue, at least for the financial market, really no one – and I’m safe to say at this point – has seen this coming.
And as a result, suddenly we all had to go back to the drawing board and think, OK, but what is the importance of regional banks? What is the importance of the banking sector in terms of credit extension? In the data from the Fed, you will see that about a third of the assets in the US banking sector are in small banks. And here small banks are defined as bank numbers 26 to 8,000. Big banks number one to 25 by asset ranking. So that means there is a long tail of banks. Some of them are quite big, but when you get out, they are smaller. And the main question for the market today is, how important are the small banks that are currently facing problems with deposits, funding costs, facing the problem of what can be applied to the credit book, and also facing the problem of what it means that we now also have to do a stress test in some these small banks?
So this episode with Silicon Valley Bank, the market is doing what it’s doing and there’s a lot of things going on, but the main problem here is that right now we don’t know what the behavior changes. availability of credit in regional banks. And given that regional banks make up 30% of assets and about 40% of all debts, which means that the banking sector is now a significant part of the banks that are now really thinking about what to do. And the risk is that the slowdown that has taken place – due to the Fed’s rate hikes – may now accelerate due to this banking situation. That’s why I changed my view from not saying no bankruptcy, everything is good for now saying, well, wait a minute, there is a risk now it can slow down because we just need to see over the next few weeks and months, what will be the response to the loan from it is this quite significant part of the banking sector that is currently experiencing the turmoil that we are seeing.
Q: We have not seen any damage to credibility. Will it play out the same way until it reduces the credit supply? Or is there any reason to think it will be different? And do we still have another shoe drop with credit quality deterioration going forward?
A: I started my career at the IMF in the 1990s, and the first thing you learn is that banking crises and banking runs usually happen because there are credit losses on the bank’s books. We saw that in 2008. If you go back to the 1990s, you see the savings and loan crisis. And these losses are very illiquid. This is not just a quick sale. That is very, very different. We have never had a banking crisis in a strong economy. And the irony of this situation is that the most liquid asset, Treasuries, is the problem.
Therefore, if the 10-year rate, let’s say the same goes down to say, 2.5% or even 2%, that will help tremendously in the banks’ balance sheets because it is the liquid side of the balance sheet that has, at least in this episode, already problems main in terms of what the problem is. Therefore, the fear is that if now it is not only the lagged effect of the Fed’s hiking rates that has slowed down the economy, but if you now have a greater effect that the slowdown could be faster, then it will certainly be done. should think about what it means for credit losses, for everything that banks have on the balance sheet.
Q: What everyone in the market is saying is that they are waiting for the Fed to “break” and now something is broken. So what to expect from the Fed meeting?
A: The challenge now, looking at the Fed meeting, is that there are some risks for the Fed to financial stability. If we had talked about this a week ago, then I would have said that he would go to 50. But today, it suddenly happened that the main priority – which we thought until now was all about inflation – has been changed and put in the back seat of the car. Now the main priority is financial stability. And while the main priority is financial stability, then the Fed must be sure that the financial system is stable and the financial markets are calm, and therefore, the credit flows to consumers, companies, residential real estate, commercial. real estate, with the idea that if you don’t, you are at risk of having a harder landing. Therefore, financial stability is the highest risk will make the conclusion that they can raise rates later if this is like Orange County and LTCM. But for now, the biggest risk going into this meeting is that the financial system needs to stabilize enough to be comfortable before we can even think about raising rates again.
– With help from Stacey Wong