Our Takeaways from the Banking Crisis
March 24, 2023
Co-CIO Greg Jensen and Co-Head of Fixed Income Research Alex Schiller discuss our recent three-part series describing how the banking crisis is reshaping the financial system, and its impact on the economy and markets going forward.
In this podcast, Daily Observations editor Jim Haskel sits down with Greg and Alex to delve deeper into the key takeaways from this series and how they connect to our economic outlook. The conversation covers the origins of the bank run, the mechanics of how it played out, the impact of the crisis on bank business models and profitability, and how all of this is flowing through to growth and assets. Greg and Alex also discuss the recent Fed meeting and how the banking strains — combined with an increasingly challenging macro environment — are creating a very difficult dilemma for policy makers.
Transcript
Note: This transcript has been edited for readability.
“We’ve been on the bearish side for the economy for a while and still are. And while we didn’t know exactly which thing will crack, the degree of the tightening, the degree to which the economy was dependent on the low interest rates and the liquidity that those cause, some things like this are going to crack. We don’t even think we’re at the end of it. When we look at the impact of this, there are a lot of questions about the substitutability of the debt that was there. But about 2.7% of GDP annualized over the last couple of years has been coming from the banks that are most under strain. Now, there are ways—I don’t think that whole 2.7% will come out of the economy right away. But this by itself could be a reasonable impact on the economy. And when you take that combined with everything else going on with respect to the tightening, that’s going to be the big deal.”—Co-CIO Greg Jensen
JIM HASKEL
I’m Jim Haskel, editor of the Bridgewater Daily Observations. Over the past two weeks, we’ve seen the failure of Silicon Valley Bank and Signature Bank and fears that additional banking institutions will also go under. This has spiraled into something larger that’s now reshaping the banking system as well as the credit pipes—and we believe will have a big impact on markets and the economy going forward.
In the last few days, we’ve published a series of Daily Observations pulling together our thoughts on these dynamics. Today, I’m joined by two of the authors of that series—co-CIO Greg Jensen and co-head of our rates team Alex Schiller—to delve deeper and discuss the key takeaways from those Observations. We’re recording this podcast right after Wednesday’s Fed meeting, so we’ll also touch on the dilemma the crisis creates for monetary policy and how the Fed is processing that challenge.
So, let’s jump right into it. Greg and Alex, I want to thank you so much for joining me. As I mentioned, this series was published in three parts. And Greg, before we start, maybe you can give a quick overview of what each part was about, and then we’ll explore each topic in more detail.
GREG JENSEN
Yes. So we broke it into three parts because there’s so much going on, and we wanted to try to make it digestible and digest it ourselves as we dug into the data in our systems to really do a diagnosis of everything that’s happening in the bank run. So, part one was exactly that: it was diagnosing the bank run itself. Where was money leaving? Where was it going? How was that playing out?
The second part was looking at how this earthquake in the banking system will affect credit pipes going forward. Basically, there are three big things that we take away from that. One is the effect on bank profitability that’s going to be rippling through the system. As it gets more expensive to hold onto deposits, the NIMs across the sector are going to be hit, and that’s going to ripple through in terms of creating some zombie banks that really have negative profitability at this level and a bunch that are a lot less profitable than they were.
The second part of that is probably no matter what happens from here, the lesson of banks and the amount of duration it’s safe for them to hold is rippling through. In some cases, literally, banks are being closed and that duration has to be sold into the market. And in other cases, either through regulation or just through the lesson being obvious, you’re likely to see very little purchase of duration by most banks and the rolling off of duration in many banks. Which means you have to find somebody in the private sector or somebody else to make up for the fact that central banks aren’t buying duration anymore and the banks aren’t buying duration, and they’re the only buyers of duration at current interest rates. So that’s a big deal.
And then third, the shift from small to big—the fact that small banks, of course, have been hit the hardest by the events. Big banks are getting bigger. That’s going to have a flow-through to the macro economy because there are elements of the economy where small banks are critical—CRE comes to mind and other places where lending to small companies and those things are going to be the most affected by this crisis. So those are the three things we really dug into in that Observations.
And then in the third part, it was really, well, how will all of that net out for the economy?
Chapter 1: How the Bank Run Played Out
JIM HASKEL
Great. So let’s jump right into the first part. Maybe, Greg, you could just summarize what actually happened over the past two weeks in terms of the bank run, what the drivers were, and where things stand now. In some sense this crisis was kicked off by a run on Silicon Valley Bank. But as you wrote, the real roots of this crisis go back much farther than that.
GREG JENSEN
The root cause really starts post-financial crisis. Credit pipes were totally rebuilt during the post-financial crisis in ways that in many ways made the financial system more safe but opened up a new gap. The basic picture is that rates drop; the Fed gets into buying assets that made the ability for banks to be profitable in their old business much lower than it was. And the fact that post-financial crisis there was such a credit hangover that the private sector wasn’t creating that much credit, that as banks didn’t have that much to do with the deposits that they got—and they got more deposits due to QE—they started taking on more government bond, government-guaranteed mortgage issuance as the assets that they were holding.
Then that trend massively accelerated in the pandemic, when you had a huge surge in deposits based on MP3 policies that pushed money into the banks at record rates. And again, there wasn’t enough private sector credit to keep up with that, although private sector credit did grow a lot. That money then flowed into the yield curve, and banks got more and more confident, in part from the lesson in 2018, where even though short rates had risen 2018, bank deposit rates never really rose. They got more confident that they could hold deposits at very low rates, even if rates rose. So they were willing to take on a little bit more duration than they would otherwise.
And then you had a wide range around the banks. Some took more duration, some took less. So at the tail you get into significant problems of the banks that a) miscalculated how likely they were to be able to hold on to their deposits, and b) if you combine that with moving out on the duration curve, you’ve got the toxic mix of the banks that you’re now seeing struggle and fail.
JIM HASKEL
Alex, let me turn to you. Greg has given the high-level background, but maybe just walk us through the more recent period up to the crisis today and just describe the details and the literal mechanics of what occurred.
ALEX SCHILLER
Sure, Jim. So you get from the environment that Greg described toward, let’s say, the end of 2021, where banks are really loaded up on long-duration bonds and mortgages, and are financing them with deposits that yield zero. Then you got a turn in that when the Fed started raising rates and draining cash from the system. And I think we started getting a dynamic around the middle of last year, 2022, that’s accelerated a lot in the last weeks. But even in the middle of 2022, you had a situation where, let’s say I’m a depositor at a bank and I’m earning 0.01% on my checking account. I look around and see that I could earn 3.5% putting money in a government money fund, and I do that. And the bank is holding long-duration bonds that they’ve put in a held-to-maturity portfolio. They can’t sell it; they were counting on my deposit being there. And so the bank needs to replace it. Maybe they’re able to do that by offering me or someone else a little bit more. But in aggregate, the system can’t because the Fed is draining money, and deposits are falling.
What a lot of banks did then—and you saw Silicon Valley Bank as an example do that—is go and find other forms of financing and market rates. A great example, and one that a lot of them did, was use the Federal Home Loan Bank System that we described a little bit in our Observations, where they go and they pledge their mortgages as collateral and borrow at market rates. Today, those rates are around 5%. One of the curious things that happens is the Federal Home Loan Bank actually goes and issues paper to fund that loan. Money market funds like the one that I just put my money into go and buy that. So in essence, I’ve taken my money out of the bank that they were giving me zero for. And the bank has gotten the same dollars through a money fund, through the Federal Home Loan Bank System, and now they’re paying 5%.
And so you had that happening starting in a trickle—let’s call it $400 billion of that switch happened between mid-2022 and the end of February this year.
JIM HASKEL
So that’s through February. And then in March we had the failure of SVB. I imagine the amount of deposits that have moved from banks to other savings vehicles like money funds—is that much higher now?
ALEX SCHILLER
Orders of magnitude. The thing that’s happened—you always had that pricing incentive, me as the depositor saying “I don’t want zero; I want 4.5%” or whatever it will be. But you added the “it’s not just me getting a little bit more, it’s me not losing all my money.” And so the amount of money that’s moved is an order of magnitude more in the last one or two weeks. We can count $500 billion that’s been replaced by the Federal Reserve and the FHLB. But there’s probably another multiple of that, where banks are having funding pulled and are needing to go say, “OK, I’ll pay you 5% for a certificate of deposit,” to get some other person to put the money in.
GREG JENSEN
That’s what’s been so interesting—that it took a lot to get people to start making that move. Because the thing that was obvious, of course, but not many people were taking advantage of, was the fact that you could get a much higher rate on holding the money market fund that holds T-bills, which is much more secure than a bank deposit. One of the big questions on how bad this dynamic will end up being for the banking system is how many people end up taking advantage of that? Some people are just shifting from their bank to a larger bank but maintaining a relatively low deposit rate. But the safest thing to do, of course, with any excess beyond transactional accounts, is to move that into T-bills, which will drain a significant amount from even the biggest banks in that case.
JIM HASKEL
I just have one question here, which is that money market accounts—you can write checks off of money market accounts. So corporates particularly, they have working capital lines but they’re much above the FDIC-insured limits. Why don’t they just do that? I’m surprised. Are you surprised that they haven’t done that quicker as that arbitrage developed over 2022?
GREG JENSEN
I mean, I’ve been somewhat surprised, although history would suggest that people move slowly on this. But I thought with the amount of technology, the ease with which it actually can be done, that when we were looking coming into the year—coming into last year, really, when we were talking about the liquidity hole—there are two elements of it. The central banks pulling back their deposits, pulling back their QE, but also the fact that the banks had been buying so many assets and that the reverse would start to happen—that you would see deposits fall because they would move into money market funds and such.
That’s been slower than I expected, even a little slower than history, despite it actually probably been easier than it ever was. I think that’s because you had such a long time—a decade of low interest rates. And so much of the money—and Silicon Valley was the extremity of it—but so many companies that had been formed when interest rates were zero, they didn’t even have a treasury function and a lot of those things that you’d set up in order to do this. In fact, ironically, for some of them this will be the most profitable thing they do. So I think you’re getting that set up, though. That’s what’s probably going to change this and make banks have to compete for deposits a lot more than they have. Because people are now aware; they are setting up the lines. It’s a push of a button once you’re set up to move the money.
So I think in a way that this is part of the earthquake—that people are going to be much more aware of where their cash is and probably force banks more to compete with, at least compete with T-bills, to get that. That would really reset things. Even in our numbers we’re being conservative in the assumption of how many people switch. If all banks had to pay market rates for the vast majority of their deposits—for all of their uninsured deposits, to put it that way—the implications are grave. I don’t think it’ll go that far, but it’s not impossible that a lot of people move in that direction. So even in the numbers, when we go through this, we’re assuming a return to historical norms of people doing that. If it goes beyond historical norms, because it’s easier technologically today and because people are more aware, you could see a lot more of a significant hit.
JIM HASKEL
OK. So you had this big move of deposits away from banks in a way that in some cases really mirrored a classic bank run, and then policy makers stepped in to keep the whole thing from spiraling too far out of control. Alex, maybe recap what the government has done and whether what they’ve done has been enough to actually stop the bleeding.
ALEX SCHILLER
The thing that is true now, and we find is true in most crises, is that policy makers—the Federal Reserve, the FDIC, the Department of the Treasury—have very powerful tools to stop the panic, to slow things down. The expansion of FDIC insurance to cover all the uninsured depositors of a certain number of banks and the Federal Reserve to open new liquidity facilities and make it such that assets can be financed, that people can get liquidity, were very good at stopping a bank run. And in some cases they didn’t even have to use them all that much—the presence of those things helps a lot.
So I would say the Fed can stop the bank run, but the thing they can’t stop, and the bell that you can’t un-ring, is the awareness that everyone now has of where their deposits are and how much they’re getting for them. I don’t think that they can stop a repricing of the funding in the system. One of the things, just as an example that I look at—we’re taping this on Wednesday, a couple of weeks past the initial failure of Silicon Valley Bank—and I’m still looking daily at the amount of money flowing into money market funds. In the first half of this week, it was $100 billion. You’re still getting immense amounts of money moving, and you’re getting reports of banks that are having to go and get different liquidity facilities from the private sector and tap the public sector more to go reprice things. And so it’s not a stampede for the door, but it’s still people replacing 0% deposits with 4.5% wholesale borrowing.
JIM HASKEL
So one of the obvious questions that our listeners will ask is, is this bank run over?
ALEX SCHILLER
Well, first of all, I want to hesitate to make any projections because it’s inherently an unstable situation. I won’t be surprised if you learn of a lot more banks that get in a lot more difficulty, and maybe the policy makers have to up their tools. I think that we are past the acute phase and into the long grind of a lot of banks dealing with a lot of their funding costs increasing, and that’s going to continue to cause pain for a long time.
Chapter 2: The Impact of the Crisis on the Banking System
JIM HASKEL
OK. Well, that actually brings us to the second part of the series, which is focused on the impact of the crisis on the banking system going forward. Greg, I want to turn back to you. What does all this pain mean for the banking system and the credit pipes more broadly?
GREG JENSEN
Let me start with the banks. So much of this hinges on that question you were just asking, Alex, which is: how does the next phase of the bank run play out? How many people say, “You know what, I’m safer in T-bills, and I can move my money there”? It is a very big deal if banks actually have to fund it at near market rates, near T-bill rates. So I don’t know where we’re going to end up on that spectrum. That’s why we’re monitoring it. It’s going fast. It could be on the higher end of what we were talking about in the piece, and that would be a big deal. Either way, what you end up with is they can stop the bank run because they essentially give them the deposits at market rates, but they will end up with zombie banks.
This is a little bit the Europe story—why is Credit Suisse failing? It’s not really that tied to this, but they were one of the zombies that were kept alive by a tremendous amount of liquidity and people putting capital in over and over again. That’s what these banks will need. They will be running at a loss when they adjust—as First Republic’s adjusting and they basically had to replace their whole deposit base—they’re running at a loss for a while, so they’re going to have to raise capital. And if people look and say, “I’m not going to put more capital in”—the Credit Suisse story is “we’ve put enough capital in; we’re not putting more in”—then you have those banks fail as well. So they’re going to have to either find capital to make it through the three or four years of losses that’ll be baked in the cake if they’re near market rates—all of which could be changed, by the way, if the Fed eases a lot, but that’s a whole other discussion we’ll come to at the end. But otherwise they’re just eating away with this bad NIM, negative profit eating into their capital. The range of whether that’s six banks or 30 or 40 banks that are in that zombie state is really going to be a function of how many people make that shift to T-bills.
The second part, as we talked about, in the credit pipes, is thinking through—it’s been interesting to watch the bond rally. There’s been a huge bond rally since this happened and a volatile one. And is that right? Do the mechanics make sense? On one hand, there’s the obvious knee-jerk reaction: banking system in trouble, Fed eases, all rates come down. That’s the market pricing and obviously makes a lot of sense. But this is, first order, going to be very difficult from a duration perspective, because if you take the last three years, the central bank and the banks were the entities buying all the bonds. There weren’t other players buying bonds—maybe in the swap market here or there, so it’s not totally black-and-white. But by and large, that’s the duration issuance.
Now, as a result of which—the higher rates and the tightening—there is less private sector issuance, so that helps a little bit in terms of the mismatch. But the government’s actually—the budget deficit’s rising again, and they are going to have to do a significant amount of the issuance in the coming year. And it’s not going to be banks, and unless economic conditions turn a lot, it’s not going to be the central bank. So where is that duration going to come from? That’s a big question. We think that actually leads to—higher interest rates and a steeper yield curve are probably going to be a necessary outcome of this.
Then the third part is this shift—that in almost all the scenarios you can imagine, small banks are much weaker; large banks are fine. The small banks supply certain areas of credit, and those are the things that, when you ask about the economy, it’s going to hit the hardest. Because a lot of the lending—small banks tend to go to real projects in small companies. The CRE market is largely small banks and such. Whereas the big banks are doing more with big companies, more financial-engineering-type lending and things along those lines.
So per dollar, the small banks actually have a bigger impact on the economy than the big banks. So even though small banks are 30-35% of the balance sheet of the banking system, they’re more impactful on the economy.
So this going to be a negative on the economy, and it’s going to depend on what sector you’re in and what area of the economy. Because some places are going to benefit from let’s say, at least so far, the lower interest rates that have occurred. But in terms of real fixed investment projects, they’re probably hit the hardest.
So you’ve got this mix and you go into—and sort of the third Observations is the impact on the economy. A lot of it’s going to be this removal of credit that’s likely in those niche areas and how big a deal that is, how much can big banks come in and replace what’s going on? And how much will small banks be able to struggle through and continue to provide credit in the way that they did? It’s clearly a negative; the degree of that negative we’ll continue to monitor.
JIM HASKEL
There’s a lot there. So I want to step back for a second and go into some of the details of some of the dynamics that you mentioned. Alex, when it comes to bank profitability, just walk us through how big you think the hits to profits will be. And how are you assessing who’s most affected?
ALEX SCHILLER
So I think the important thing to keep in mind is where bank funding costs were, let’s call it three months ago, and how far they could go up. If you take the typical spread that banks finance at below the fed funds rate—over time it’s averaged about 150 basis points—they were, depending on the bank, 100-150 basis points below that at the end of last year. We did a very simple calculation that if you just raise the aggregate cost of funding for the entire banking sector by a percent, something like two-thirds of the return on equity that they’re earning—their profits as a percent of their capital—are going away. That’s before they adjust their businesses and so on and so forth.
But as Greg said, it’s going to depend hugely by bank. In some cases, I think it’s reasonable to think that there won’t be much pressure on a bank at all—a big money center bank that’s actually the beneficiary of people fleeing to something that they perceive as very safe. And for some banks, it’s going to be a disaster. The big thing that is important is figuring out which are the ones that are going to be more vulnerable and which aren’t.
On the asset side, the people who are vulnerable are the ones with a high portion of fixed-duration assets, of low-yielding assets. A good way to look at that is, what are the banks who, during the time that interest rates are rising, say the year 2022, their asset yields weren’t rising at all? There are some banks who basically earned the same asset yield in 2022 as they did in 2021, even when interest rates had gone up by hundreds of basis points.
Then on the funding side, you have the banks that have a very large portion of their funding base coming from deposits over $250,000, above FDIC-insured limits—obviously, we’ll see what FDIC implicit or explicit insurance limits look like; I wouldn’t be surprised if we get some movement on that in the coming months—and those who are really benefiting from having non-interest-bearing deposits, just huge amounts of checking deposits.
I think it’s pretty clear that the market is on the lookout for these types of things. If you go and put these types of factors in, you can do a pretty good job distinguishing what types of banks have seen their share prices fall by 50%, 60%, 70% versus those where it’s more like 5% or 10%. I do think we’re going to get a big dispersion of outcomes. And some are going to become zombies. Some are going to fail. Some are going to be purchased. You could have a strong bank buying a weak bank, and that’s how the situation resolves itself. Either they’re going to be a zombie or they’re going to be folded into a bigger operation.
JIM HASKEL
Then when it comes to the duration issue that Greg mentioned, just size for us how big a deal it would be if banks significantly pulled back on their duration purchases. What would that mean for the hole, for example, in the treasury market?
ALEX SCHILLER
If you look at where the budget deficit is likely to go, we’re probably going to see 5% or 6% of GDP once we get a year or two out from here. And, you know, just pencil in the assumption that in the near term, banks are not in the market or are selling a bit. And the Federal Reserve is, of course, also selling a couple percent of GDP—2%, 3%, 4% of GDP.
JIM HASKEL
This is through the quantitative tightening?
ALEX SCHILLER
Through quantitative tightening, letting their portfolio roll down. So you get to a number that’s like 8%, 9%, 10% of GDP that has to be purchased in duration. And that doesn’t happen—it’s been very few times that that has happened in the last 100 years. There were maybe a couple of times when foreign central banks were buying a lot of US bonds in 2005 and 2006, when they were accumulating reserves—that can make that market clear. When the yield curve is steep and a lot of players have the incentive to go fund at zero and buy a steep yield curve—that can make it work.
But if you just look at the organic savings generated by the economy and how much life insurers and pensions are going to buy, you get to something like half that number. Obviously the bond market will clear. But the question is at what price and at the expense of what other activity? Are you going to need a much steeper yield curve, higher bond yields? Are you going to need other asset prices falling as people sell them to move into the bond market?
Chapter 3: The Impact of the Crisis on the Economy
JIM HASKEL
All right. Let’s move on now to the third part of the BDO series, which looked at the impact of this whole crisis on the economy. So when you look, Greg, at the economy, what kind of hit do you think this is going to create for growth going forward?
GREG JENSEN
Well, I’d start with the fact that—as everybody listening probably has heard more than they feel like they need to hear—we’ve been on the bearish side for the economy for a while and still are. We think that growth is likely to go to something like -2% to -2.5%. So a significant recession on the horizon here. And while we didn’t know exactly which thing will crack, the degree of the tightening, the degree to which the economy was dependent on the low interest rates and the liquidity that those cause, some things like this are going to crack. We don’t even think we’re at the end of it. More things will likely crack with respect to the huge shift in the regime we’re in relative to the regime we’ve been in for a decade.
And then when you look at—so this is just one of the dominoes. Just as you went through the UK pensions, they get squeezed, these guys get squeezed. There will be other squeezes because you’ve had such a significant tightening and it’s not over yet. And the implications don’t just pop the day they tighten; they happen over time because people lose money over time. It’s not like everybody has to reset the day the short rates rise. It resets over time. Debts come due over a period of time. The CRE market looks particularly vulnerable as those debts come due and so on. So we expect other cracks to occur and that as a result of all of those pressures that have been built, that you’re going have a significant growth down-move like that.
When we look at the impact of this, there are a lot of questions about the substitutability of the debt that was there. But about 2.7% of GDP annualized over the last couple of years has been coming from the banks that are most under strain—the small banks and the medium banks that are under strain. You’re likely to see that go to zero or even negative. Right before I came into the call, I was looking at the lending rates—the prime rate and the lending rates that smaller banks are now offering. They’re raising them quickly. They have to stop lending, and they’re doing that by raising the rate at which they’re lending. So new debt’s either going to roll at much higher rates or not roll at all, and so that could be a major part of it.
Now, there are ways—I don’t think that whole 2.7% will come out of the economy right away. Already, it had been shrinking before the last couple of weeks, and there will be some substitutability. But this by itself could be a reasonable impact on the economy. And when you take that combined with everything else going on with respect to the tightening, that’s going to be the big deal. In the end, I think that the biggest issue is, what’s it going to take to have households start to return savings rates back to a more normal level? How many of these things will cause that?
Normally it’s actually going to take some firing. It’s going to take profits going down to do that. How long will that take, and how significant will those firings be? What will it take for the Fed—if you don’t get the labor force to cool off a bit and get wage growth down toward their inflation target, they’re either going to have to give up on their inflation target or continue to have these high rates that hurt the banking system and hurt credit. So that’s going to be how that plays forward.
So overall, this by itself is important. And that with the tightening together we think is very significant to the likely outcome for growth.
ALEX SCHILLER
So the other interesting thing that I’d add to what Greg said about the way that this will flow through is you’re getting this degree of strain on the banking sector and likely pullback in credit conditions and availability, when there’s been almost no credit loss cycle. You go back through history and look at the times that you’ve had banks fail—the major waves are right after 1930, there’s a wave in the S&L crisis in the 1980s, and there’s a wave in 2008-10—and those were all driven by credit and were hugely, hugely bad for availability of credit to the private sector.
When you think about what it would be like to have had the banking sector go through the stress they’re dealing with right now in March 2023, with just duration trades going underwater—and now go add on to that a loss cycle where you start having loans default and people becoming worried about who are we going to lend to, and you get a double whammy that reinforces itself in that way.
GREG JENSEN
It rhymes with the savings and loan crisis more than the other two crises, in the sense that that started in a similar way. It came out of the fact that they were built on having short-term interest rates low and deposits at low rates, and being able to borrow at 3% and lend at 6%. That was the whole business.
So when you go into the tightenings due to inflation, actually in the 1970s and you get the same yield curve, then of course the credit cycle came later, and the credit cycle [inaudible] made that even worse. A similar thing—as Schiller is saying here—is I think it’s likely you weaken the banks with this move, and you hurt them further if you get the kind of growth move that our systematic process would point to and the credit losses associated with that. So it could be a one-two punch, a little bit like it was with the savings and loans.
ALEX SCHILLER
And of course, they are helped a little bit—if we enter a recession and bond yields fall and the Fed eases a lot, it does solve the duration problem for the banks. But I don’t think that banks’ lending standards are going to go accelerate if you just fix that problem. So you could fix the particular squeeze that they’re getting from high funding costs and their asset yields being low relative to bond yields. But if you’re doing that at the same time as a credit crisis is hitting, it’s not like they’re going to go restart lending to the economy. It’s going to be a mess.
Chapter 4: The Fed’s Dilemma
JIM HASKEL
So let’s move to the Fed now and what seems to be the horrible dilemma that they’re in. We purposely waited to have this conversation until after the Fed met, and their decision was to raise rates another 25 basis points but remove all forward guidance thereafter. Now, we discussed that one way to help alleviate the pressure on the banks is for the Fed to cut rates, and they are facing a potential growth problem as this crisis occurred and all the tightening is flowing through. But they’ve also got this sticky inflation problem.
So, Greg, taking a step back, how are you thinking about what the Fed is up against and how investors should process the dilemma they’re facing?
GREG JENSEN
Like you said, it’s an almost impossible position to be in, the Fed is. And what’s been interesting is how little the markets have actually reacted to the risk that’s building. Bonds rallied a lot. But the risk is that you’re very constrained. This is quite different than the downturns that have really come since the 1980s, where every downturn, inflation was low, the Fed was able to ease quickly. And they have. And this is the Greenspan Fed: the idea of getting in front of the downturns was a big deal.
Here the Fed is forced—and already, we think, are lagging the deterioration in conditions. And they’re going to lag the deterioration in conditions because inflation is not going to turn down until last. Rightfully, they’re not going to over-count on forecasts, right? They over-counted on forecasts and got us into the problem a little bit in 2020-21 when they were assuming the inflation was going to be transitory, and they just looked past it. I don’t think they’re going to do that again. And so they’re going to be slow.
Now they’re not going to be that slow. It was easy to talk tough and say “we’re going to get inflation down to 2%, whatever it takes”—until it takes a little. It does take. The problem is the inflation isn’t just cyclical; it’s secular. It’s going to take a lot if you really mean the 2% inflation target. And then you have to let banks fail and let credit go bad and those things, just as Volcker did in the 1980s, if you actually want to get, in a secularly inflationary world, inflation back to a 2% target.
So while I think they’re going to lag, I do also think they’re not really going to take the inflation all that seriously. As you can see, even as inflation actually got a little bit worse over the last month or whatever, although that’s lagging data. But at the same time, a little thing happens here or there, they’re somewhat pressured politically to start moving. So, you know, if things get worse, they probably will move.
But they’re going to move slower than they would otherwise, and probably going to move too slowly. And so really you should have risk premiums pretty wide. When you combine the fact that the Fed is boxed in in a way they haven’t been for 45 years and the geopolitical issues, which we’re not going to get into here—but there are many reasons to be concerned, and the US domestic political situation is not going that great either—interesting that you’re near lows in risk premiums.
So we think that’s one of the big mistakes that markets are thinking that, “OK, well, the Fed will ease, and the economy will pick up.” By the time the Fed starts easing, the economy is going to be in a self-reinforcing slowdown, and it’s not going to simply react to lower rates. It’s actually going to be very hard. How low rates have to get to get a big reaction is probably pretty significant given that—let’s say to start refinancing homes, mortgage rates have to fall basically in half to get down to the average mortgage rate.
So you’re a long way from easing being able to bail us out of the next recession, and you’re probably still a pretty long way from the Fed moving to easing. So we’ve got a long way to go in the cycle. People that were looking at the last four months and the decline in the inflation stats over that period and the holding up of growth stats—we think extrapolating that was overly optimistic, and we’re probably in the part where you’re now going to see a more pronounced slowdown in the economy. And while inflation will likely fall, it’ll probably fall at a slower rate than the Fed hopes, and it’s going to go on for a while, and the recession is going to probably be pretty significant.
JIM HASKEL
So that is, you know, a very cheery outlook. But Alex, let me just close with you and talk a little bit about that kind of scenario and what the markets are discounting. Greg is talking about very tight risk premiums. We see interest rates discounting a total change from where they were before. We don’t see equity markets repricing in the same way. So walk us through a little bit about how you’re seeing this scenario play out with regard to where markets are currently priced.
ALEX SCHILLER
I think you make a good point. If people in the future look back at the stock market through this, they wouldn’t notice that there was a banking crisis at all. The stock market is basically flat—it’s slightly up on the year, and it’s more or less flat since this whole thing started, outside of obviously the banking sector. I think a fair reading is that the only reason that it’s flat is that the two-year bond yield has fallen more than 100 basis points in two weeks. This has to be one of the fastest moves in short rates that that we’ve basically ever seen. I think that the equity valuations that we’re seeing are more or less conditioned with the Fed moving in that direction and easing pretty substantially over the next year and a half. And my view is that if they do that, your inflation outcomes are not going to be the outcomes that they want.
So I think it’s right to visualize the Fed as stuck between a situation where lowering rates causes that to happen to inflation, and raising rates makes the banking situation a lot worse. And in that case, stopping and seeing where things end up feels like the reasonable choice to do—do maybe another rate hike or two, and I don’t want to be overly precise about that, but see how the data starts evolving. The risk that you have, for the markets at least, is that just doing nothing, just keeping policy where it is—which is historically tight; we still have raised interest rates by 500 basis points—doing that is taking out a support. Just not easing, as is discounted in the rate market, is taking out a huge support that is baked into equity pricing at this point.
JIM HASKEL
All right. I think we’ll leave it there. Greg and Alex, thank you so much for being here, and I look forward to checking in with you both again real soon.
GREG JENSEN
Thank you, Jim.
ALEX SCHILLER
Thank you, Jim—a pleasure, as always.
In this podcast, Daily Observations editor Jim Haskel sits down with Greg and Alex to delve deeper into the key takeaways from this series and how they connect to our economic outlook. The conversation covers the origins of the bank run, the mechanics of how it played out, the impact of the crisis on bank business models and profitability, and how all of this is flowing through to growth and assets. Greg and Alex also discuss the recent Fed meeting and how the banking strains — combined with an increasingly challenging macro environment — are creating a very difficult dilemma for policy makers.
Transcript
Note: This transcript has been edited for readability.
“We’ve been on the bearish side for the economy for a while and still are. And while we didn’t know exactly which thing will crack, the degree of the tightening, the degree to which the economy was dependent on the low interest rates and the liquidity that those cause, some things like this are going to crack. We don’t even think we’re at the end of it. When we look at the impact of this, there are a lot of questions about the substitutability of the debt that was there. But about 2.7% of GDP annualized over the last couple of years has been coming from the banks that are most under strain. Now, there are ways—I don’t think that whole 2.7% will come out of the economy right away. But this by itself could be a reasonable impact on the economy. And when you take that combined with everything else going on with respect to the tightening, that’s going to be the big deal.”—Co-CIO Greg Jensen
JIM HASKEL
I’m Jim Haskel, editor of the Bridgewater Daily Observations. Over the past two weeks, we’ve seen the failure of Silicon Valley Bank and Signature Bank and fears that additional banking institutions will also go under. This has spiraled into something larger that’s now reshaping the banking system as well as the credit pipes—and we believe will have a big impact on markets and the economy going forward.
In the last few days, we’ve published a series of Daily Observations pulling together our thoughts on these dynamics. Today, I’m joined by two of the authors of that series—co-CIO Greg Jensen and co-head of our rates team Alex Schiller—to delve deeper and discuss the key takeaways from those Observations. We’re recording this podcast right after Wednesday’s Fed meeting, so we’ll also touch on the dilemma the crisis creates for monetary policy and how the Fed is processing that challenge.
So, let’s jump right into it. Greg and Alex, I want to thank you so much for joining me. As I mentioned, this series was published in three parts. And Greg, before we start, maybe you can give a quick overview of what each part was about, and then we’ll explore each topic in more detail.
GREG JENSEN
Yes. So we broke it into three parts because there’s so much going on, and we wanted to try to make it digestible and digest it ourselves as we dug into the data in our systems to really do a diagnosis of everything that’s happening in the bank run. So, part one was exactly that: it was diagnosing the bank run itself. Where was money leaving? Where was it going? How was that playing out?
The second part was looking at how this earthquake in the banking system will affect credit pipes going forward. Basically, there are three big things that we take away from that. One is the effect on bank profitability that’s going to be rippling through the system. As it gets more expensive to hold onto deposits, the NIMs across the sector are going to be hit, and that’s going to ripple through in terms of creating some zombie banks that really have negative profitability at this level and a bunch that are a lot less profitable than they were.
The second part of that is probably no matter what happens from here, the lesson of banks and the amount of duration it’s safe for them to hold is rippling through. In some cases, literally, banks are being closed and that duration has to be sold into the market. And in other cases, either through regulation or just through the lesson being obvious, you’re likely to see very little purchase of duration by most banks and the rolling off of duration in many banks. Which means you have to find somebody in the private sector or somebody else to make up for the fact that central banks aren’t buying duration anymore and the banks aren’t buying duration, and they’re the only buyers of duration at current interest rates. So that’s a big deal.
And then third, the shift from small to big—the fact that small banks, of course, have been hit the hardest by the events. Big banks are getting bigger. That’s going to have a flow-through to the macro economy because there are elements of the economy where small banks are critical—CRE comes to mind and other places where lending to small companies and those things are going to be the most affected by this crisis. So those are the three things we really dug into in that Observations.
And then in the third part, it was really, well, how will all of that net out for the economy?
Chapter 1: How the Bank Run Played Out
JIM HASKEL
Great. So let’s jump right into the first part. Maybe, Greg, you could just summarize what actually happened over the past two weeks in terms of the bank run, what the drivers were, and where things stand now. In some sense this crisis was kicked off by a run on Silicon Valley Bank. But as you wrote, the real roots of this crisis go back much farther than that.
GREG JENSEN
The root cause really starts post-financial crisis. Credit pipes were totally rebuilt during the post-financial crisis in ways that in many ways made the financial system more safe but opened up a new gap. The basic picture is that rates drop; the Fed gets into buying assets that made the ability for banks to be profitable in their old business much lower than it was. And the fact that post-financial crisis there was such a credit hangover that the private sector wasn’t creating that much credit, that as banks didn’t have that much to do with the deposits that they got—and they got more deposits due to QE—they started taking on more government bond, government-guaranteed mortgage issuance as the assets that they were holding.
Then that trend massively accelerated in the pandemic, when you had a huge surge in deposits based on MP3 policies that pushed money into the banks at record rates. And again, there wasn’t enough private sector credit to keep up with that, although private sector credit did grow a lot. That money then flowed into the yield curve, and banks got more and more confident, in part from the lesson in 2018, where even though short rates had risen 2018, bank deposit rates never really rose. They got more confident that they could hold deposits at very low rates, even if rates rose. So they were willing to take on a little bit more duration than they would otherwise.
And then you had a wide range around the banks. Some took more duration, some took less. So at the tail you get into significant problems of the banks that a) miscalculated how likely they were to be able to hold on to their deposits, and b) if you combine that with moving out on the duration curve, you’ve got the toxic mix of the banks that you’re now seeing struggle and fail.
JIM HASKEL
Alex, let me turn to you. Greg has given the high-level background, but maybe just walk us through the more recent period up to the crisis today and just describe the details and the literal mechanics of what occurred.
ALEX SCHILLER
Sure, Jim. So you get from the environment that Greg described toward, let’s say, the end of 2021, where banks are really loaded up on long-duration bonds and mortgages, and are financing them with deposits that yield zero. Then you got a turn in that when the Fed started raising rates and draining cash from the system. And I think we started getting a dynamic around the middle of last year, 2022, that’s accelerated a lot in the last weeks. But even in the middle of 2022, you had a situation where, let’s say I’m a depositor at a bank and I’m earning 0.01% on my checking account. I look around and see that I could earn 3.5% putting money in a government money fund, and I do that. And the bank is holding long-duration bonds that they’ve put in a held-to-maturity portfolio. They can’t sell it; they were counting on my deposit being there. And so the bank needs to replace it. Maybe they’re able to do that by offering me or someone else a little bit more. But in aggregate, the system can’t because the Fed is draining money, and deposits are falling.
What a lot of banks did then—and you saw Silicon Valley Bank as an example do that—is go and find other forms of financing and market rates. A great example, and one that a lot of them did, was use the Federal Home Loan Bank System that we described a little bit in our Observations, where they go and they pledge their mortgages as collateral and borrow at market rates. Today, those rates are around 5%. One of the curious things that happens is the Federal Home Loan Bank actually goes and issues paper to fund that loan. Money market funds like the one that I just put my money into go and buy that. So in essence, I’ve taken my money out of the bank that they were giving me zero for. And the bank has gotten the same dollars through a money fund, through the Federal Home Loan Bank System, and now they’re paying 5%.
And so you had that happening starting in a trickle—let’s call it $400 billion of that switch happened between mid-2022 and the end of February this year.
JIM HASKEL
So that’s through February. And then in March we had the failure of SVB. I imagine the amount of deposits that have moved from banks to other savings vehicles like money funds—is that much higher now?
ALEX SCHILLER
Orders of magnitude. The thing that’s happened—you always had that pricing incentive, me as the depositor saying “I don’t want zero; I want 4.5%” or whatever it will be. But you added the “it’s not just me getting a little bit more, it’s me not losing all my money.” And so the amount of money that’s moved is an order of magnitude more in the last one or two weeks. We can count $500 billion that’s been replaced by the Federal Reserve and the FHLB. But there’s probably another multiple of that, where banks are having funding pulled and are needing to go say, “OK, I’ll pay you 5% for a certificate of deposit,” to get some other person to put the money in.
GREG JENSEN
That’s what’s been so interesting—that it took a lot to get people to start making that move. Because the thing that was obvious, of course, but not many people were taking advantage of, was the fact that you could get a much higher rate on holding the money market fund that holds T-bills, which is much more secure than a bank deposit. One of the big questions on how bad this dynamic will end up being for the banking system is how many people end up taking advantage of that? Some people are just shifting from their bank to a larger bank but maintaining a relatively low deposit rate. But the safest thing to do, of course, with any excess beyond transactional accounts, is to move that into T-bills, which will drain a significant amount from even the biggest banks in that case.
JIM HASKEL
I just have one question here, which is that money market accounts—you can write checks off of money market accounts. So corporates particularly, they have working capital lines but they’re much above the FDIC-insured limits. Why don’t they just do that? I’m surprised. Are you surprised that they haven’t done that quicker as that arbitrage developed over 2022?
GREG JENSEN
I mean, I’ve been somewhat surprised, although history would suggest that people move slowly on this. But I thought with the amount of technology, the ease with which it actually can be done, that when we were looking coming into the year—coming into last year, really, when we were talking about the liquidity hole—there are two elements of it. The central banks pulling back their deposits, pulling back their QE, but also the fact that the banks had been buying so many assets and that the reverse would start to happen—that you would see deposits fall because they would move into money market funds and such.
That’s been slower than I expected, even a little slower than history, despite it actually probably been easier than it ever was. I think that’s because you had such a long time—a decade of low interest rates. And so much of the money—and Silicon Valley was the extremity of it—but so many companies that had been formed when interest rates were zero, they didn’t even have a treasury function and a lot of those things that you’d set up in order to do this. In fact, ironically, for some of them this will be the most profitable thing they do. So I think you’re getting that set up, though. That’s what’s probably going to change this and make banks have to compete for deposits a lot more than they have. Because people are now aware; they are setting up the lines. It’s a push of a button once you’re set up to move the money.
So I think in a way that this is part of the earthquake—that people are going to be much more aware of where their cash is and probably force banks more to compete with, at least compete with T-bills, to get that. That would really reset things. Even in our numbers we’re being conservative in the assumption of how many people switch. If all banks had to pay market rates for the vast majority of their deposits—for all of their uninsured deposits, to put it that way—the implications are grave. I don’t think it’ll go that far, but it’s not impossible that a lot of people move in that direction. So even in the numbers, when we go through this, we’re assuming a return to historical norms of people doing that. If it goes beyond historical norms, because it’s easier technologically today and because people are more aware, you could see a lot more of a significant hit.
JIM HASKEL
OK. So you had this big move of deposits away from banks in a way that in some cases really mirrored a classic bank run, and then policy makers stepped in to keep the whole thing from spiraling too far out of control. Alex, maybe recap what the government has done and whether what they’ve done has been enough to actually stop the bleeding.
ALEX SCHILLER
The thing that is true now, and we find is true in most crises, is that policy makers—the Federal Reserve, the FDIC, the Department of the Treasury—have very powerful tools to stop the panic, to slow things down. The expansion of FDIC insurance to cover all the uninsured depositors of a certain number of banks and the Federal Reserve to open new liquidity facilities and make it such that assets can be financed, that people can get liquidity, were very good at stopping a bank run. And in some cases they didn’t even have to use them all that much—the presence of those things helps a lot.
So I would say the Fed can stop the bank run, but the thing they can’t stop, and the bell that you can’t un-ring, is the awareness that everyone now has of where their deposits are and how much they’re getting for them. I don’t think that they can stop a repricing of the funding in the system. One of the things, just as an example that I look at—we’re taping this on Wednesday, a couple of weeks past the initial failure of Silicon Valley Bank—and I’m still looking daily at the amount of money flowing into money market funds. In the first half of this week, it was $100 billion. You’re still getting immense amounts of money moving, and you’re getting reports of banks that are having to go and get different liquidity facilities from the private sector and tap the public sector more to go reprice things. And so it’s not a stampede for the door, but it’s still people replacing 0% deposits with 4.5% wholesale borrowing.
JIM HASKEL
So one of the obvious questions that our listeners will ask is, is this bank run over?
ALEX SCHILLER
Well, first of all, I want to hesitate to make any projections because it’s inherently an unstable situation. I won’t be surprised if you learn of a lot more banks that get in a lot more difficulty, and maybe the policy makers have to up their tools. I think that we are past the acute phase and into the long grind of a lot of banks dealing with a lot of their funding costs increasing, and that’s going to continue to cause pain for a long time.
Chapter 2: The Impact of the Crisis on the Banking System
JIM HASKEL
OK. Well, that actually brings us to the second part of the series, which is focused on the impact of the crisis on the banking system going forward. Greg, I want to turn back to you. What does all this pain mean for the banking system and the credit pipes more broadly?
GREG JENSEN
Let me start with the banks. So much of this hinges on that question you were just asking, Alex, which is: how does the next phase of the bank run play out? How many people say, “You know what, I’m safer in T-bills, and I can move my money there”? It is a very big deal if banks actually have to fund it at near market rates, near T-bill rates. So I don’t know where we’re going to end up on that spectrum. That’s why we’re monitoring it. It’s going fast. It could be on the higher end of what we were talking about in the piece, and that would be a big deal. Either way, what you end up with is they can stop the bank run because they essentially give them the deposits at market rates, but they will end up with zombie banks.
This is a little bit the Europe story—why is Credit Suisse failing? It’s not really that tied to this, but they were one of the zombies that were kept alive by a tremendous amount of liquidity and people putting capital in over and over again. That’s what these banks will need. They will be running at a loss when they adjust—as First Republic’s adjusting and they basically had to replace their whole deposit base—they’re running at a loss for a while, so they’re going to have to raise capital. And if people look and say, “I’m not going to put more capital in”—the Credit Suisse story is “we’ve put enough capital in; we’re not putting more in”—then you have those banks fail as well. So they’re going to have to either find capital to make it through the three or four years of losses that’ll be baked in the cake if they’re near market rates—all of which could be changed, by the way, if the Fed eases a lot, but that’s a whole other discussion we’ll come to at the end. But otherwise they’re just eating away with this bad NIM, negative profit eating into their capital. The range of whether that’s six banks or 30 or 40 banks that are in that zombie state is really going to be a function of how many people make that shift to T-bills.
The second part, as we talked about, in the credit pipes, is thinking through—it’s been interesting to watch the bond rally. There’s been a huge bond rally since this happened and a volatile one. And is that right? Do the mechanics make sense? On one hand, there’s the obvious knee-jerk reaction: banking system in trouble, Fed eases, all rates come down. That’s the market pricing and obviously makes a lot of sense. But this is, first order, going to be very difficult from a duration perspective, because if you take the last three years, the central bank and the banks were the entities buying all the bonds. There weren’t other players buying bonds—maybe in the swap market here or there, so it’s not totally black-and-white. But by and large, that’s the duration issuance.
Now, as a result of which—the higher rates and the tightening—there is less private sector issuance, so that helps a little bit in terms of the mismatch. But the government’s actually—the budget deficit’s rising again, and they are going to have to do a significant amount of the issuance in the coming year. And it’s not going to be banks, and unless economic conditions turn a lot, it’s not going to be the central bank. So where is that duration going to come from? That’s a big question. We think that actually leads to—higher interest rates and a steeper yield curve are probably going to be a necessary outcome of this.
Then the third part is this shift—that in almost all the scenarios you can imagine, small banks are much weaker; large banks are fine. The small banks supply certain areas of credit, and those are the things that, when you ask about the economy, it’s going to hit the hardest. Because a lot of the lending—small banks tend to go to real projects in small companies. The CRE market is largely small banks and such. Whereas the big banks are doing more with big companies, more financial-engineering-type lending and things along those lines.
So per dollar, the small banks actually have a bigger impact on the economy than the big banks. So even though small banks are 30-35% of the balance sheet of the banking system, they’re more impactful on the economy.
So this going to be a negative on the economy, and it’s going to depend on what sector you’re in and what area of the economy. Because some places are going to benefit from let’s say, at least so far, the lower interest rates that have occurred. But in terms of real fixed investment projects, they’re probably hit the hardest.
So you’ve got this mix and you go into—and sort of the third Observations is the impact on the economy. A lot of it’s going to be this removal of credit that’s likely in those niche areas and how big a deal that is, how much can big banks come in and replace what’s going on? And how much will small banks be able to struggle through and continue to provide credit in the way that they did? It’s clearly a negative; the degree of that negative we’ll continue to monitor.
JIM HASKEL
There’s a lot there. So I want to step back for a second and go into some of the details of some of the dynamics that you mentioned. Alex, when it comes to bank profitability, just walk us through how big you think the hits to profits will be. And how are you assessing who’s most affected?
ALEX SCHILLER
So I think the important thing to keep in mind is where bank funding costs were, let’s call it three months ago, and how far they could go up. If you take the typical spread that banks finance at below the fed funds rate—over time it’s averaged about 150 basis points—they were, depending on the bank, 100-150 basis points below that at the end of last year. We did a very simple calculation that if you just raise the aggregate cost of funding for the entire banking sector by a percent, something like two-thirds of the return on equity that they’re earning—their profits as a percent of their capital—are going away. That’s before they adjust their businesses and so on and so forth.
But as Greg said, it’s going to depend hugely by bank. In some cases, I think it’s reasonable to think that there won’t be much pressure on a bank at all—a big money center bank that’s actually the beneficiary of people fleeing to something that they perceive as very safe. And for some banks, it’s going to be a disaster. The big thing that is important is figuring out which are the ones that are going to be more vulnerable and which aren’t.
On the asset side, the people who are vulnerable are the ones with a high portion of fixed-duration assets, of low-yielding assets. A good way to look at that is, what are the banks who, during the time that interest rates are rising, say the year 2022, their asset yields weren’t rising at all? There are some banks who basically earned the same asset yield in 2022 as they did in 2021, even when interest rates had gone up by hundreds of basis points.
Then on the funding side, you have the banks that have a very large portion of their funding base coming from deposits over $250,000, above FDIC-insured limits—obviously, we’ll see what FDIC implicit or explicit insurance limits look like; I wouldn’t be surprised if we get some movement on that in the coming months—and those who are really benefiting from having non-interest-bearing deposits, just huge amounts of checking deposits.
I think it’s pretty clear that the market is on the lookout for these types of things. If you go and put these types of factors in, you can do a pretty good job distinguishing what types of banks have seen their share prices fall by 50%, 60%, 70% versus those where it’s more like 5% or 10%. I do think we’re going to get a big dispersion of outcomes. And some are going to become zombies. Some are going to fail. Some are going to be purchased. You could have a strong bank buying a weak bank, and that’s how the situation resolves itself. Either they’re going to be a zombie or they’re going to be folded into a bigger operation.
JIM HASKEL
Then when it comes to the duration issue that Greg mentioned, just size for us how big a deal it would be if banks significantly pulled back on their duration purchases. What would that mean for the hole, for example, in the treasury market?
ALEX SCHILLER
If you look at where the budget deficit is likely to go, we’re probably going to see 5% or 6% of GDP once we get a year or two out from here. And, you know, just pencil in the assumption that in the near term, banks are not in the market or are selling a bit. And the Federal Reserve is, of course, also selling a couple percent of GDP—2%, 3%, 4% of GDP.
JIM HASKEL
This is through the quantitative tightening?
ALEX SCHILLER
Through quantitative tightening, letting their portfolio roll down. So you get to a number that’s like 8%, 9%, 10% of GDP that has to be purchased in duration. And that doesn’t happen—it’s been very few times that that has happened in the last 100 years. There were maybe a couple of times when foreign central banks were buying a lot of US bonds in 2005 and 2006, when they were accumulating reserves—that can make that market clear. When the yield curve is steep and a lot of players have the incentive to go fund at zero and buy a steep yield curve—that can make it work.
But if you just look at the organic savings generated by the economy and how much life insurers and pensions are going to buy, you get to something like half that number. Obviously the bond market will clear. But the question is at what price and at the expense of what other activity? Are you going to need a much steeper yield curve, higher bond yields? Are you going to need other asset prices falling as people sell them to move into the bond market?
Chapter 3: The Impact of the Crisis on the Economy
JIM HASKEL
All right. Let’s move on now to the third part of the BDO series, which looked at the impact of this whole crisis on the economy. So when you look, Greg, at the economy, what kind of hit do you think this is going to create for growth going forward?
GREG JENSEN
Well, I’d start with the fact that—as everybody listening probably has heard more than they feel like they need to hear—we’ve been on the bearish side for the economy for a while and still are. We think that growth is likely to go to something like -2% to -2.5%. So a significant recession on the horizon here. And while we didn’t know exactly which thing will crack, the degree of the tightening, the degree to which the economy was dependent on the low interest rates and the liquidity that those cause, some things like this are going to crack. We don’t even think we’re at the end of it. More things will likely crack with respect to the huge shift in the regime we’re in relative to the regime we’ve been in for a decade.
And then when you look at—so this is just one of the dominoes. Just as you went through the UK pensions, they get squeezed, these guys get squeezed. There will be other squeezes because you’ve had such a significant tightening and it’s not over yet. And the implications don’t just pop the day they tighten; they happen over time because people lose money over time. It’s not like everybody has to reset the day the short rates rise. It resets over time. Debts come due over a period of time. The CRE market looks particularly vulnerable as those debts come due and so on. So we expect other cracks to occur and that as a result of all of those pressures that have been built, that you’re going have a significant growth down-move like that.
When we look at the impact of this, there are a lot of questions about the substitutability of the debt that was there. But about 2.7% of GDP annualized over the last couple of years has been coming from the banks that are most under strain—the small banks and the medium banks that are under strain. You’re likely to see that go to zero or even negative. Right before I came into the call, I was looking at the lending rates—the prime rate and the lending rates that smaller banks are now offering. They’re raising them quickly. They have to stop lending, and they’re doing that by raising the rate at which they’re lending. So new debt’s either going to roll at much higher rates or not roll at all, and so that could be a major part of it.
Now, there are ways—I don’t think that whole 2.7% will come out of the economy right away. Already, it had been shrinking before the last couple of weeks, and there will be some substitutability. But this by itself could be a reasonable impact on the economy. And when you take that combined with everything else going on with respect to the tightening, that’s going to be the big deal. In the end, I think that the biggest issue is, what’s it going to take to have households start to return savings rates back to a more normal level? How many of these things will cause that?
Normally it’s actually going to take some firing. It’s going to take profits going down to do that. How long will that take, and how significant will those firings be? What will it take for the Fed—if you don’t get the labor force to cool off a bit and get wage growth down toward their inflation target, they’re either going to have to give up on their inflation target or continue to have these high rates that hurt the banking system and hurt credit. So that’s going to be how that plays forward.
So overall, this by itself is important. And that with the tightening together we think is very significant to the likely outcome for growth.
ALEX SCHILLER
So the other interesting thing that I’d add to what Greg said about the way that this will flow through is you’re getting this degree of strain on the banking sector and likely pullback in credit conditions and availability, when there’s been almost no credit loss cycle. You go back through history and look at the times that you’ve had banks fail—the major waves are right after 1930, there’s a wave in the S&L crisis in the 1980s, and there’s a wave in 2008-10—and those were all driven by credit and were hugely, hugely bad for availability of credit to the private sector.
When you think about what it would be like to have had the banking sector go through the stress they’re dealing with right now in March 2023, with just duration trades going underwater—and now go add on to that a loss cycle where you start having loans default and people becoming worried about who are we going to lend to, and you get a double whammy that reinforces itself in that way.
GREG JENSEN
It rhymes with the savings and loan crisis more than the other two crises, in the sense that that started in a similar way. It came out of the fact that they were built on having short-term interest rates low and deposits at low rates, and being able to borrow at 3% and lend at 6%. That was the whole business.
So when you go into the tightenings due to inflation, actually in the 1970s and you get the same yield curve, then of course the credit cycle came later, and the credit cycle [inaudible] made that even worse. A similar thing—as Schiller is saying here—is I think it’s likely you weaken the banks with this move, and you hurt them further if you get the kind of growth move that our systematic process would point to and the credit losses associated with that. So it could be a one-two punch, a little bit like it was with the savings and loans.
ALEX SCHILLER
And of course, they are helped a little bit—if we enter a recession and bond yields fall and the Fed eases a lot, it does solve the duration problem for the banks. But I don’t think that banks’ lending standards are going to go accelerate if you just fix that problem. So you could fix the particular squeeze that they’re getting from high funding costs and their asset yields being low relative to bond yields. But if you’re doing that at the same time as a credit crisis is hitting, it’s not like they’re going to go restart lending to the economy. It’s going to be a mess.
Chapter 4: The Fed’s Dilemma
JIM HASKEL
So let’s move to the Fed now and what seems to be the horrible dilemma that they’re in. We purposely waited to have this conversation until after the Fed met, and their decision was to raise rates another 25 basis points but remove all forward guidance thereafter. Now, we discussed that one way to help alleviate the pressure on the banks is for the Fed to cut rates, and they are facing a potential growth problem as this crisis occurred and all the tightening is flowing through. But they’ve also got this sticky inflation problem.
So, Greg, taking a step back, how are you thinking about what the Fed is up against and how investors should process the dilemma they’re facing?
GREG JENSEN
Like you said, it’s an almost impossible position to be in, the Fed is. And what’s been interesting is how little the markets have actually reacted to the risk that’s building. Bonds rallied a lot. But the risk is that you’re very constrained. This is quite different than the downturns that have really come since the 1980s, where every downturn, inflation was low, the Fed was able to ease quickly. And they have. And this is the Greenspan Fed: the idea of getting in front of the downturns was a big deal.
Here the Fed is forced—and already, we think, are lagging the deterioration in conditions. And they’re going to lag the deterioration in conditions because inflation is not going to turn down until last. Rightfully, they’re not going to over-count on forecasts, right? They over-counted on forecasts and got us into the problem a little bit in 2020-21 when they were assuming the inflation was going to be transitory, and they just looked past it. I don’t think they’re going to do that again. And so they’re going to be slow.
Now they’re not going to be that slow. It was easy to talk tough and say “we’re going to get inflation down to 2%, whatever it takes”—until it takes a little. It does take. The problem is the inflation isn’t just cyclical; it’s secular. It’s going to take a lot if you really mean the 2% inflation target. And then you have to let banks fail and let credit go bad and those things, just as Volcker did in the 1980s, if you actually want to get, in a secularly inflationary world, inflation back to a 2% target.
So while I think they’re going to lag, I do also think they’re not really going to take the inflation all that seriously. As you can see, even as inflation actually got a little bit worse over the last month or whatever, although that’s lagging data. But at the same time, a little thing happens here or there, they’re somewhat pressured politically to start moving. So, you know, if things get worse, they probably will move.
But they’re going to move slower than they would otherwise, and probably going to move too slowly. And so really you should have risk premiums pretty wide. When you combine the fact that the Fed is boxed in in a way they haven’t been for 45 years and the geopolitical issues, which we’re not going to get into here—but there are many reasons to be concerned, and the US domestic political situation is not going that great either—interesting that you’re near lows in risk premiums.
So we think that’s one of the big mistakes that markets are thinking that, “OK, well, the Fed will ease, and the economy will pick up.” By the time the Fed starts easing, the economy is going to be in a self-reinforcing slowdown, and it’s not going to simply react to lower rates. It’s actually going to be very hard. How low rates have to get to get a big reaction is probably pretty significant given that—let’s say to start refinancing homes, mortgage rates have to fall basically in half to get down to the average mortgage rate.
So you’re a long way from easing being able to bail us out of the next recession, and you’re probably still a pretty long way from the Fed moving to easing. So we’ve got a long way to go in the cycle. People that were looking at the last four months and the decline in the inflation stats over that period and the holding up of growth stats—we think extrapolating that was overly optimistic, and we’re probably in the part where you’re now going to see a more pronounced slowdown in the economy. And while inflation will likely fall, it’ll probably fall at a slower rate than the Fed hopes, and it’s going to go on for a while, and the recession is going to probably be pretty significant.
JIM HASKEL
So that is, you know, a very cheery outlook. But Alex, let me just close with you and talk a little bit about that kind of scenario and what the markets are discounting. Greg is talking about very tight risk premiums. We see interest rates discounting a total change from where they were before. We don’t see equity markets repricing in the same way. So walk us through a little bit about how you’re seeing this scenario play out with regard to where markets are currently priced.
ALEX SCHILLER
I think you make a good point. If people in the future look back at the stock market through this, they wouldn’t notice that there was a banking crisis at all. The stock market is basically flat—it’s slightly up on the year, and it’s more or less flat since this whole thing started, outside of obviously the banking sector. I think a fair reading is that the only reason that it’s flat is that the two-year bond yield has fallen more than 100 basis points in two weeks. This has to be one of the fastest moves in short rates that that we’ve basically ever seen. I think that the equity valuations that we’re seeing are more or less conditioned with the Fed moving in that direction and easing pretty substantially over the next year and a half. And my view is that if they do that, your inflation outcomes are not going to be the outcomes that they want.
So I think it’s right to visualize the Fed as stuck between a situation where lowering rates causes that to happen to inflation, and raising rates makes the banking situation a lot worse. And in that case, stopping and seeing where things end up feels like the reasonable choice to do—do maybe another rate hike or two, and I don’t want to be overly precise about that, but see how the data starts evolving. The risk that you have, for the markets at least, is that just doing nothing, just keeping policy where it is—which is historically tight; we still have raised interest rates by 500 basis points—doing that is taking out a support. Just not easing, as is discounted in the rate market, is taking out a huge support that is baked into equity pricing at this point.
JIM HASKEL
All right. I think we’ll leave it there. Greg and Alex, thank you so much for being here, and I look forward to checking in with you both again real soon.
GREG JENSEN
Thank you, Jim.
ALEX SCHILLER
Thank you, Jim—a pleasure, as always.