If you asked Torsten Slok a week ago how the economy would fare this year, he told you that he expected a no-landing scenario, where the Federal Reserve can prevent inflation without causing a recession.
But that all changed after the collapse of three US banks in a matter of days. The chief economist of Apollo Global Management now says he is preparing for a hard landing. He joined the What’s 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 entire podcast on Terminal, or subscribe below to Apple Podcasts, Spotify or wherever you listen.
Q: You changed your view from looking at a no-landing scenario to a hard landing — tell us about it.
A: The debate until recently was that, well, why doesn’t the economy slow down when the Fed raises rates? Why is the consumer still good? And a very important answer to that is that, well, there’s a lot of savings left in the income distribution, that households have a lot of savings left after the pandemic. And to this day, the debate is why this economy has not slowed down? And call that what you want, but that’s what we call a no-landing. And that’s why inflation continues to be in the range of 5%, 6%, 7%. That’s why the Fed has to raise rates.
What happened, of course, here with Silicon Valley Bank so suddenly out of the blue, at least for the financial markets, in fact no one – and I think that’s safe to say at this point – saw this coming.
And as a result of that, suddenly we all have to go back to our drawing boards and think, OK, but what is the importance of regional banks? What is the importance of the banking sector in terms of extending credit? In data from the Fed, you can see that almost one-third of the assets of the US banking sector are in small banks. And here a small bank is defined as bank number 26 to 8,000. A large bank is the number one to 25 ranking of assets. So that means there is a long tail of banks. Some of them are pretty big, but the farther you go out, the smaller they get. And the key question for the markets today is, how important are the small banks that are currently facing issues with deposits, with funding costs, facing issues of what could be explained in their credit books, and also facing issues of what does it mean if we now also have to do a stress test on some of these smaller banks?
So this episode of Silicon Valley Bank, the markets are doing what they’re doing and there’s a lot of things going on, but what’s really the most important issue here is that we just don’t know right now what’s going to change -or the behavior of the terms. the lending willingness of regional banks. And since regional banks make up 30% of assets and approximately 40% of all lending, that means the banking sector now has an important part of banks that are now thinking about what happening. And the risk of this is that the slowdown that has already started – due to the Fed raising rates – could come faster just because of this banking situation. So I changed my view from saying no landing, everything is fine now to saying, well, wait a minute, there is a risk now that the things because we need to see in the coming weeks and months ahead, what will be the response in terms of lending from this relatively important part of the banking sector that is currently going through this turmoil that we are seeing.
Q: We have never seen any deterioration in creditworthiness. Will it play out the same way as far as credit supply constraints go? Or is there any reason to think it is different? And is it possible that we will have another shoe drop with credit quality deterioration in the future?
A: I started my career at the IMF in the 1990s, and the first thing you learn is that a banking crisis and a banking run usually happen because there are credit losses on the banks’ books. We saw that in 2008. If you go back to the 1990s, you saw that in the savings and loan crisis. And these are illiquid losses. It just doesn’t sell very quickly. That is very different. Basically we have never had a banking crisis in a strong economy. And the irony of this situation is that it is actually the most liquid asset, which is Treasuries, that has become a problem.
So if the 10-year rates, let’s say they go down to say, 2.5% or even 2%, that’s going to help the balance sheets of the banks a lot because it’s the liquid part of the balance sheets that there is, at least at this stage, the main problem of what the issues are. That’s why the fear is that if we now have not only the lagged effects of the Fed hiking rates that are already slowing the economy, but if you now have an amplified effect that the slowdown will be come faster, then of course we can eventually. need to look at what credit losses mean, for everything that banks have on their balance sheets.
Q: What everyone in the market is saying is that they have been waiting for the Fed to “break” something and now something has broken. So what do you 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 it a week ago, I would have said that they would go to 50. But now, suddenly it is the case that the main priority – which we thought until now was all inflation – has been replaced and put on the back car seat. Now the main priority is financial stability. And if the top priority is financial stability, then the Fed must be absolutely sure that the financial system is stable and the financial markets are calm, and that, therefore, that credit is flowing to consumers, in corporations, in residential real estate, commercial real estate, with the idea that if that’s not the case, then you risk having a clear harder landing. That is why the financial stability that is the highest risk leads me to the conclusion that they can always raise the rates later if it turns out like Orange County and LTCM. But for now, the biggest risk going into this meeting is that the financial system needs to be stable so they feel comfortable before they can start thinking about raising rates again.
— With the help of Stacey Wong