This daily economic journal is written in conjunction with weekly economics updates for our investment clients at nVest Advisors, LLC, It is copyright and may not be republished in whole or in part without written permission.
This information is also not a solicitation to do business with me as a financial advisor, though for the right readers, that offer is available. It is intended solely to provide timely economic data and analysis from the vantage point of a 15-year industry veteran (but also, always still a student) of personal finance and economics.
I highly recommend you read the past few weekly economic updates that I write for my financial advisory firm, nVest Advisors, LLC to get brought current on what’s happening in the broader economy, because this journal will be jumping right in without too much of a primer. I will be writing a primer into this blog as we go, but for now, the best place to catch up on what’s happening (and it’s a lot) is to read the macro blog at nVest.
Friday, March 24, 2023
Bank liquidity problems will tighten lending and slow the economy
The most interesting news of the day is definitely this excellent compilation of bank lending information by The Daily Shot (a shameless plug for this great subscription-based macroeconomic data compiler). TDS is one of several sources I use each day to get a quick read of the day’s most important economic data from around the globe.
Today, we see that the banking crisis, particularly in smaller regional banks, is pretty widespread. There is simply no denying the mad scramble by these banks to grab up the emergency money (the Fed calls it a “credit facility”, but it means low-cost loans to banks that need to shore up their reserve requirements) over the past two weeks. The first look is at the normal Fed “Discount Window”, which is sort of a “loan of last resort” for banks that need typically just an overnight loan to maintain their government-mandated reserve requirements. At the end of each business day, a bank must balance its books and meet specific cash reserve thresholds. If they are above their thresholds, they can offer their surplus out to other banks in the form of overnight loans (usually at next-to-nothing interest rates). This allows a bank that might have had an unusual number of deposits and falls short of its reserve requirements for the day, to borrow that money overnight to maintain its required liquidity.
When banks needing this help cannot borrow from another bank, the Fed Discount Window is the last resort that a bank can go to for this short-term lending need. As you can clearly see in the last two weeks, something significant has happened to bank liquidity. The Discount Window activity jumped exponentially:
Additionally, on March 13 2023, the Fed announced the creation of a second line of credit to help banks beyond the traditional Discount Window lending. This is specifically for banks struggling with liquidity problems related to recent tightening of Federal Reserve monetary supply (quantitative tightening and interest rate hikes), as well as banks seeing larger default levels on the loans they’ve given out to businesses and individuals. This facility jumped into existence in a major way the past two weeks:
When recessions get underway, businesses will start to struggle to pay their bills, including payments on loans they’ve received from their local bank. Banks know this. They also know that as money gets tight for individuals and businesses, the amounts held in checking and savings accounts will drop.
This makes perfect sense if you think about it in terms of MICROeconomics (the study of the money decisions of individuals and companies). Right now, individuals have less money and are currently having to spend more of it due to higher prices, and businesses are seeing a slowdown in their sales, meaning less profit), so their own bank balances will decline. Eventually, some businesses will fail outright, others will downsize, some consumers will be laid off, and so the money sitting idly in banks (that banks use to lend and invest) will also decline.
All if this is known to banks (or at least SHOULD be), and so as the economy begins to wind down, banks will move to protect more of the cash on hand by giving depositors more incentive to save at the bank (notice how interest rates on your savings, money market and CDs are climbing?), while also tightening the standards for who they will lend to, and for how long. They will also match the interest rates on their loans to keep up with the rising rates it’s cost them to get the money to loan out in the first place.
We can now see that banks are indeed tightening their lending standards (the blue line), and borrowing like crazy from the Fed (the black line). In fact, banks borrowed more last week from the Fed than ANY week of the Great Recession (2007-2010). They have not yet tightened their lending standards as much, but it’s definitely coming fast.
In fact, a look at the number of loans banks plan on granting in the next few years shows it will be significantly tougher for a homebuyer or a business to obtain a loan. More down payment and higher credit scores will most definitely be required:
This will definitely impact the growth rate of the economy, particularly for small businesses and startups, who get most of their loans from smaller banks. Small business is typically the hardest to get funded because they are (logically) the most likely to fail, especially when economic conditions get nasty on them. We are already seeing loan default rates climb for corporate debt, the highest default rate since the Great Recession (and we’re just getting started). As you can see by the blue portion of each bar, the US is in far worse shape in terms of corporate default than other parts of the world already. A lot of that has to do with how flippantly our banks toss money at any idea during good times, and it always tends to blow up on us as conditions tighten:
What this means to you
What does this mean? Two things. First, banks are in worse shape than it looks at the moment, and second, the Federal Reserve, in propping up the banking system yet again, has reversed much of the work it’s done on inflation in the last year.
Small businesses are going to see significant tightening in the lending standards of their normal money sources, especially smaller banks. They will also see rising interest rates on their floating debt (many businesses have essentially a credit card-style revolving line of credit available to them to meet cash flow needs – these revolving lines of credit almost always have a variable interest rate). This will be especially true in commercial real estate, where I expect to see substantial losses in the coming months. We will definitely see declines in residential housing prices, but this current bank liquidity crisis, combined with the downsizing of commercial real estate already underway since so many companies adopted remote work during Covid, may very well cause a collapse in commercial real estate values.
Regarding inflation, we expect to see inflationary pressure resume due to the Fed’s emergency lending. This is due to what is called the velocity of money. For any of the money banks borrow from the Fed that ultimately ends up in the hands of a bank customer or in a new loan, it will cause inflation.
And what the Fed just did (and continues to do) cannot be overstated. In just the last two weeks, the Fed reversed MORE THAN HALF of the quantitative tightening (reducing the money supply) that they’ve done since March of 2022:
We believe this will add to the already-swelling pressure on inflation. The Fed was able to pull inflation down slightly by reducing the money supply for most of last year (that should be obvious by the chart above), but inflationary pressures were already starting to pop again last month when most of the “core” inflation came in slightly higher than expected. This huge infusion of new money back into the banking sector can cause a massive reinflation in prices again, if much of it gets lent back out or used for customer withdrawals (which is its purpose). Letting $400,000,000,000 of new money loose into the economy – again – is a massive monetary mistake, but one the banks forced on the Fed due to lax lending all throughout the last decade, and will likely cause a surge in inflation once again.
The Fed believes that the economy will now erode quickly enough to eliminate this inflationary pressure and that their interest rate hikes and keeping those rates higher for longer than the markets expect, will do the trick. Time will tell, but so far, the Fed has been wrong about inflation the entire time it’s been surging since 2020.
See you tomorrow!