The Daily Spark

The stock of CRE debt outstanding today is significantly smaller than the stock of residential mortgage debt outstanding in 2007, see chart below. 

As a result, this recession will be milder than in 2008, but it will likely be longer because the required correction in CRE prices will be spread out over a longer period.

A survey of 67 banks in the Dallas Fed district carried out in early May shows that credit standards have tightened significantly since SVB collapsed, and bank credit conditions are now at 2020 levels, and the deterioration continues, see chart below.

Combined with still tight IG and HY spreads, the Fed will look at this and conclude that tighter credit conditions are needed to get inflation down from currently 5% to the Fed’s 2% inflation target. In particular in a situation where households are still sitting on plenty of cash, see also this new Fed working paper, which finds that consumers have plenty of excess savings left at least until the end of the year.

The consensus expects a recession starting next quarter, but the upside risk to this negative forecast is that consumers still have plenty of savings left, see also this new Fed paper, which finds that households will not run out of excess savings before the fourth quarter of 2023.

It is surprising how narrow high yield credit spreads are given the ongoing tightening in credit conditions in the banking sector, see chart below.

One way to calculate how much the ongoing banking crisis corresponds to in Fed hikes is to look at how much borrowing costs have increased for regional banks and money center banks since Silicon Valley Bank collapsed. 

The chart below shows that since SVB failed, IG credit spreads for regional banks have widened 200bps and for diversified banks 50bps. 

And for all banks, the spread widening has stayed at a new higher level because many banks have been downgraded. Spreads first moved up to a higher level after SVB and then another higher level after FRC, showing that the ongoing banking crisis is having a permanent negative effect on the economy. 

Put differently, the increase in borrowing costs since SVB failed corresponds to a 200bps permanent Fed hike for regional banks and 50bps permanent Fed hike for large banks. Weighing these estimates together using the shares of loans and leases accounted for by small and large banks, respectively, gives an economy-wide Fed tightening of a bit more than 100bps for the entire banking sector.

In short, the jump in funding costs for banks is permanent, and it has become a lot more expensive for many banks to run their business, and the banking crisis is not over. 

There are some important differences in CRE, with some sectors such as office having negative performance and industrial and warehouses showing positive performance, see chart below.

It used to be the case that higher long-term interest rates were positive for banks because higher long rates meant wider net interest margins.

But since the Fed started hiking rates last year, this correlation has broken down, see chart below.

Now higher rates are negative for banks because it has a negative impact on their assets, and higher rates and an inverted yield curve increase the risks of a recession and hence credit losses.

The housing market has started to recover, and this is a problem for the Fed because more demand for housing will boost home prices and rents, and with housing having a weight of 40% in the CPI, this will make it more difficult to get inflation down from currently 5% to the Fed’s 2% inflation target.

The Fed’s Senior Loan Officer Survey for Q2 was done in April after SVB but before First Republic Bank, and it shows an ongoing tightening in credit conditions across all types of lending.

Specifically, the survey asks banks if they have tightened lending standards for firms and households relative to last quarter, and across all indicators for demand for loans and supply of loans, we are now at or close to 2008 levels, see charts below.

In addition, the first sentence in the notes to the Fed’s Senior Loan Officer Survey shows that it only covers large banks out of the roughly 4,000 banks in the US, so credit conditions in small and medium-sized banks are likely tightening even more than seen in the charts below.

The bottom line for markets is that with inflation still at 5%, well above the FOMC’s 2% inflation target, and the Fed not cutting rates anytime soon, credit conditions will continue to tighten, and as a result, a recession is coming that could be deeper or longer than the consensus currently expects.

There is an ongoing banking crisis, the consensus expects a recession, and a default cycle has started. But markets are pricing that this will only have a mild negative impact on lower-rated credits and small and medium-sized companies. Our monthly credit market outlook is available here.