In the fight against inflation, the recent banking flare-up may prove to be a blessing.
Facing the spectre of a full-on banking crisis, many lenders will now be forced to build up their defences. That typically involves tightening lending standards and restricting credit, which is precisely what central banks have been trying to orchestrate for the past year.
Brian Madden, chief investment officer of First Avenue Investment Counsel, said central bankers are likely breathing a sigh of relief. “It makes their job easier getting inflation under control, because credit is the lifeblood of the modern economy.”
Last year, when the major monetary powers realized that inflation had become a grave economic threat, they embarked on a tightening campaign for the history books. The U.S. Federal Reserve, the Bank of Canada and others raised policy rates from near zero to upwards of 4.5 per cent in about a year.
This campaign was meant to squeeze the financial system without breaking it, and wipe out excess demand without triggering a recession.
The problem was that the real economy mostly shrugged off this monetary provocation. Interest-rate-sensitive sectors, like real estate, got clobbered. But the jobs market, on both sides of the border, stayed hot, leading to higher wages. Consumers continued to spend freely. And inflation did not wane as much as hoped.
As recently as three weeks ago, Fed Chair Jerome Powell was warning of an even more aggressive path of rate hikes to come.
A few days later, Silicon Valley Bank collapsed, setting off a cascade of instability. Bank stocks everywhere nosedived.
While no central banker is pulling for a banking crisis, they may be privately thankful for what has already transpired. Stock market investors, too, for that matter.
There’s every reason to think that banks will be spooked into behaving more conservatively, thus doing part of the job of central bankers. The effect could be the equivalent of 100 basis points of central-bank rate hikes, according to Ed Yardeni, chief investment strategist at Yardeni Research. (A basis point is one hundredth of a percentage point.)
“We are just guessing, but financial conditions have surely tightened a lot as a result of the SVB earthquake and its aftershocks,” Mr. Yardeni said in a recent note.
Other analysts have estimated the effect at 150 basis points. Those are rate hikes that investors may now be spared from enduring. Policy makers want to see slowing growth, regardless of the cause. The ruckus involving the banking sector may be just the thing.
Regional banks like Silicon Valley Bank, which had less than US$250-billion in assets, are a crucial part of the U.S. financial system. They account for about half of U.S. commercial and industrial lending, and more than half of the country’s residential and commercial mortgages, according to a recent report by BCA Research.
“As such, the turmoil engulfing U.S. regional banks will invariably weigh on economic growth,” BCA chief strategist Peter Berezin wrote.
It seems like the stock market has sniffed out the upside from all of this. After all, wouldn’t it be better if the economy slowed because of banks voluntarily reining in lending, rather than interest rates being hiked another 100 or 150 basis points? This is one possible explanation for the S&P 500 index having gained about 3 per cent since SVB’s demise.
A silver-lining scenario for bank stocks specifically, however, is not quite so convincing. Recession fears are creeping back into the picture. For Canadian banks, that probably means an uptick in provisions for credit losses and a cut to profit expectations.
“The consensus that the Canadian banks are going to muddle through over the next year or two with low- or mid-single-digit earnings growth – that’s going to be a challenge,” Mr. Madden said.