Fixed Income Outlook  |  Q2 2023

Financial stability risk and recession odds rise

Michael V. Salm, Chief Investment Officer, Fixed Income

Financial stability risk and recession odds rise

Fixed income markets are likely to be volatile given macro-driven risks and the higher cost of borrowing.

  • The Federal Reserve will move cautiously in the coming months, we believe.
  • After the bank failures in Q1, only time will tell whether the policy actions taken to minimize contagion will be sufficient to restore confidence.
  • We continue to position portfolios with reduced risk, including lower spread duration across credit sectors.

Banking stress tightens financial conditions

The collapse of Silicon Valley Bank (SVB) and later of Signature Bank (SBNY), along with the cryptocurrency-focused Silvergate Bank, brought financial stability concerns to the forefront in the first quarter. The Fed, the Treasury, and the FDIC jointly acted to minimize further contagion from the failed banks to other financial institutions or markets, but they avoided providing full-spectrum guarantees or support.

The FDIC took over SVB and SBNY and said it will fully protect all depositors, which were mostly large and, hence, uninsured. This raised the expectation that the FDIC will do the same if another bank fails but fell short of providing a blanket deposit guarantee some market participants were looking for. The FDIC insured deposit limit stayed at $250,000, which is determined by Congress.

Congress is reluctant

There is no appetite in Congress to lift the limit on deposit guarantees at this point, especially considering the unresolved debt ceiling issue. The policymakers prefer to avoid extensive guarantees unless the situation deteriorates materially, as the creative approach taken trying to settle the First Republic Bank stress ($30 billion deposit by large banks) also shows. Policymakers know deep inside that their large-scale policy support contributed to today's high inflation.

Once the confidence in banking is shaken, it might be hard to restore it quickly and fully. Time will tell if the policy actions will be sufficient to raise confidence in the market.

Figure 1. U.S. Treasury rates rallied during the period

Q2 2023 Putnam fixed income sector views

Source: U.S. Treasury Department. Past performance is not indicative of future results.

Credit channels may be pinched

The importance of the bank credit channel varies across sectors. The banking sector plays a much bigger role in consumer loans and commercial real estate, but bank size also matters. Small banks have been the dominant players in commercial real estate (CRE). They have provided about 67% of bank lending to CREs, including multifamily lending. Small banks' consumer loan books make a smaller share — a little less than 30% — of total consumer lending.

Because the role of capital markets in non-residential consumer lending is relatively small by comparison, any stress in the banking sector, whether in large or small banks, can damage the consumer credit channel notably. Small banks have also gained market share in residential real estate for the last 10 years.

Meanwhile, CRE loan growth among small banks has been strong in recent years, although with tightened lending standards for CRE borrowers. On the other hand, CRE loan growth has been slowing at large banks. Bank lending standards to CRE borrowers are likely to be further tightened or, at least, stay tight for longer. This can create a serious problem for the CRE market, some segments of which had already been struggling with the structural and pandemic-induced changes.

Commercial real estate may see costs rise

Even if funding is available, the cost of debt may rise. The growing concern is that this will happen at a time when CRE refinancing needs are high. About $1.1 trillion of CRE loans are expected to mature in 2023 and 2024. Some CRE borrowers will naturally come to the capital markets and will likely face higher interest costs. In a relatively less-liquid market, this can raise the cost of borrowing for all types of CMBS borrowers. Lack of and/or costly funding can lead to an increase in defaults and restructurings in an economy with a deteriorating outlook.

Recession odds rise

Consumer spending is holding up, and the labor market is tight, but some deterioration in leading indicators has caused anxiety. While this deterioration may not be enough to crack the labor market, the probability of a recession has risen. If the activity stabilizes at a low level, the soft-landing discussion is likely to make a comeback.

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