Capital Markets Outlook  |  Q2 2023

Be careful what you wish for

Jason R. Vaillancourt, CFA, Global Macro Strategist

Be careful what you wish for

Capital Markets Outlook offers perspective on the global economy and asset classes with insight on market history.

Jason Vaillancourt is a Global Macro Strategist on the Capital Market Strategies team. He provides in-depth global macroeconomic research to Putnam clients and the broader financial community.

This quarter, we explain how tighter bank lending standards may bring demand back into balance with supply, perhaps faster and with more risks than the Federal Reserve realizes.

  • Banks are tightening lending standards, which may reduce future loan growth.
  • Consumers are beginning to lose the financial cushion from excess savings built up during the Covid-19 pandemic.
  • We continue to advocate a relatively defensive posture.

Why bank lending standards matter to economic growth

Every quarter, the Fed releases its Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOS). The survey poses a series of mostly qualitative questions to a regionally diverse panel of domestically chartered commercial banks. While the survey itself has existed in some form since 1964, the current roster of questions and panel composition has good and consistent data since the beginning of 1990.

We have written in the past about how important the availability of credit is to the corporate sector, acting essentially as the oxygen that makes business work and grow. It follows that the ebbs and flows of the availability of credit is a critical signpost for future macroeconomic growth, and it is best proxied by the SLOS measurement of the net percentage of banks tightening lending standards for commercial and industrial loans to large and mid-sized firms.

Tighter C&I (commercial and industrial) loan standards could tighten credit

Looking back on this data over the past three-plus decades, we see that every time banks have tightened lending standards, credit conditions as measured by loan growth have fallen about a year later.

Figure 1. Bank behavior leads credit creation

Percent of banks tightening loan standards (projected through Q4 2023) and Q/Q change in commercial and industrial loans

Bank behavior leads credit creation chart

Sources: Federal Reserve Board.

While the largest companies have other avenues to finance themselves — for example, through the bond and loan markets — small and mid-size companies overwhelmingly rely on lending from traditional banks. In the U.S., regional banks (like Silicon Valley Bank and First Republic Bank) account for approximately half of all commercial and industrial loans as well as consumer loans and about 60% of residential loans.

Credit conditions began to tighten before the Silicon Valley Bank crisis

While stories of traditional bank runs were dominating the headlines in the closing weeks of the first quarter, careful observers of the economic landscape would have noticed that credit conditions had already been tightening since mid-2022, based on the early August release of the SLOS. With the traditional lags at work, this trend shift would put the start of a contraction in loan growth 3 to 6 months away. The chaos caused by deposit flight from regional banks witnessed over the past several weeks will almost certainly have made that contraction deeper and more likely to arrive sooner.

Fedspeak inconsistency adds uncertainty

Another troublesome yet more nuanced problem for Fed Chair Powell will be the perceived contradiction created by public comments merely two weeks apart. In his semiannual Humphrey-Hawkins congressional testimony on March 7 and 8, in which he reiterated the Fed's "data dependence," his remarks might best be described as "peak hawkishness." Yet, in the press conference after the FOMC meeting on March 22, he acknowledged that recent issues in the banking system were both likely and expected (emphasis added) to tighten credit conditions.1 Powell further described tightening credit conditions as functionally equivalent to additional rate hikes and a tightening of policy. No member of the press at the time asked the direct question that will eventually need to be answered: "Are you data dependent or not?" Such seeming internal inconsistencies harken back to the days of Alan Greenspan, who once said, "If I seem unduly clear to you, you must have misunderstood what I said."

Financial markets reprice economic risk

In any case, the risk to the economy from the tightening of said credit conditions were clear to financial markets. In the span of those two weeks, the December 2024 federal funds futures contract moved from an expected year-end policy rate of nearly 5.5% to 4% — a breathtaking repricing of policy.

Banks are likely to increase borrowing costs

The increase in nominal interest rates has made borrowing more expensive, and tightening credit conditions will continue to add to that cost as banks may increase the spread they require above their funding costs. While it is certainly the case that U.S. households have a reasonably sized cushion from excess savings, that does not mean consumption will continue at the breakneck pace established in the post-pandemic period. By most accounts, the size of that excess savings has declined by something on the order of one-third to one-half since its peak in 2022.

Credit and auto loan delinquency signals consumer stress

It is troubling that delinquency rates for a whole host of consumer loan types, although still low in absolute terms, have turned up steadily since mid-2022. Delinquencies for auto loans are almost back to their pre-pandemic levels. Delinquency rates for credit cards held by younger borrowers — those in their 20s to 40s — are now well above their pre-pandemic levels. None of this behavior strikes us as indicative of a household sector flush with cash and certain about their employment prospects.2

Figure 2. Consumer credit delinquency beginning to rise to pre-pandemic levels

Delinquency rates on bank credit cards, consumer loans, mortgages, and auto loans

Consumer credit delinquency beginning to rise to pre-pandemic levels chart

Sources: Federal Reserve Board and, Center for Microeconomic Data.

Adding to the stress on the lower portion of the wealth and income distribution is the sunsetting of various supplemental programs (such as enhanced SNAP payments) due to the planned expiry of the public health emergency on May 11, 2023. The moratorium on federal student loan payments is also very likely to end this summer, which should also put upward pressure on delinquency rates in other forms of consumer credit. Central banks have been at pains to reinforce the message that fighting inflation requires tightening policy to bring demand back into better balance with supply. They may soon get their wish.

Investors seek out defensive investments and downside protection

The massive flow of capital into money market funds continues to highlight the attraction to hold cash in short-dated, risk-free instruments. Large-cap equity indexes continue to look expensive ahead of what is likely to be further downward earnings pressure. Corporate high-yield spreads continue to look too tight relative to volatility and likely further upward pressure on future default rates. We continue to advocate a relatively defensive posture. Surely something has broken, but Silicon Valley Bank may not be the last "thing."

1 Federal Reserve, Transcript of Chair Powell's Press Conference, March 22, 2023.

2, "Job Listings Abound, but Many Are Fake," March 20, 2023 (accessed March 29, 2023).