Impact of the banking turmoil

Following a Bloomberg article that revealed that PacWest, another US regional bank, was considering a sale, the S&P Regional Bank Index lost another 9% last week, with PacWest down by 31%.

Is this the continuation of a series of falling dominos? What will be the effects on macro and markets?

Looking at the hard data, there is a limited impact so far on aggregated weekly lending growth (see below). Manufacturing and services surveys also indicate that the US economy is holding up vs other countries, especially in the manufacturing sector.

Looking at market indicators, we see contained stress so far outside banking stocks, which is surprising given the other negative newsflow around the likelihood of the US debt ceiling being reached as early as next month.

The narrative around the banking failures remains that there will be no contagion, and that “this is not 2008”. Because this is the consensus scenario, we are uneasy with it. Of course, the sources of volatility are different than in 2008 (duration issue rather than credit issue, and risk management weaknesses from a subset of banks) but the lagged effect on aggregate US loan growth could be non negligible. Since the last few weeks, new lending guidelines would have been deployed by banks’ management committees, likely much more restrictive. We would not be surprised to witness more consolidation in the sector either. Until we see the effects of this lending contraction, it is therefore difficult to make conjectures about the importance of the banking events.

Central banks’ reaction function

We note that monetary and fiscal policy are turning less accommodative in the US. With a divided Congress that cannot even agree on preventing a US bankruptcy, fiscal policy will likely become less accommodative until the next elections.

Meanwhile, the temporary liquidity facilities deployed by the Fed in March, which bumped the Fed’s balance sheet higher, are starting to retrace lower. The Fed’s balance sheet has resumed its decrease under the effect of quantitative tightening.

All of these factors are bearish risk assets, unless, as bond markets are pricing, the Fed pivots soon (as early as September say future bond markets). At its last meeting, the Fed implicitly indicated a preference to hold rates steady after hiking its policy rate to 5.0-5.25%: “The Committee thinks that inflation is not going to come down so quickly… we won’t cut rates” said Powell last week.

At the same time, when and if the next domino falls (it could be in banking or outside), if the Fed blinks and cuts rates or pauses quantitative tightening, this would be bullish risk assets and crypto. In the same press conference, Fed Chair Powell highlighted that: “The strain that emerged in the banking sector in early March appears to be resulting in even tighter credit conditions for households and businesses. [...] Policy is tight. If you put credit tightening and the ongoing quantitative tightening that is ongoing, we may not be far off, we may be at that level [the neutral rate]”.

Given how robust the US labor market and other macro data remain (all the labor market indicators point to a slow normalization of supply-demand imbalance, rather than speedy deterioration), and given the stickiness of core inflation above 4% YoY, 2%pts above-target, the Fed does not have enough leeway to cut yet, at least not before the impact of tighter lending conditions is fully visible.

The macro ambiguity and the uncertainty around the Fed’s reaction function (Will it hold rates through macro weakness?) are the reasons why we remain cautious on crypto and expect range-bound price moves with possibly a revisit of Q4 2022 lows, in case of severe macro stress and if the Fed takes some time to pivot. The counterargument is that the Fed has already intervened to prevent a banking contagion crisis, and is likely to intervene again if another major domino falls. This is a valid counter-argument and we have to stay alert and open to this more bullish scenario.

Turning to the European Central Bank (ECB), the stance remains hawkish, Christine Lagarde having repeated several times at the press conference last week “We are not pausing”. The central bank also announced the end of reinvestments in its Assets Purchased Programme (APP) from July on. This would account for a net asset decrease of ~30bn € per month according to the redemption calendar. The ECB’s balance sheet has been decreasing by ~210bn € monthly since November 2022 or ~2.5% per month, and this additional announcement would push the rate closer to -3% per month.

The ECB’s policy rate minus the Eurozone’s core inflation still stands at ~-260bps, so the central bank, along with other central banks like the Reserve Bank of Australia and, obviously, the Bank of Japan, are behind the curve in tackling inflation. This is the main argument for a weaker US dollar.

Crypto: Trading the range

We have witnessed no significant change in our tactical indicators for crypto. The BTC call-put spread correctly picked up the latest weakness in prices, while other indicators like momentum have stayed tactically positive.

Cyclically, the macro scenarios that we have described earlier do not argue for a crypto bottoming yet, but rather for ongoing range-trading. Also, crypto implied volatility remains too low if the scenario of a hard landing materializes (same issue with volatility and credit spreads of traditional assets, which continue to price a “soft landing” of the economy).

This week: US CPI

Wednesday 10 May

German April CPI (consensus 7.2% YoY)

US April CPI (consensus 5.0% YoY) and core CPI (consensus 5.5% YoY). We expect to see the first month of weakness for shelter inflation.

Thursday 11 May

Bank of England MPC meeting (consensus is for a 25bps hike to 4.50%)

US April PPI (consensus 2.4% YoY)