Inside Markets — Credit Standards

Credit standards have been tightening over the past year as banks anticipate a recession.  The tightening of credit standards will now accelerate and lending will slow as banks build cash on hand to match the velocity of recent deposit flows. Banks need to report a sequential increase in cash on hand or face the consequences.  The only organic way to grow cash on hand is by retaining it when loans mature or pay down.

Banks and many other financial businesses primarily use a ‘carry trade’ to generate profits. This is achieved by borrowing at lower short-term rates and lending at higher long-term rates. This business becomes extremely challenging when the yield curve is inverted. The rapid pace of Fed rate hikes and QT operations have created a steep curve inversion. Fed policy works through the banking system and bank failures serve no purpose.  Increasing FDIC insurance can slow the pace of deposit flows, but it doesn’t address balance sheet losses or a bank’s disincentive to lend.  Curve steepening from a Fed policy pivot is the only way to address those issues.  

Reduced bank credit creation will slow the economy and slow inflation with the lagged effects of official government statistics causing the Fed to remain behind the curve. Our near-term outlook for the S&P 500 (SPX) remains bearish based on increased economic pain from a delayed Fed reaction function.  At the moment, markets are looking through the pain to an eventual Fed pivot and cyclical recovery, but will likely change if credit spreads continue to rise.