7 minute read
As a financial advisor or investor, it isn’t easy to navigate what’s happening in the market.
One expert forecasts recession; another claims growth.
One data point comes in awful; another comes in robust.
Thus, there are a tremendous number of conflicting views and opinions about where things are headed.
What’s a financial advisor to do? There’s so much noise out there. . .
Well, as always, I believe it’s important to stay informed and look at what others choose to ignore.
And there’s something currently going on that many in the mainstream media aren’t even talking about. . .
And that’s the sinking bank lending data.
Or – said another way - after 18 months of the Federal Reserve’s tightening, bank loan growth is fading quicker than many realize. And that may be a warning sign.
“But why does this matter?”
Well, because the U.S. economy is driven essentially by credit. And as credit demand erodes, so does marginal buying and liquidity. Which – in general – isn’t great for the economy, profits, and prices.
Remember, if any clients ask, credit is demand.
It’s when some entity takes out debt to buy now and re-pay it later. This is what fuels excess sales and growth.
Imagine going to Macy’s to buy a shirt. If you have the cash to buy one shirt, that’s great. But Macy’s may offer you a credit card so that you can buy two shirts and maybe some pants.
Obviously, Macy’s benefits by selling more inventory without cutting prices and collecting interest income. Meanwhile, the buyer is happy with more clothes he can pay off later.
Seems like a win-win, right? Well, it is until the borrowing slows. . .
When credit growth is declining, that could indicate the opposite trend – pulling away from potential sales and growth.
So, let’s take a closer look at the data and see what we can make of it. . .
Bank Lending Growth Continues To Decline – Why You Should Care
The annual rate of bank lending has continued to decline sharply across the board over the last year.
For instance – as of October 11th 20231 – commercial banks saw year-over-year declines in:
· Loans and leases (L&Ls) – down to just 3.7% from 12.1%.
· Commercial and Industrial loans (C&I; aka business loans) – down to negative 0.1% from 15%.
· Auto loans – down to negative 3.7% from 4.2% (keep in mind this is the first time it’s been negative since the Fed began compiling data).
· Credit card and other revolving plan loans – down to 10.3% from 18.2% (which remains elevated compared to pre-pandemic levels, but still slowing steadily).
Now, it’s important to note I’m looking at the annual change in credit, not the aggregate amount.
Or put simply, I’m focusing on the ‘flow’ (rate of change); not the ‘stock’ (total), as a potential leading indicator.
For example, the ‘stock’ would be how much money a household has in a bank account. Whereas the ‘flow’ is how much money’s coming in and out. Both matter, but the flow is important to gauge the trend of the future stock balance.
One could make the argument that base effects are playing a role – meaning that because of the surge in bank lending in 2022, it’s reverting to its historic mean now.
And while that is true, it does show that the momentum is decelerating.
Making matters a bit more worrisome is that bank credit has declined to negative 0.6% year-over-year.
This hasn’t happened since 2009.
Keep in mind that the ‘bank credit’ category is divided into two broad buckets: securities and loans.
· Securities – which include bonds and financial assets held by banks – make up roughly 30%.
· The loan book – which is loan and leases extended – makes up the other 70%.
Now, it’s no surprise that bank credit has plunged into negative territory.
On the one hand - banks are dealing with massive unrealized losses on their bond holdings as the Fed raised interest rates rapidly (remember, when yields rise, bond prices fall. And vice versa). In fact, according to Reuters2, U.S. banks could be sitting on at least $650 billion in unrealized losses. Meaning if they had to sell their securities on the market today, they’d realize these hefty losses.
On the other hand, as I highlighted above, bank lending has decelerated and indicates less profitability amid less loan creation.
Now, I will detail in another piece more on banks and what seems to have led to this situation – but the main takeaway here is that banks are still feeling pressure. And will likely get worse even if the Fed doesn’t hike any further and just holds as is.
Thus, declining credit may potentially indicate a weakening economy and further banking instability.
But there’s something else that’s also worth monitoring.
And that’s the surge in long-term yields as of late. . .
The Yield Curve Is Steepening Fast – And According To History, This May Be Something To Worry About
To provide some context: the U.S. yield curve has been in an inverted state since the middle of 2022.
Put simply, this means that the longer-term yields are yielding less than their shorter-term counterparts.
Now, you might wonder why this inversion occurs.
Well, it's essentially a clash between the bond market, which influences the longer end of the yield curve, and the central bank, which holds sway over the shorter end.
Inversions typically happen when a central bank decides to artificially raise short-term rates, like when the Federal Reserve increases its discount rate. This prompts investors to anticipate a slowdown and deflation, leading them to invest in longer-term bonds, which drives down their yields.
But it's not the inversion itself that serves as the significant signal (although it does mark the initial stage).
Many don’t know this, but historically speaking, the real cause for concern is when the yield curve begins to rapidly steepen.
This is known as the “bear steepener”.
For instance, look at the spread between the two-year U.S. Treasury yield against the 10-year. It’s risen sharply over the last 33 days from – from negative 0.77% to negative 0.14% as of writing this.
That’s a 63-basis point move in roughly a month.
This implies that investors continue dumping long-term bonds.
And what makes this situation even harder to navigate is the fact that the curve is still inverted - the two-year yield is still higher than the 10-year yield.
This translates into greater tightening (higher borrowing and lending costs) – which implies that the Fed’s tightening may finally (18 months later) have its intended effects.
Meanwhile, borrowers must deal with these higher interest costs. Thus eating away at disposable income.
To put this into perspective – according to LendingTree3 – U.S. average interest rates surpassed 21.5% for all credit card accounts as of August 2023. Marking the highest level since data was first compiled in 1994.
This is something to monitor as private sector debt can’t rise forever.
Eventually, borrowing capacity will be reached and require greater servicing (aka repayment). And as households cut back on credit, this may ripple into weaker economic growth and corporate profits.
Worse, banks could see further deterioration in their loan books if delinquencies continue rising (which they are).
Higher interest rates – all else equal – I believe will only amplify this.
So, as detailed in the previous section, bank credit looks to feel continued pressure as securities and lending further decline.
Summary
The financial landscape remains enigmatic, with experts offering contrasting views on the market's trajectory.
And while no one can predict the exact future, it's important to stay informed and explore unconventional angles for potential insights.
One concerning development is the ongoing monetary tightening, as evidenced by the steady decline in bank lending. This shift may signal broader economic challenges, particularly as global prosperity relies heavily on credit.
Additionally, the steepening yield curve raises questions, and the "bear steepener" phenomenon is worth monitoring.
With borrowing costs on the rise and households facing record-high credit card interest rates, a delicate balance must be maintained to prevent adverse economic consequences.
Ultimately, the intertwined dynamics of bank credit, lending, and yield curves call for vigilance and deeper scrutiny in these uncertain times and their potential effects on the economy and markets.
But as always, time will tell.
Sources:
1. https://fred.stlouisfed.org/series/TOTLL#0
3. https://www.lendingtree.com/credit-cards/average-credit-card-interest-rate-in-america/
Disclosure:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax, or investment advice or an investment recommendation, or as a substitute for legal counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy, or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.
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