US Banking Turmoil Sparks Uncertainty for Economy and Stocks

US Banking Turmoil Sparks Uncertainty for Economy and Stocks

Deposits at small banks have declined by a record $120bn, with other liquid deposits, such as savings and checking accounts, declining by 6.1%, the most in data back to the early 1970s, according to the Federal Reserve's H.8 report. While the decline in deposits at smaller institutions contributed to the significant one-week decline in bank deposits to $17.5tn ending March 15, it appeared that some people moved their deposits to larger banks, where deposits increased by almost $67bn. However, with uncertainty surrounding deposits, banks are expected to be more cautious with lending, which is a headwind to economic growth. As uncertainty puts downward pressure on stock prices, investors demand more return for their capital, though this uncertainty premium also helps explain why returns tend to be relatively high in the stock market.

With the run on the Silicon Valley Bank, Federal Reserve, Treasury, and FDIC announced that all of the bank's depositors, including uninsured depositors, would be made whole, essentially signalling to every American bank depositor that all their cash is safe. However, there is no guarantee that people will not move their cash elsewhere, resulting in more financial instability. If enough people do move their deposits elsewhere, banks may respond by tightening lending standards, working in the same direction as rate tightening. This will weigh on economic activity, hiring, and inflation.

According to UBS economist Paul Donovan, the future depends on two hard-to-predict behaviours: whether bank investors and depositors will keep moving their money and whether loan officers will respond by tightening lending standards. While nothing is ever really certain, the quotes suggest Fed officials are particularly uncertain about what comes next. If there is a silver lining, it is that everyone now has banking turmoil on their minds, with a "systemic credit event" overtaking "inflation stays high" as the top risk, according to Bank of America's March Global Fund Manager Survey. As we discussed recently, markets will go haywire when a little-known risk suddenly emerges as traders and investors scramble to price in the downside.

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