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Credit Crunch Fears are Taking Hold, Fueling Concerns of a Crippling US Recession. Here’s Why Investors are so Worried About Lending Drying Up

Credit Crunch Fears are Taking Hold, Fueling Concerns of a Crippling US Recession. Here’s Why Investors are so Worried About Lending Drying Up

By Zahra Tayeb

– Investors are worried that another problem could soon hit the US economy – a credit crunch.
– The fears were sparked by the failure of SVB, and Americans say they’re feeling the squeeze.
– We’ve laid out what’s going on, and which are the key drivers behind a potential credit crunch.

It’s easy for investors to find something to stress about these days.

Four months into 2023, fears now center around a potential credit crunch following the implosion of Silicon Valley Bank and Signature Bank in March.

Prominent commentators including “Dr. Doom” economist Nouriel Roubini, Bill Gross and Jeffrey Gundlach have warned a credit crunch is looming – and that could ultimately trigger a US recession.

Americans are already feeling the squeeze. A consumer expectations survey by the New York Federal Reserve found that a rising number of US households believe their access to credit has deteriorated, with the share of respondents saying so hitting a new high.

“The legacy of the bout of financial instability and banking-sector stresses is likely to be tighter credit conditions. We expect more stringent lending standards going forward,” Daniele Antonucci, chief economist at Quintet, told Insider.

“Whether this qualifies as a full-blown ‘credit crunch’ remains to be seen. Even though we’d describe it more as a ‘credit squeeze’ at this juncture, there’s a risk that, if left unchecked, it could morph into something broader,” he added.

A credit crunch refers to a dramatic reduction in lending by banks to consumers and businesses, meaning loans become harder to obtain and more expensive.

So, what’s driving credit crunch fears?

Banking turmoil

The recent collapse of Silicon Valley Bank and Signature Bank due to a tidal wave of withdrawals has sparked fears that regional US banks could also run into trouble.

Depositors have rushed to move their funds out of regional banks and into money-market funds, which typically offer larger yields and are perceived as safer than uninsured deposits.

Around $120 billion in deposits was pulled from small banks in the week ended March 15, leaving a tally of $5.46 trillion, Federal Reserve data released Friday showed.

The deposit outflow has stoked concern among investors that regional banks could be hit by “bank runs,” and wary lenders might pull back to make sure they’re not too exposed, leading to a credit crunch.

“[You] have deposits running away from banks and going into money funds and you have bank management thinking, ‘Okay, how do we survive this now? Well, we probably don’t do it by lending,'”  Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a CNBC interview.

Higher interest rates

Elevated rates are a a two-pronged catalyst for a US credit crunch.

The Federal Reserve has lifted interest rates to as high as 5% from almost zero 12 months ago — the steepest jump in US borrowing costs since the 1980s — to rein in surging inflation.

The higher rates – which played a part in SVB’s demise by slashing the value of its bond portfolio – have fanned fears that other mid-sized and smaller lenders face similar risks, causing a flight of deposits. About $1 trillion in deposits have been withdrawn from the “most vulnerable US banks” since the Fed began hiking interest rates in March 2022, according to JPMorgan.

That could translate into banks tightening their lending standards.

“Bond Kings” Gross and Gundlach echoed this view, noting that higher rates have chipped away at the value of banks’ bonds and other assets, and exposed lenders to greater risk of loan defaults, specifically in the commercial real-estate business.

“450 basis points and more rate hikes in 12 months time are bound to affect balance sheets that use proper accounting — duration and credit as well,” Gross said.

At the same time, higher rates have increased borrowing costs. That’s a concern for banks because borrowers faced with elevated costs may not be able to repay and service their loans – and that could lay the groundwork for banks to toughen their lending standards.

“Admittedly, however, we don’t how much the spate of bank failures which have already occurred will lead to a general contraction in credit. And my expectation is that the Fed won’t starting cutting rates until December 2023, in the meantime we could see further issues,” Caldwell said.

Fed uncertainty

The possibility of tighter lending muddies the water for the US central bank, making it difficult to gauge how much of an impact further rate hikes could have on credit and economic growth.

“The credit crunch complicates the Fed’s job because it creates uncertainty about the sensitivity of the economy to changes in monetary policy,” Preston Caldwell, chief US economist at Morningstar Research, told Insider.

Recession risks

The sharp rise in interest rates already threatens to choke US economic growth, as it has lifted borrowing costs and encouraged saving over spending, investing, and hiring.

If lending dries up, that could weigh on the value of stocks, real estate, and other assets, and crimp overall demand — a recipe for a painful recession. Moreover, if a credit crunch leads to a spike in loan defaults and bankruptcies as financing opportunities evaporate, that could hammer banks and the wider financial system, worsening the economic downturn.

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