Dissecting the banking crisis

Last week’s roller coaster for financial markets was dominated by concerns over banks after the failure of two in the US and the takeover of Credit Suisse by UBS. This week we consider what is all means for interest rates and financial markets.

The concerns in the US relate to small and mid-sized US banks who have been more loosely regulated than the larger counterparts and offer deposit rates that are not competitive with money market funds. The trickle of deposit outflows has turned into a flood, and this will exacerbate credit tightening, a process that was underway well before the latest crisis erupted. Credit to smaller firms and to commercial real estate more generally will be hit – this is painful but is part of the monetary transmission process. Tighter credit conditions mean that the Federal Reserve will likely not have to raise official rates as far. Indeed, the markets are now pricing in steep rate cuts before year end and expect them to start soon.

Over in Europe the mismatch in regulation is absent and there hasn’t been the same mass outflow of deposits. The banks are generally well capitalised, and many European banks are in the process of returning capital to their shareholders. It does look as if Credit Suisse is an isolated case. The same is true for UK banks and although credit conditions are being tightened in Europe it is at a more gradual pace than in the US.

Economic data have been overshadowed by the banking crisis, but the recent numbers have been strong. The purchasing managers’ indices published for Europe and the US show a surge in services activity though manufacturing was weaker. Manufacturing is important for the stock market but services matter much more for the overall economy and especially for employment. And that is what matters for monetary policy. Without the banking crisis and these recent data points would have raised the prospect of more interest rate hikes from the central banks.

We think that the credit crisis in the US has brought recession closer, but it does seem that the economy was stronger going into the crisis. Over in Europe, falling natural gas prices has been bringing relief to consumers, corporates, and governments alike.

Against this background, we generally prefer risk assets in Europe, but equities overall may struggle. And the euro could strengthen against the dollar. Bonds remain attractive, despite the recent rally.