Banks’ Tightening Another Dovish Nudge for the Fed

The Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices – from now on let’s just call it ‘the survey’ – was released last night, and as usual provided us with useful insight. The survey was conducted between December 21 and January 7, and covered 73 US domestic banks and 22 branches of foreign banks.

The headlines will note that there was a modest tightening in lending standards for the first time since 2016.

From a consumer perspective, the area that experienced most tightening was credit cards, while other sectors such as real estate loans remained unchanged. For commercial and industrial lending, most terms were again unchanged but in some areas spreads charged on loans did increase.

However, the larger banks reported that terms had actually eased, either through rates being lowered or through certain loan covenants being dropped. Also noteworthy was a drop in demand for loans from commercial borrowers. Within the real estate sector, there was modest tightening for some commercial sectors such as multi-family residential and construction and development loans. From a residential perspective, terms were basically unchanged.

More importantly, the Fed also prepared a special section on the banks’ outlook for lending in 2019, which included lending standards, loan demand and expected loan performance. In summary, most banks expected some lending standards to tighten in 2019, with broadly weaker demand and worse loan performance. This varied by bank and by sector, but the overall tone was one of modest tightening.

Where banks expected tightening, they were additionally asked why they expected to tighten, and the most common answer was expectations that loan collateral would fall in value, followed by a reduction in their own risk appetite. This makes perfect sense and is consistent with an ageing cycle and higher interest rates.

So what can we take away from this?

Typically once commercial banks start to tighten, it is hard for them to stop and the end of the economic cycle tends to approach. However, this is not always the case, as seen in 2016 when we essentially had a mini cycle in the US, which turned out to be just a slowdown with banks happy to adjust to the new conditions.

We have been expecting this type of response from the Fed survey for a few quarters now, as the cycle continued to age and more forecasters were putting a date on the cycle’s end. However, banks remained resilient and their loan performance data gave them confidence to continue lending. The data remains solid, but the banks’ outlooks have deteriorated, which is an important change.

Is this the banks just being prudent? We think this is sensible. Or could the survey, conducted in the midst of a brutal market correction, have been affected by the negative sentiment? We also think that is probable.

It is certainly worth noting that the modest tightening from the banks in Q4 will hardly have moved the dial compared to the tightening induced by financial markets at the end of the year, or indeed the four rate hikes put through by the Fed in 2018. Tightening comes from many sources. So when we try and interpret this data we also have to assess what the Fed might do going forward, and what the market might do.

The Fed is now clearly on hold, and once it has digested the survey data it should also conclude that any forward-looking tightening by the commercial banks essentially removes some of the need for the tightening by the central bank itself. On balance then, the Fed should be more dovish after reading this.

Secondly we should also consider the financial market easing that has happened in the weeks since this survey data was taken. US high yield corporate yields are around 100 basis points lower today than in late December. Given this, will the banks feel they need to follow through on their outlooks? We think it is prudent for them to do so, and consequently we believe they will, at least to some extent. But we also have to recognise the market backdrop during the survey period, which may have contributed to a more bearish result.

It is too early to draw radical conclusions from this survey, but investors need to be alert to what the commercial banks are doing, in the same way that they follow the Fed. The April survey (no release date yet scheduled) will be a very interesting read.