Hello and welcome to our latest video Macro Memo. And the focus will very much be on recent banking sector stress. We'll talk about that in various ways over the next little while. We'll talk about what's happened, how the problems arose, the solutions that have been deployed, what happened in Switzerland, which was similar, but ultimately different, how this is not the same, we think, at least as the global financial crisis and what it all means for central banks and what they can do going forward and what it means for the economy as well.

We'll also spend a moment on an unrelated subject. We'll talk about China's economic recovery, which is progressing, but not all that quickly. And we'll also spend a moment on inflation, which is still a very important macro issue. Let's start, though, with banking sector stress. And so two prominent regional U.S. banks failed in early to mid March. And while neither bank was enormous, they were both among the 25 largest banks in the U.S. So they were certainly big enough.

Each one suffered a bank run in which many depositors tried to withdraw their deposits all at the same time. And it was something that these particular banks were not able to accommodate because they had a combination of some liquidity problems, but also really ultimately some insolvency problems. They bought a lot of bonds. The bonds had declined in value as they were forced to sell those bonds.

They just didn't have enough money. They'd become insolvent as those losses were crystallized. And so as this process was starting, the clients became nervous and the outflows accelerated. And indeed, we began to see some outflows with certain other banks as well. And so the concern was that there was a risk of cascading bank failures. At this juncture, we haven't seen it cascade beyond two, but nevertheless there is some trepidation.

And so let's talk about why these problems arose and what's been done to fix those problems. And so in terms of why these problems arose. Really the root cause is there was a sharp increase in interest rates over the last 18 months and banks frequently hold a fraction of their assets in bonds. And the value of those bonds fell as interest rates went up.

Normally, that doesn't matter too much because banks usually hold those bonds until maturity, and when a bond matures, it returns to its full par value. However, when people withdraw money at a faster rate than the bank had expected, the bank can be forced to sell some of those bonds and suddenly losses accrue. And in this case, those losses were big enough to render these banks insolvent.

Silicon Valley Bank in particular had a clientele that was very skewed toward the tech sector, and the tech sector was cooling, and that was requiring those companies to pull money out. They weren't getting the kind of venture capital funding they'd enjoyed before. And so that was putting pressure on the bank and it all essentially snowballed from there. And in particular, the clients of this bank disproportionately were companies.

They often had more than $250,000 in their checking accounts, and $250,000 is the limit for deposit insurance more money than that. And these people were at some risk if the bank failed. And so the outflows were quite intense. And eventually the Federal Deposit Insurance Corporation had to step in to take over those two banks. That failed. And as it happens in this particular case, they then offered a guarantee on all deposits, even beyond $250,000.

But that's not the normal state of affairs. I think it's important to emphasize most banks are not as vulnerable as those two banks. Most banks have a more diverse set of customers. Most banks don't hold such a large fraction of their assets in bonds. They're often making loans instead. And so the value of those loans aren't gyrating quite as much.

Most banks didn't grow so fast over the last few years. Silicon Valley Bank was very connected to the tech sector. Most banks don't grow so fast. They didn't have to buy a lot of bonds at the absolute peak of the bond market. Just bad luck in 2020 and 2021. And that's what Silicon Valley Bank did. Many banks hedge their bond holdings, so they don't actually suffer significant losses even as interest rates rise.

Many banks have higher capital ratios, meaning they have more of a buffer against danger. And the vast majority of banks don't operate as aggressively, in particular as Silicon Valley bank operated. And so there's reason to think that these particular banks were singled out for a good reason. Other banks are not as endangered as those. The solution that was reached in terms of dealing with these two banks and ultimately trying to avoid a further set of runs is that the US government stepped in and created a special liquidity facility at the Federal Reserve.

And what that essentially means is that any US bank can now temporarily swap its bond holdings for cash and it can swap those bond holdings not a fair market value which is fallen, but at their face value. And so essentially, even if a bond is less valuable, the Fed will give all of the theoretical value. And so these banks do have enough money to meet whatever their depositors want.

And presumably markets settle over the next year and all returns to normal. And so that is a credible solution. We think that is ultimately enough to stop additional bank runs. Banks do have or rather regulators do have in their back pocket the ability to insure more deposits if they want to. If that if that proves not to be enough.

But this is theoretically enough, we think. A quick word on Canadian banks. So Canadian banks have not been central to any of this, but it's maybe worth emphasizing Canadian banks are in a somewhat different situation. Yes, the Canadian housing market is softer. Yes, there's a lot of debt in Canada. So let's not underestimate some made in Canada banking stresses.

But in terms of precisely what's happened in the US, I would say that the US has a more fractured banking sector. Canada has a larger, more diversified and better capitalized set of banks. So the risks are just fundamentally smaller in general, historically, the Canadian deposit base has been stickier. There's less of a history or precedent of bank runs is that risk is in theory, a fair bit lower.

Canadian banks are regulated by one national regulator in the US. It's a patchwork system of state regulators with quite varying degrees of stringency. Canadian banks put less of their assets into long dated bonds, which was the problem in the US case. Canadian banks have to mark those bonds to market, so there are not hidden losses on the balance sheet and a significant fraction of the bond losses that have occurred with Canadian banks have been hedged against.

There have been hedges in place to limit those losses. And of course, it's also worth remembering Canadian banks have a history of stability, even when U.S. banks encountered distress as per 2008. So we don't think these problems, particularly apply to Canada. Now, there was a problem outside of the US in Switzerland, though, and so Credit Suisse recently ran into significant problems.

And I should say as much as there was a certain overlap in the sense that recent banking stress in the US has just put greater scrutiny on banks around the world. And Credit Suisse has long been a weak bank. And so that scrutiny ultimately did contribute, I suppose, to the problems at Credit Suisse. But the real Credit Suisse problems are that ever since the global financial crisis, this is a bank that has not been very profitable.

It has made a string of operating or operational rather, mistakes. It has largely been unprofitable. It was projecting that it would continue to make losses over the next several years. It really just wasn't a going concern. And investors became more nervous about banks in general and they decided they'd had enough. And so there was a solution found. The Swiss government stepped in and essentially arranged a marriage between Credit Suisse and the other Swiss banking giant UBS.

UBS bought credit Suisse for a small amount of money and the crisis does seem to be averted. And the combined entity is a credible, viable entity. It looks as though it has ample capital and enough liquidity. And so that problem seems to be solved. I think it's worth spending a moment also on saying what's different with what's been happening recently versus the global financial crisis in 2008-2009.

And I would say there are some important differences. Banks were much less well capitalized then. In fact, the average bank has 2 to 3 times more capital today, which is quite a larger buffer of protection. Banks were less well regulated then. That's been remedied since bank losses were significantly greater then due to severe housing market problems, due to lax lending standards and all sorts of exotic securitized assets that were bouncing around the world.

And it was quite opaque as to who had them and who didn't. And so I would say in contrast, today, what we have is really a classic bank run. It's been in a handful of obviously vulnerable financial institutions, which the US government has credibly addresses a smaller scale problem, though still certainly also a problem. Seems to me we've gotten a pretty clear message from central banks as to how they're juggling their various obligations.

You could say banking sector stresses argue for rate cuts, but inflation problems argue for rate hikes. They're sticking with the rate hikes for now. We got the Bank of Canada on hold, but we had other central banks, including the Federal Reserve in the US and the European Central Bank and the Bank of England, all opting to raise rates.

Inflation is still priority number one for them and they are still focusing on that. Better solution for banking sector stress is to do things specifically with regard to the banking sector like the liquidity program that was recently created. And so central banks, they need to tighten less than they would have. Financial conditions have tightened that sound a bit of their work for them, but nevertheless they've stuck to tightening and there may be a little bit left to go before they feel comfortable that inflation can continue to decline.

From an economic perspective, what does all this banking stress mean? And so financial stress is never good for growth. It reduces risk taking. It forces banks to tighten their lending standards, maybe with particular relevance to commercial real estate, which regional US banks had a particular involvement in. And financial conditions tighten more generally, which stimulates additional rate hikes. And so it is net negative for economic growth.

We've seen quite different estimates of the effect that the recent events will have on growth and some say that the effect is equivalent to several percentage points worth of tightening. I think that's probably an exaggeration. Some say it's worth a 25 basis point rate hike or two. That might be closer to the truth. But bottom line is it does damage growth a little bit more.

I guess the main message from us is that we're still comfortable with what has long been a below consensus growth forecast for the coming year. And we're still comfortable calling for a recession and a recession that's maybe a bit deeper, not deep, but a bit deeper than the market's been assuming. So we're happy to be pessimists at a time when things like this get larded on top of other challenges out there.

None of this is an exact science, to be clear. But whereas we once been calling for a 70% chance of recession in the US over the next year, maybe now it's something like an 80% chance. That's the kind of magnitude of effect we think it has. Okay, let's move from banking stresses in other directions. Let's talk about China's economic recovery.

You might recall China abandoned its zero-tolerance policy in December. It's been recovering ever since. We've said for a while we think there will be a recovery, but it might be a bit underwhelming, at least not as powerful as some had hoped for. And indeed, as we look at the economic data now, we see signs of recovery, to be sure.

But we also do see that it's a fairly mild one. And so, for instance, the property sector is bouncing, but only mildly plans as consumer plans to go to restaurants, to go to movies and shows, they've reverted to fairly muted pandemic kind of levels. We're not seeing people planning on going wild on those fronts.

We have a consumer activity composite metric that we maintain and it's increased, but it's only increased slightly. It's still not that exciting. And when we look at some of the real time metrics out there, such as traffic congestion and Chinese subway usage, these are still looking pretty good on a level basis, but they've declined over the last month. There's been a big surge and they've been settling back down.

And so a Chinese recovery, yes, but not a wildly fast recovery. We're sticking with a 5% growth forecast for this year, which is a lot better than last year, but still really would have been disappointing even for a normal year in the pre-pandemic period. And let me finish with a couple of quick thoughts on inflation. And so inflation matters a lot.

It's been much too high. It did come down nicely over the second half of 2022. It's been edging lower in early 2023, but not that enthusiastically. And that was consistent with the February data that recently came out for a number of countries. Inflation decelerating. The annual number is generally lower than they were, but not that low. And the monthly trend really only consistent with inflation of about 5% annualized, which is far from the 2% that we're all looking for.

So there is more work needed. In particular, inflation is taking time to decline in terms of service sector inflation, in terms of core inflation, and in terms of just the breadth of inflation as well. The number of things that are rising quickly is still pretty high. We see a bit of improvement on those things, but there's still a long way to go.

We do think theoretically there's reason to expect a further decline. Central banks are helping, commodity prices are helping, Supply chains are almost completely solved at this point in time. The real time inflation measures we look at are pretty clear that inflation is continuing to fall. So that makes us feel good. We do look for further progress ultimately, but in the meantime, we're not getting quite the cooperation you might have hoped for in early 2023.

In terms of the actual data, central banks can't take too many chances here, and that's why they're continuing to tighten even as the economy looks set to weaken and even as there have been some new banking sector complications. Well, that's it for me. Thanks so much for your time. I hope you found this interesting and please choose to tune in again next time.