What a difference a few weeks makes.

This time last month, market participants were convinced the US economy was running so hot that the Fed might need to hike rates beyond 6% to have any hope of moderating demand such that growth would come in below-trend in 2023.

Fast forward to mid-March and shell-shocked investors are reeling from a trio of successive US bank failures, including the second-largest collapse in American history and pondering the highly disconcerting prospect of a disorderly SIFI unwind .

The dovish reversal in short-end US rates and STIRs was so abrupt and so dramatic, that it drove the largest two-day drawdown on a benchmark index for CTA Trend on record+, and markets now suspect the Fed’s tightening cycle might be over.

As discussed here on several occasions, including late Tuesday+, it’s not just the risk-off shock and the fear factor from failed banks that threatens the macro outlook. Banks are staring at a profitability crisis, and that could curtail lending materially.

On Wednesday, Goldman cited the possibility of tighter credit while cutting their outlook for US GDP. “Banks with less than $250 billion in assets account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending and 45% of consumer lending,” the bank’s Manuel Abecasis and David Mericle noted.

In order to estimate the potential ramifications of small bank stress on macroeconomic conditions, Goldman used an accounting approach and an “expanded” version of their FCI growth impulse model, which includes both the impact of tightening from the bank’s widely-cited FCI index and changes in lending standards on the Fed’s Senior Loan Officer survey.

For the accounting approach, Goldman assumes that “small banks with a low share of FDIC-covered deposits reduce new lending by 40% and other small banks reduce new lending by 15%,” with some turned-away borrowers able to get credit from large banks who are assumed to take a more cautious approach given the circumstances, and thus aren’t expected to extend more credit on net (i.e., whatever business they capture from risk-averse small lenders would be offset by lower loan volumes to less credit-worthy borrowers they’d have serviced in a more friendly environment).

Abecasis and Mericle calculate that the drag on bank lending would come to 2.5% under the accounting approach, or around $300 billion. The implication for GDP is a Q4/Q4 drag of 0.25%.

As for the financial conditions approach, Goldman said that because banks have already tightened lending standards, “the incremental impact of a further tightening brought on by recent small bank stress might be more limited than it seems at first.” In all, Goldman assumes that standards will tighten more than they did during the dot-com bust, but not as much as they did during the GFC.

Explaining the figures shown above, Abecasis and Mericle wrote that, “Our expanded FCI growth impulse model implies a drag of a further 0.5pp beyond that already implied by the lagged impact of the tightening in recent quarters [and] the tightening we assume implies an additional 3pp drag on capex in 2023Q4/Q4.

If you’re wondering whether and to what extent this implied tightening would “substitute” for additional Fed rate increases, the answers are “Yes” and “Somewhere between one and two ‘regular’-sized 25bps hikes,” according to Goldman’s math, which Abecasis and Mericle helpfully noted “should not be used too mechanically.”

Ultimately, Goldman cut their 2023 Q4/Q4 GDP growth forecast by 0.3pp to 1.2%, taking account of both approaches to estimating the drag from stress on small banks. The forecast cuts are concentrated in business and residential investment, areas which didn’t need additional headwinds.

In the executive summary, Goldman offered a kind of glass half-full assessment vis-à-vis the Fed’s workload. “Tighter bank lending standards help to limit demand growth, sharing the burden with monetary policy tightening,” the bank said.