Why big banks are "canaries in the economic coal mine"

This will be a big week for economic news. The consumer price index will come out Thursday and tell us whether inflation continues to moderate under the influence of continuing Federal Reserve rate hikes. And the kickoff of corporate earnings season will also help fill in the near-term picture for interest rates and a potential economic slowdown.

FactSet estimates that calendar fourth-quarter profits for S&P 500 companies will be down more than 4% from a year earlier — the worst showing since early in the pandemic.

Friday, we'll hear from a gaggle of big banks: JPMorgan Chase, Citigroup, Bank of America and Wells Fargo. So far, predictions aren't great for corporate earnings in Q4 — when the economy was slowing and layoffs were spreading in tech and finance.

Equity analyst Ken Leon at CFRA Research sees the big banks' earnings reports as a harbinger of what's to come: "a weaker fourth quarter in '22 versus '21, lots of uncertainty for 2023."

Mortgage finance, investment banking, mergers and initial public offerings have all slumped, Leon said, as markets faltered and borrowing costs increased.

But higher interest rates also create an upside for banks, according to Mark Zandi at Moody's Analytics.

"The interest rates on their deposits, they're rising very slowly," he said. "But the interest rate they charge on their loans are up, so they are doing pretty well on that so-called net interest margin — that's their profit margin."

But Zandi doesn't think that'll last, which might be welcome news for savers. "I do think banks will need to pay their depositors more to hold on to deposits. They are starting to lose deposits."

What happens to banks' balance sheets in 2023 will tell us a lot about recession risk, said Karen Petrou at Federal Financial Analytics.

"Banks are canaries in the economic coal mine," she said.

Quincy Krosby, chief global strategist at LPL Financial, puts it this way: "Whatever happens in the economy is going to manifest itself in the banks."

She'll be watching for any rise in defaults on mortgages, car loans and credit cards and how much banks have to put aside to cover those losses.

"That will give us an indication of how Americans are dealing with paying back debt," Krosby said.

Banks' reporting on credit card use has already told us something important, she added. "Lower-wage earners have been using their cards more and more for necessities than just discretionary items."

That's a sign that high prices and dwindling savings are pushing those consumers a little closer to the edge.