Here's why the Silicon Valley Bank crash has made a recession much more likely in 2023

• The Silicon Valley Bank implosion has raised the odds for a US recession.
• That's because fears of a bank crisis could distract the Fed from its goal of lowering inflation.

Wall Street is worrying that the fall of Silicon Valley Bank has significantly raised the risk of recession in the US.

The chief concern is that the episode has complicated the Federal Reserve's mission to keep fighting inflation, experts say, and the turmoil could be a distraction that spells trouble for the economy heading into the rest of this year.

Goldman Sachs this week raised its odds of recession this year from 25% to 35%, citing recent volatility and near-term stress stemming from SVB's collapse. And judging by signals in the bond market, investors concur: the inversion between the 2-year and 10-year Treasury yields – a notorious indicator of an incoming downturn – began flashing its largest recession warning in 42 years in early March.

The yield on the 2-year Treasury posted the largest two-day drop since the 2008 recession last Friday, the day SVB was taken over by the FDIC. That's another grim omen, according to "Bond King" Jeffrey Gundlach, who noted that the 2-10 Treasury yield curve typically begins to de-invert several months before a recession.

"At this point, with the de-inversion happening, the four to six month time window is starting to seem much more plausible," the billionaire investor said of his recession outlook in a recent interview on CNBC.

Fed fund futures are pricing in 75 basis-points of rate cuts by the end of 2023. That suggests markets see the need for significant monetary easing by year-end, a sign investors believe the Fed will soon be worrying about softening the blow of a downturn.

"I think a recession is extremely likely. I don't really see a pass through the next 12 months without getting a recession," DataTrek co-founder Nicholas Colas told Insider. The severity of an impending downturn, he said, would become clearer once the Fed issued its next policy move at the March 21-22 meeting.

Inflation battle

The next interest rate decision will arrive after a chaotic few weeks for markets, with the collapse of Silicon Valley Bank on March 10 sparking a intense sell-off in bank stocks and stoking fears of a new banking crisis. The event puts pressure on the Fed to ease up on its interest rate hikes in order to avoid putting pressure on the financial system.

While this could be taken as a signal that a recession could be less likely, given that commentators have said pushing interest rates any higher will overtighten the economy, the Fed would be making a pivot in response to stress on the wider system.

But it's a tough call for officials over whether to let up on rate hikes or even start cutting in response to what some say is ample evidence the Fed has broken something in the economy.

If rates are too low, it could hamper the goal of bringing down inflation, which remains the chief concern for the economy even in light of the banking turmoil.

Meanwhile, hiking rates too high is also problematic. Colas was hesitant to say a banking crisis could be in the cards – especially since others experts say contagion from SVB's downfall is unlikely – but its collapse last week was a major warning, and central bankers need to tread carefully.

"It's a real warning shot about the health of the financial system. It might be limited to that one bank. It might more widespread. It might filter off into other issues," he warned.

Central bankers are essentially torn between fighting inflation and quelling volatility, which spells trouble on the recession front.

Banking turmoil on it own has the potential to slow the economy, Colas said, as banks pull back lending activity and generally tighten financial conditions independent of the Fed's moves.

All eyes are on the Fed's next policy meeting on March 21-22. Markets are expecting a 25 basis-point hike, or even possibly a pause next week, according to the CME FedWatch tool.

Colas speculated that a 25 basis-point interest rate hike could be enough for the Fed to quell banking-related volatility, while sticking to its inflation goals. A pause in interest rates would be a major warning, he said.

"If the Fed pauses entirely, that's going to be a warning to the markets. That's a signal the Fed and other agencies the Fed talks to see other stresses in the banking system," he said.