Could the recent banking sector stress persuade the Fed to go slow?
- Fed’s policy decision has been complicated by banking sector stress
- A 25bps hike this week is still the most balanced outcome, but the outlook future rate hikes is questionable
- High quality fixed income provides resilience in a weak growth environment
The U.S. Federal Reserve (Fed) is meeting this week to discuss policy rates. It will also publish the latest Summary of Economic Projections that will shine a light on the FOMC’s view on the outlook on inflation, growth and policy rates. The market’s view on what the Fed will do at this meeting has swung dramatically in the past two weeks.
What are the arguments for or against an aggressive rate hike in March?
On March 7, Fed Chair Powell warned that the Fed was ready to step up the size of rate hikes if needed based on incoming data, and interest rates could head higher than the market and central bankers had expected. This prompted futures market to reflect a much higher chance of a 50 basis points (bps) increase in the policy rate in the upcoming meeting. The robust February non-farm payroll data supported this view.
However, at the same time as the release of the jobs data, Silicon Valley Bank (SVB) and Signature Bank were closed by regulators. This prompted concerns of contagion of more stress in the banking sector. This was calmed by the joint announcement by the Fed, Treasury Department and the Federal Deposit Insurance Corporation to make whole to all depositors of these two banks, as well as the Bank Term Funding Program to provide additional funding to eligible financial institutions.
The collapse of the SVB is seen as an early signal that aggressive policy tightening in the past year is starting to pressure the economy and financial system. This calls for a less aggressive rate increase in March and in subsequent meetings. The market is also pricing in more rate cuts in 2H 2023.
So what is the Fed going to do?
In addition to the steady job report, the February CPI inflation report adds weight to the argument for the Fed to hike in March. Inflation is decelerating, but not as fast as the Fed would hope for. Headline CPI rose 0.4% month-on-month (m/m) and CPI ex-food and energy rose 0.5%.
Yet the Fed’s policy calculation is no longer just focusing on the macroeconomy and inflation. The SVB incident should have introduced some additional considerations on financial market stability whether to limit both further upside to bond yields, which exacerbates unrealised losses of banks’ bond portfolio, as well as reduce market volatility.
The UK government bond market volatility in September 2022 has shown that a central bank can address short term market turmoil while holding onto its medium-term inflation beating mandate. The European Central Bank’s decision to raise its policy rate by 50bps last week, despite sharp correction in European banking stocks also shows the developed market central banks still have a considerable part of its policy priority focused on taming inflation. The Fed may adopt a similar approach in deploying interest rates to cool inflation, while rely on other liquidity measures to stabilize financial challenges.
On balance, we think a 25bps this week is the most likely outcome. It would send a message that the Fed is not panicking over recent banking stress. However, it does introduce considerable uncertainties towards the policy rate path in 2Q23. The bottom line is that we are getting close to the end of the hiking cycle.
Exhibit 1: Expectations for the Fed Funds rate
U.S. implied policy rate based on Overnight Index Swap rates
Considering the potential slowdown of the U.S. economy in coming quarters, we continue with our recommendation of fixed income over equities. While government bond yields have already declined significantly on the back of the SVB incident, further deceleration in growth should pressure government bond yields in the next 6-12 months, including a steepening of the yield curve. Given this economic backdrop and potential financial or corporate stress event, we maintain our bias towards high quality fixed income. This includes U.S. government bonds, investment grade corporate debt and mortgage-backed securities.
This could also put U.S. equities in a more challenging environment in the near term, but differentiation is important. Low bond yields traditionally has benefited growth stocks and the end of Fed hiking cycle has typically seen equities delivering positive returns over a 12-month period. However, the earnings outlook remain challenging. We believe China and Asian equities offer the benefit of diversification, considering China’s positive growth momentum and accommodative policy. Although Asian exporters would feel the pinch from weaker demand, domestic demand recovery across the region would benefit companies that generate a higher share of revenue from domestic sales.