After all, that happened last week with Credit Suisse and especially with SVB, in which the Federal Reserve declared that it will make additional funds available to “ensure that banks have the capacity to meet the needs of all depositors”, markets are trying to digest what could be a change of scenery from a few days ago and analysts are beginning to wonder whether, under the new conditions, it is still imperative for the Fed to continue raising interest rates. These and other questions could be answered at the Fed’s next meeting on 21-22 March.
Gilles Moëc, chief economist at AXA IM
We continue to expect the Fed to raise rates by 25 basis points this week. Powell could emulate Lagarde last week by stressing “data dependence” in the coming months. The Fed appears to be in a somewhat more comfortable position than the ECB should it decide to change course. Core inflation is decelerating, albeit a slower process than the Fed would like to see, and the policy rate is more in tightening territory than in the eurozone.
We agree that greater caution is warranted in the pace of central bank tightening […] the Fed would suffer a significant erosion of its credibility if it chose to pause this week before it becomes clear that liquidity and the various government support measures have failed to cope with the current turbulence and the economy suffers. Confidence always plays an important role in banking crises. In the 1980s, it took years to resolve the Savings and Loans saga (which bears some resemblance to the current situation in the US). This time, the public authorities are clearly determined to act big and fast.
Kevin Thozet, Member of the Carmignac Investment Committee
Through its soft landing narrative and its maintenance of excessively easy monetary policy, the Fed has painted itself into a financial dominance endgame. The US central bank is both withdrawing liquidity (through tightening monetary policy) and providing liquidity to the system (by coming to the rescue of troubled banks), echoing the Bank of England’s discordance last autumn in responding to the pension fund liquidity crisis.
However, in a context where the Federal Reserve is poised to maintain tight financial conditions, with both the labour market and inflation proving uncomfortably resilient, the volatility associated with such a conundrum is not entirely bad news. In fact, the recent banking sector strains will lead to even tighter credit conditions (companies have hoarded labour, now banks will hoard cash) and thus weigh on demand (which plays somewhat in the Fed’s favour).
So the key question is what will happen to the hiking cycle beyond 25 basis points next week.
We believe that the future path of monetary policy beyond the March meeting will depend on the evolution of financial conditions. Should they continue to tighten once the current tensions are digested, the Fed could pause to assess how much damage has been done by the move from 0% to 5% target rates in 12 months, and whether that pain is acceptable.
Conversely, if markets rally on the mantra that ‘bad news (for the economy) is good news (for the markets)’, traders who have opted for a tempered sweet spot will be in for a rude awakening as they realise that central banks’ reliance on data is a double-edged sword.
François Rimeu, estratega senior de La Française AM
We expect the Federal Open Market Committee (FOMC) to hike rates by a second-consecutive 25 basis points (bps) at its March meeting. The Federal Reserve will keep unchanged its new Summary of Economic Projections (SEP) compared with the December SEP, and the dot plot will show a quarter of a percentage point of additional tightening in 2023 given the persistence of underlying inflation. We do not believe the board will stop reducing the size of its balance sheet despite the financial risk.
Please find below what we expect:
- The FOMC to hike rates by another 25 bps to a range of 5.00%-5.25% to bring inflation down to its 2% target.
- Chair Powell will reaffirm that monetary policy is data-dependent.
- Despite the failure of two U.S. regional banks and the risk of contagion in the banking industry (tighter financial conditions, credit supply, deposits flight), the Fed will continue its quantitative tightening at $95bn per month given their new backstop named Bank Term Funding Program (BTFP) to contain financial risks. The BTFP announced by the Fed on March 12 is an additional source of liquidity against high-quality securities marked at par, eliminating an institution’s need to quickly sell those securities in times of stress.
- Mr. Powell will signal that the board is ready to adjust the rate and balance sheet path if conditions warrant.
- On the side of the dot plot, we expect to see the median dot up from 5.10% to 5.4% in 2023 and from 4.1% to 4.4% in 2024 but no change at 3.1% in 2025 with inflation declining.
- On the new economic projections, we expect a minimal change in growth and inflation (Personal Consumption Expenditure, PCE) for 2023 (at 0,5% and 3,1%), 2024 (at 1,6% and 2,5%) and 2025 (at 1,8% and 2,1%).
As was the case last week before the ECB meeting, the decision from the FED is highly uncertain. Our analysis is that the FED (like the ECB) is hoping that the mechanisms (BTFP, USD swap lines) put in place lately to contain risks will prove to be efficient. As of now, if we exclude US regional banks and the AT1 market in Europe, financial markets do not show a high level of stress. With the still very high level of inflation and a very low unemployment rate, the Fed will in our opinion choose to proceed with a 25bps hike.
Paul McNamara, Investment Director, GAM Emerging Market Debt
2022 was a difficult year for all asset classes, but this year markets look in good shape thanks to a more favourable inflation outlook. The opportunities in emerging market debt are numerous.
We think it is important to highlight the main developments of the year just ended. In economic terms, the surge in inflation and monetary tightening, particularly by the Federal Reserve but also by other central banks, in both developed and emerging markets. The consequences for all markets, not just emerging markets, were particularly painful. No one had ever seen such a loss-making year for both stocks and bonds, with virtually no alternatives. On a political level, the Russian invasion of Ukraine had many economic implications, not only directly for food prices (given Ukraine’s importance in agriculture), but also for the repercussions of Russia’s suspension of gas and oil supplies to Europe. For the time being, the worst seems to have been avoided thanks to a mild winter in Europe. If the weather had been very harsh, Europe would have run out of gas. However, the price of oil remained high, which heavily affected the prices of many commodities. This is also one of the reasons why pessimism prevailed for most of the year.
Finally, some good news came on the inflation front. Inflation in the US now seems to have peaked. In Europe, the more positive news is spreading. Even in the UK, the worst seems to be over. Of course, central banks are still raising rates. But, as in the case of Russia, we have avoided the worst and that is crucial. The ideal conditions for Europe coincide with robust growth worldwide, but not driven by the US because when growth is concentrated in America the dollar is strong and emerging market currencies struggle. However, Europe is recovering after escaping the gas crisis caused by Russia. China has finally lifted restrictions due to repeated Covid outbreaks and is reviving its economy. So, the other two big poles of the global economy seem to be in better shape. As long as Europe and China hold up, the outlook for emerging markets will remain favourable. In fact, historically global emerging markets are very dependent on growth and both currencies and equities do well when global growth is good.
Things will do well provided the inflation outlook remains favourable. The rest of the winter should be mild, though not necessarily as warm as it has been so far. But Europe cannot run out of gas. In that case, the outlook is quite positive. However, there is no shortage of problems, for example on the interest rate side: we believe that interest rate hikes in the US will continue. to be one of the factors to monitor this year. The scenario, however, is favourable. Emerging markets in general look cheap and, at the moment, we believe there are plenty of opportunities in our asset class.
Erik Weisman, chief economist, and portfolio manager at MFS Investment Management
The question everyone seems to be asking ahead of the next Fed meeting is whether the turmoil created by the failure of two US banks and the increased focus on Credit Suisse’s vulnerability will have broader implications for both the US banking sector and the broader US economy. And if so, how this would affect the Federal Reserve’s decisions regarding its monetary policy in the short to medium term?
Given that the central bank meeting is still a couple of days away, we will be watching to see if the market believes that the banking problems are systemic or not. In my view, at the moment it looks more like a market event that is relatively unlikely to turn into a macroeconomic event or a black swan precipitating a systemic financial crisis in the short term. What we have witnessed over the course of the last few days in the US and Europe is a market overreaction.
The feeling I get is that the Fed’s base case is to keep raising rates, especially in the wake of the ECB’s 50 basis point hike on Thursday. The actions taken by the Fed and the US Treasury over the weekend to support deposits at distressed US banks should allow them to use the regulatory mechanism to safeguard the banking system and at the same time continue to raise rates at the front end of the curve to reduce inflation and slow the overall economy.
All in all, this is a very uncertain and rapidly evolving situation. While the Fed and the SNB have reacted swiftly and forcefully, markets will continue to look for vulnerable targets and conditions could deteriorate, which could force the Fed to pause, at least temporarily, at its meeting on 22 March.
Blerina Uruci, Chief US Economist, T. Rowe Price
In the US, last week’s consensus increase in the core consumer price index (‘CPI’) was modest (0.45% month-on-month unrounded, versus 0.40% expected), but the underlying details are worrying. The breakdown shows continued strength in all components of services, not just rents and owner-occupier equivalent rents (‘OER’). Commodities, excluding used cars, also showed robustness. The Manheim index of used cars suggests that prices are likely to rise again in the coming months, reversing some of the progress on disinflation. Hotel, restaurant and recreation services inflation remained stable, reflecting the continued strength of services spending. Last month’s resilience in labour market, inflation and activity data suggests that further monetary tightening will be needed to slow inflation.
What this will mean for next week’s Fed meeting
We expect the Fed to raise rates by 25 basis points at its 22 March meeting due to three factors: job creation and wage inflation remain strong, February inflation beat expectations and confirms the halt of the disinflationary momentum that was evident in Q4 2022, and finally, market stress appears to have subsided after the initial reaction to the collapse of SVB and Signature Bank.
I believe that had it not been for the recent bank failures and the market stress that followed, Fed Chairman Powell would have pushed for a 50 basis point hike at this week’s meeting, but such events make a higher hike an unlikely event.
It is reasonable to assume that 50 bp rises are off the table for now
Maintaining a restrictive stance, proceeding with more gradual increases and staying with higher rates for longer is a prudent risk management strategy for the Fed. A different strategy could lead to crashes that would force the Fed to ease too soon or have its hands tied when the economy heads into a recession. It is important to remember that a too-rapid shift would entail significant risks, that the US economy is sensitive to rate hikes, and that the lagged effects of rate hikes are still unfolding.
A higher peak than the market is expecting is conceivable
There is much more uncertainty about the Fed’s future path. Although the recent bank failures cannot be blamed on the US central bank’s policy, it is also fair to say that raising interest rates at a sustained pace will inevitably highlight the weak links in the economy. After the publication of the CPI data, market prices for the next three meetings moved in the right direction, with a higher probability of hikes in March and May and a lower probability of cuts in June. We tend to rule out the assumption that there will be cuts in June as it would be premature for the Fed to cut interest rates in the second quarter.
Expectations for peak Federal funds rates for the next six months should be lower once the pace of tightening slows to 25bp. A risk to be considered now is the negative multiplier effect on the macroeconomy due to reduced lending by banks in response to the recent tensions. Lending conditions were already tightening, but could worsen, which would accelerate any recessionary dynamics in the second half of the year. Data on loan growth in the coming months will provide clarity.
As a result, we now expect the terminal rate in the 5.25% – 5.5% range with risks of +/-25bp, depending on the strength of the data and market conditions. In short, this means a higher peak than the market is currently pricing in, and for longer.