If ECB is any indication, the Fed should continue hiking next week!
Global bank stress sent the central bank expectations on a rollercoaster ride since last week. The rate hike expectations cratered. Yet the European Central Bank (ECB) gave the first response to the banking crisis: the Europeans chose to fight inflation and hike by 50bp.
The ECB decision fueled the bets that the Fed could also continue hiking interest rates next week.
Central bank expectations have been on a rollercoaster ride in the past two weeks.
First, the Federal Reserve (Fed) Chair Jerome Powell told the US Senate at his semi-annual testimony that the Fed is ready to increase the pace of its interest rate hikes.
‘Nothing in the economic data seems to me that we tightened by too much’, he said.
But a few days after, the Silicon Valley Bank (SVB) — whose clients were mainly highly-rate-sensitive technology startups — collapsed following an attempt to raise capital to fill in an almost $2 billion hole after the bank sold a part of its loss-making portfolio, rich in long-term US treasuries, to cover deposit outflows.
The SVB’s collapse fueled panic across the global banking industry, led to the fall of Signature Bank, and triggered a broad-based selloff in global bank stocks.
The US government quickly stepped in to protect the depositors of the collapsed banks and calmed the markets’ nerves. The Fed’s Bank Term Funding Program will allow the banks to meet deposit outflows without being brought to sell their probably loss-making assets for one year.
The banking crisis is now contained, yet the turmoil in the US banking sector resulted in a severe U-turn in Fed rate hike expectations.
While, at the wake of Powell’s testimony, activity on Fed funds futures were pointing at 80% chance for a 50bp hike from the Fed at the March 21–22 meeting, the likelihood of a 25bp hike, or no rate hike, rose immediately following the SVB debacle.
Fed expectations are all over the place.
As of today, activity on Fed funds futures assesses above 75% chance for a 25 bp hike next week.
But on a granular level, there is little consensus among investors and analysts regarding what the Fed should do.
Given the sufficiently soft US inflation data and bank stress, most market participants abandoned the idea of a 50bp hike.
The majority believes that a 25bp hike accompanied by a clear signal that the Fed would pause the rate hikes from next meeting would be the best option.
Some analysts think that the Fed will bypass a rate hike this month, and a few even bet that the Fed’s tightening cycle could already be over.
Could the SVB debacle force the Fed’s hand to opt for a surprise pause in interest rate hikes?
No, if the European Central Bank’s (ECB) decision is any indication of what the Fed will do.
Despite discomfort around Credit Suisse followed the SVB panic this week, the European Central Bank (ECB) decided to proceed with a 50 bp hike as planned, saying that inflation is expected to remain ‘too high for too long’.
The ECB decision came as a hint that the Fed could also play down stress in banking sector, highlight that the liquidity issues could be addressed with available tools and keep focus on economic data.
Economic data calls for further Fed hike
The latest NFP data revealed another strong month. The US economy added 311’000 new nonfarm jobs in February, on top of more than half a million jobs added the month before. In total, the US economy added more than 800’000 jobs in the first two months of the year.
US unemployment rate rose as a result of higher participation, and wages grew slower-than-expected. But unemployment remains at multi-decade low, and wages grew by 4.4% over the year — enough to prevent the Fed from achieving its 2% policy target.
US inflation on the other hand eased to 6% in February, as core inflation eased to 5.5%, from 9.1% peak last summer, and 6.6% peak last fall respectively.
But the speed of the inflation slowdown also eased. And the actual inflation levels remain significantly above the Fed’s 2% policy target.
Further easing in US inflation from March is expected due to a favourable base effect, as the year-on-year data will fully compare war months to war months from next month. The faster-than-expected fall in producer prices and softer retail sales also favour the latter scenario.
But the chances are that inflation may not ease as fast as in the second half of 2022, and more interest rate hikes could be needed to keep US inflation on a falling path.
Therefore, the Fed will likely refrain from a premature pause to its actual tightening policy and raise the interest rates at next week’s meeting.
Yet, the Fed may not be as a courageous as the ECB to dare a 50bp hike and end up hiking the rates by 25bp — in line with expectations, if expectations don’t reverse until next Wednesday.
The devil will then be in the details: the updated March dot plot and Powell’s post-FOMC statement will hint at whether the Fed is done hiking the interest rates this month, or US policymakers have more hikes to pull out of their hats.
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