Investors are betting that the Federal Reserve’s rate hike this week will be the latest in its campaign to curb inflation, with the failure of two regional US banks and a Credit Suisse bailout deal aiding the central bank’s mission to tighten financial conditions and inflation to change screws on borrowers.
Two weeks ago, futures markets reflected expectations that the Federal Reserve’s interest rate would rise to 5.7 percent by the summer.
But the collapse of Silicon Valley bank and its competitor Signature – and the shotgun wedding of Credit Suisse and UBS after a tense weekend of negotiations – have forced a drastic reassessment of how far the Fed has to go to pursue its policy goals.
The Fed hiked interest rates in the world’s largest economy from near zero early last year to a range of 4.75 to 5 percent following its latest monetary policy announcement on Wednesday – the highest rate since 2007. But the recent disruptions in banking The industry has raised fears of tighter credit conditions, and financial institutions are expected to increasingly withdraw lines of credit to protect their own balance sheets.
Markets are not ruling out the possibility of another quarter-point rise in May, but a hold followed by a series of lowers later in the year is now seen as the most likely scenario.
Fear in the banking sector has already dampened banks’ willingness to lend to businesses and individuals, and higher interest rates are having the same effect. The waves will likely continue. US corporate bond and equity issuance has slowed over the past two weeks, and a market measure that quantifies banks’ funding stress — the FRA-OIS spread — rose to its highest level in more than three months on Wednesday.
Investor fears of a dramatic slowdown in mortgage lending, particularly commercial real estate, which is largely driven by regional banks, have increased.
“Banks are under pressure on three distinct fronts: funding costs, declining asset values and regulatory scrutiny. When you combine these three things, you start to wonder about banks’ willingness to lend in the coming quarters,” said Torsten Slok, chief economist at Apollo Global Management.
“The Fed was already tightening credit conditions. Now we suddenly have a magnification effect that could potentially mean a faster tightening of financial conditions, which in turn increases the risk of a sudden halt to the economy.”
Fed Chair Jay Powell conceded on Wednesday that the events of the past two weeks are “likely to lead to some tightening of credit conditions”. This market-induced tightening will, in turn, work “in the same direction as a rate hike,” he said, implying that the central bank might not need to raise borrowing costs as aggressively as previously thought, as investors would do the work instead.
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“You can think of that as the equivalent of a rate hike, or maybe more than that,” Powell said.
The Fed’s dot plot, also released Wednesday, showed officials still expect at least one more rate hike this year.
“The lack of bank credit that we’re going to see over the medium term will exacerbate financial conditions, which is what the Fed wants,” said John McClain, portfolio manager at Brandywine Global Investment Management. “Banks will act at the behest of what the Fed is trying to accomplish.”
As conditions get tougher for borrowers, the Fed may be under less pressure to continue its own fight against inflation and take one foot off the pedal that has weighed on financial markets for the better part of 12 months.
“The price of credit is going up,” said Steve Booth, head of investment grade corporates at T Rowe Price. “As a result, financial conditions will tighten and that creates broader economic risk. And then, of course, the next obvious question is what that means for politics.”
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