Financial strains at US regional banks have slammed shut the door on a potential re-acceleration of interest-rate hikes just days after Federal Reserve Chair Jerome Powell suggested the possibility.
Goldman Sachs Group economists have said they no longer expect the Fed to increase rates next week. Surprising, considering authorities took measures to contain a crisis caused by the departure of depositors from Silicon Valley Bank and Signature Bank.
This sudden shift has resulted in Treasury two-year yields dropping 18 basis points to 4.34%. It marks their sharpest three-day decline since the Black Monday equities rout in October 1987.
Traders rapidly shift back to betting on Fed rate cuts. Therefore, there is increasing concern that 4.5 percentage points of rate hikes in a year will prompt a recession. In addition, it will trigger a rout in riskier assets, undermining the Fed’s efforts to cool the economy and tame inflation.
Initially, economists overwhelmingly expected a quarter-point increase at the March 21-22 meeting. Six of them forecasted a half-point move. However, regulators were spurred into action over the weekend to contain the problem.
The Fed established a new emergency facility to enable banks to pledge high-quality assets for cash over one year. Plus, regulators pledged to fully protect even uninsured depositors at SVB and relaxed terms for lending through the Fed’s discount window.
However, Goldman Sachs economist Jan Hatzius has pulled his previous call for a quarter percentage point increase next week. He also said there is “considerable uncertainty” about the path beyond then.
Yields on two-year Treasury notes had surged above 5% last Wednesday, to the highest level since 2007. That came after Powell indicated that a 50 basis-point rate hike was on the table if upcoming economic reports kept coming in strong ahead of this month’s meeting.
However, the Fed is now seen as likely to raise rates a quarter point next week. As a result, the Fed funds rate may peak at about 5.1% six months from now. That is down from a terminal rate of 5.74% priced on Wednesday.
Eurodollar markets have moved to bet on two Fed r1ate cuts for the second half of the year. Swaps traders have also reduced their projections for six-month changes in central bank rates across eight major developed-market economies. Canada and Norway are expected to hold policy over that time frame.
According to OIS contracts, Australia’s central bank is now seen as having better than a 75% chance to hold rates next month.
A lesser magnitude increase – or even pausing the tightening campaign – would allow Powell and his colleagues more time to assess whether there are further problems to emerge in the banking system.
A senior US Treasury official said on Sunday that some institutions look like they have similarities to SVB and perhaps to Signature. “It may take some time before the full ramifications of SVB’s collapse are apparent,” said Tom Kenny and Arindam Chakraborty, economists at Australia & New Zealand Banking Group.
“Front of mind for markets is the risk of contagion, deteriorating risk sentiment and potentially a broader financial crisis.”
While the economic data is still pending, Fed policymakers will receive the latest reading on inflation on Tuesday, with the consumer price index for February due.
Economists predict that the CPI will rise 0.4% from the previous month, down slightly from a 0.5% gain in January.
