The Federal Reserve appears likely to hike its key interest rate a quarter point on Wednesday, keeping up its battle against inflation as the banking panic subsides. Yet ongoing concerns about bank health have upended policymakers’ plan to hold interest rates higher for longer. The S&P 500 rose in Tuesday stock market action as the two-day Fed meeting began.
Wall Street isn’t entirely ruling out a Fed rate-hike pause, which would signal deeper concern among officials about the health of banks.
A decision not to hike could “exacerbate the tightening of financial conditions that has already occurred,” wrote Deutsche Bank chief U.S. economist Matthew Luzzetti.
For now, markets are cheering the more moderate interest-rate outlook. Although the 10-year Treasury yield jumped 13 basis points to 3.6% on another day of relative banking calm, that’s down from around 4% before the bank crisis. In general, lower long-term yields make it cheaper to borrow for auto and home loans, while the lower risk-free interest rate supports higher growth stock valuations.
However, bank credit was already tightening for small business before the recent panic, and the bank liquidity crisis is expected to make it worse. Consumers may also find less competition for their business.
The upshot: The banking crisis has increased the risk of recession and will likely require a Fed U-turn in coming months.
Fed Rate-Hike Odds
As of Tuesday morning, markets were pricing in about 87% odds that the Federal Reserve will announce a 25-basis-point hike, lifting the federal funds rate to a range of 4.75%-5%.
Odds barely favor (55%-45%) another quarter-point hike to a range of 5%-5.25% at the subsequent Fed meeting on May 3. If it happens, investors are betting that would be the last hike of cycle.
That’s a stark change from March 7, when chair Jerome Powell’s hawkish testimony before the Senate had markets pricing in a half-point hike at this week’s Fed meeting. At the time, markets expected the Fed’s key rate to reach a range of 5%-5.75% by September. Yet two days later, SVB Financial Group started a downward spiral that quickly infected much of the U.S. banking sector.
Now markets see a strong chance of rate cuts starting over the summer, with the federal funds rate falling to 4.25%-4.5% by year’s end.
Federal Reserve Meeting Statement
The Federal Reserve meeting policy statement seems certain to drop language indicating a likelihood of “ongoing increases” in the key policy rate.
Deutsche Bank’s Luzzetti expects the Fed to follow the blueprint drawn up the European Central Bank last week. “Raise rates in line with expectations, drop forward guidance, but signal a continued tightening bias.”
The ECB hiked its key interest rate a half-point last week even as Europe faced its own banking crisis centered on Credit Suisse.
The Fed could say that further tightening may be needed to reach a “sufficiently restrictive” stance to bring inflation down to 2%, but incoming data will inform that judgment.
Policymakers also will issue new quarterly projections for the economy and rate outlook. But Powell will likely play down their significance, given a high degree of economic uncertainty. The December batch of projections showed the Fed’s key rate finishing 2023 at a range of 5%-5.25% this year.
If the Fed is concerned about bank health but doesn’t want to create alarm, it could hike a quarter-point but indicate a lower year-end target interest rate than it did in December.
Fed Chair Powell’s News Conference
Up until now, Powell and other Fed officials have stressed that the costs of not hiking enough, which could lead inflation to become entrenched, are much greater than the costs of hiking too much.
If an extended bout of inflation becomes baked into expectations, “this is a very difficult risk to manage,” Powell said on Feb. 1. But if Fed overtightening hits the economy harder than necessary, “we have tools that would work on that.”
The sudden emergence of bank-sector woes could lead Powell to say that the economic risks have become more balanced.
Loan demand “is already approaching recessionary levels” and likely to keep falling as rates offered to small businesses rise further, wrote Jefferies economists Thomas Simons and Aneta Markowska.
“With small and medium-sized banks finding liquidity more scarce and more expensive, it is hard to foresee any other outcome.”
That would choke off credit to a key engine of U.S. job growth.
Investors also will listen closely for any hint from Powell about a coming change in the Fed’s balance-sheet drawdown, if rate cuts are on the table later in 2023.
S&P 500 Rallying
The S&P 500 rose 1.3% in Tuesday stock market action, following Monday’s 0.9% gain that saw the index regain its 200-day moving average.
Investors are weighing both the outcome of the Fed meeting and whether the banking crisis could turn out to be good news for stocks.
“Arguably, it would be better for the broader stock market if growth slowed because banks became more conservative in their lending than if it slowed because the Fed had to raise rates to over 6%,” BCA Research strategists led by Peter Berezin wrote on March 16.
The economy would slow in either case, BCA wrote. But in a banking-led slowdown, “the discount rate applied to earnings would not be as high,” which would be better for stock valuations. Yet, the analysts acknowledge that growth might not just slow but collapse. That could happen if the Fed keeps policy too tight as credit becomes harder to obtain.
Through Monday, the S&P 500 had climbed 10.5% from its bear-market closing low on Oct. 12, but remained 17.6% off its record closing high in January 2022.
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