After March’s market madness, what’s next for the Fed?
Find out how turmoil in the banking sector has affected the Fed’s interest rate path, and what it all means for investors.
March wasn’t an easy month for the US Federal Reserve. With the collapse of Silicon Valley Bank (SVB) and subsequent turmoil in the banking sector, market expectations swung from rate hikes to rate cuts.
What do the past month’s developments mean for the world’s biggest economy, the Fed’s rate path, and markets going forward? Let’s dive in.
First off, how did we get to this point?
At the start of the month, stickier-than-expected inflation and a stronger-than-expected economy contributed to expectations that the Fed would need to re-accelerate its pace of rate increases and shift up its terminal rate. (That’s the peak interest rate of its hiking cycle.)
But just a week and a half into March came SVB’s collapse, which created serious concerns about the stability of the broader banking system. Market expectations shifted dramatically, with futures markets pricing in a rate pause at the Fed’s 21-22 March meeting and rate cuts beginning from around mid-year.
The Fed moved quickly and launched an emergency lending programme to provide banks with liquidity and shore up confidence in the financial system. That allowed it to press on with another 25 basis point (bp) rate hike this month, making it clear that fighting inflation was its top priority.
But the Fed and markets aren’t seeing eye to eye on the path of interest rates
At its March meeting, the Fed sent two important signals about the trajectory of rates:
- First, it held its projection for its terminal rate at 5.1%. With the fed funds rate currently at a range of 4.75% to 5%, this implies just one more rate hike in this cycle. That may be partly because the impact of recent banking turmoil could help slow the economy – effectively doing part of the Fed’s work for it. Some analysts estimate that the resulting tightening in financial conditions could be equivalent to about 25-50 bps of rate hikes.
- Second, given that inflation remains well above its 2% target, Fed Chair Jerome Powell pushed backon the prospect of any rate cuts this year – and reiterated that the central bank could raise rates by more than expected if needed.
Markets, however, aren’t buying it. Instead, a number of market measures indicate that they’re expecting rate cuts in the near term:
- Fed funds futures are pricing in rate cuts beginning in June, with an implied rate of about 4.3% by December.
- Yields on 10-year Treasuries have tumbled to about 3.5% as of end-March from more than 4% at the start of the month, reflecting expectations of slowing growth and moderating inflation.
- The “near-term forward spread,” which looks at the difference between the yields of current three-month Treasury bills and their expected yields in 18 months, is is an indicator that Powell himself watches closely. And this indicator points to a more than 100 basis point decline in yields over that period.
Under what circumstances would the Fed cut rates?
The Fed’s March hike made it clear that the central bank still sees taming inflation as its highest priority, and inflation is still more than double the Fed’s target.
So, are markets getting ahead of themselves in pricing in rate cuts as soon as mid-year? What would actually prompt the Fed to start cutting rates?
The Fed could cut rates if the economy deteriorates rapidly
A significant pullback in the economy in the coming months could prompt the Fed to start cutting rates. One way this could happen is that the turmoil in the banking sector could result in even stricter lending standards that would make it even harder for borrowers to access credit, dragging further on growth.
In fact, getting access to loans has already been getting more difficult over the past few quarters. The Fed’s January survey of senior loan officers, for example, showed that about 45% of respondents have tightened lending standards for businesses of all sizes – a trend consistent with past recessions. Banks are also becoming increasingly less inclined to extend credit to consumers.
A recession appears to be in the realm of possibilities for the Fed. The central bank forecasts still-positive – albeit modest – growth of 0.4% this year, down from its December forecast of 0.5%. Given expectations of relatively robust growth in Q1, this would imply a relatively swift slowdown in the coming quarters, potentially in the second half of the year.
Market indicators also point to a heightened probability of a recession in the period ahead. The Federal Reserve Bank of New York’s gauge, for example, points to a 55% probability of a recession in the coming 12 months, while a Bloomberg survey places odds at 65% over that same period.
But dissenting opinions show that recession is not necessarily a foregone conclusion: Goldman Sachs, for example, sees just 35% odds on resilience in the labour market.
As the economy slows, inflation should naturally come down with it – that’s been the Fed’s objective all along. But barring a significant shock, a sharp decline in inflation is unlikely to happen in the next few months. And with its job not done, the Fed would likely be reluctant to start easing so soon, as that could lead to worse problems down the line.
The central bank could also cut rates if banking sector turmoil intensifies into a more severe crisis
While the Fed and US government have implemented backstops for the banking sector, the situation is still unfolding. The impact of the Fed’s rapid 475 bps of rate hikes since last March could also start to show up in other places in the economy. The worst case scenario will be hard to predict, but any signs of a systemic crisis would likely result in swift action from the Fed.
If the Fed were to cut rates, how would asset classes respond?
Given all the moving parts, it’s too early to say what the Fed will do. And, as we’ve now seen clearly over the past month, market expectations can turn on a dime.
To better prepare ourselves for what’s to come, we can look to history to see how various asset classes have responded to past rate cuts.
Our analysis of 21 Fed easing cycles since the 1970s shows that, in the immediate aftermath of the first rate cut (or 1 month after), median returns across all major asset classes have historically been flat to slightly negative.
But as the chart above shows, over time, asset classes have bounced back, with bonds leading the recovery and equities following. (We touched upon this dynamic last year in our CIO Insights: “How the Fed’s Balancing Act Could Play Out”) The key takeaway? It’s important to keep a longer-term perspective and stay invested in a diversified portfolio through the markets’ ups and downs.
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