Investors are betting that the Federal Reserve’s interest rate rise this week will be the last in its campaign to curb inflation, with the failure of two regional US banks and a rescue deal for Credit Suisse aiding the central bank’s mission to tighten financial conditions and turn the screws on borrowers.
Two weeks ago, futures markets reflected expectations that the US central bank’s key rate would rise as high as 5.7 per cent by the summer.
But the collapse of Silicon Valley Bank and its peer Signature — and the shotgun wedding of Credit Suisse and UBS after a tense weekend of negotiations — have forced a drastic repricing of how much further the Fed will need to act to pursue its policy goals.
The Fed has jacked up interest rates in the world’s largest economy from near zero at the start of last year to a range of 4.75 to 5 per cent after its latest policy announcement on Wednesday — the highest rate since 2007. But recent ructions in the banking industry have sparked fears about tougher lending conditions, with financial institutions expected to increasingly pull back credit lines to protect their own balance sheets.
Markets are not excluding the possibility of one more quarter-point rise in May, but a hold followed by a series of cuts later in the year is now seen as the most likely scenario.
The angst in the banking sector has already damped banks’ willingness to lend to businesses and individuals, the same effect produced by higher interest rates. The ripples are likely to continue. US corporate debt and equity issuance has slowed in the past two weeks, and a market measure that quantifies bank funding stress — the FRA-OIS spread — on Wednesday rose to its highest level in more than three months.
Investor fears of a dramatic slowdown in mortgage lending, particularly in commercial real estate, which is primarily driven by regional banks, have proliferated.
“Banks are under pressure on three different fronts: funding costs, the declining value of assets, and regulatory scrutiny. If you combine these three things, you do begin to wonder about banks’ willingness to lend over the coming quarters,” said Torsten Slok, chief economist at Apollo Global Management.
“The Fed was already in the process of tightening credit conditions. Now suddenly we have a magnifying effect, which could potentially mean faster tightening of financial conditions, which in turn raises the risk of a sudden stop in the economy.”
Fed chair Jay Powell on Wednesday admitted that the events of the last fortnight were “likely to result in some tightening of credit conditions”. In turn, that market-induced tightening will work “in the same direction as rate tightening”, he said, implying that the central bank may not need to raise borrowing costs as aggressively as previously anticipated because investors will do the job instead.
“You can think of it as being the equivalent of a rate hike, or perhaps more than that,” said Powell.
Also released on Wednesday, the Fed’s “dot plot” showed that officials are still expecting at least another interest rate increase this year.
“The lack of bank lending that we are going to see over the intermediate term will tighten financial conditions, which the Fed wants to do,” said John McClain, portfolio manager at Brandywine Global Investment Management. “The banks will act at the behest of what the Fed is trying to accomplish.”
With conditions becoming tougher for borrowers the Fed may be under less pressure to continue its own battle against inflation — taking a foot off the pedal that has compressed financial markets for the better part of 12 months.
“The price of credit is moving higher,” said Steve Booth, head of investment grade corporates at T Rowe Price. “Financial conditions will tighten on the back of this, and that introduces broader economic risk. And then obviously, what that means for policy is the next obvious question.”
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