Markets could be in a vulnerable position ahead of the Federal Reserve meeting this week as traders bet the banking crisis could lead to significant interest rate cuts over the next year.
The Fed, which announced on March 12 the creation of its emergency bank term funding program to help banks meet the needs of their depositors following the collapse of California’s Silicon Valley Bank and the Signature Bank of New York will hold a two-day policy meeting this week. . Fed Chairman Jerome Powell will host a press conference following its conclusion on Wednesday.
“A lot of people thought that because there was a banking crisis, it would cause the Fed to start easing monetary policy” in the coming months, Bob Elliott, managing director and chief investment officer of Unlimited, said by telephone. funds. He pointed to federal funds futures, saying they show “interest rates are likely to come down significantly over the next year.”
But according to him, the Fed’s emergency measures have helped stabilize the financial system, leaving it the margin “to go and fight inflation which remains too high in the economy”.
The Fed “should tighten monetary policy,” he said. Still, economic expansion in the United States and inflationary pressure from wage growth do not match traders’ expectations for rate cuts over the next 12 months, according to Elliott. That leaves markets at risk, he thinks.
“The problem is that you could easily embed tighter monetary policy, which would hurt both stocks and bonds,” Elliott said. He said he sees regional bank failures as a result of “management mismanagement” that regulators failed to detect, rather than Fed rate hikes.
“Banker of Last Resort”
“For the first time in a long time,” the Fed has returned to its “original roots” as the “banker of last resort,” Rob Arnott, founder and chairman of Research Affiliates, said in a phone interview.
“If you’re going to protect depositors and let stock and bondholders take the hit they rightly deserve,” he said, “that’s fine.” Describing himself as “a practical libertarian”, Arnott said: “I’m all for saving two or three medium-sized banks to avoid contagion.”
But he said he wouldn’t go so far as to say “everything is clear”, pointing to problems at Europe’s biggest bank, Credit Suisse Group.
CSGN
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For example. When it comes to investing in stocks, Arnott likes to buy “at the height of fear”.
“Are we at the height of fear in the United States? Probably not,” he said, adding that Europe probably isn’t either.
In a sign of stress in the United States, banks borrowed $165 billion from the Fed’s discount window, its longstanding support facility and the new bank term funding program during the week ending on March 15, according to Fed data released on March 16. Approximately $11.9 billion was borrowed from the Bank’s new term funding program.
According to Arnott, the Fed helped create the crisis in part because it kept rates near zero for too long. “They finally got religion in early 2022,” he said, with the Fed rapidly raising rates last year to fight high inflation. “So you get people addicted to free money and then you crush them with expensive money,” he said. Meanwhile, “the inflationary threat has not gone away.”
Stocks and bonds sank in 2022 as the Fed aggressively raised rates in an effort to rein in the soaring cost of living.
Although inflation has come down this year, it remains elevated and Arnott predicts it could end up being more rigid in the second half of 2023 when year-over-year comparisons become more difficult. As a result, the inflation rate could end the year in a range of 5% to 6%, he estimated.
The market is largely expecting the Fed to announce on Wednesday that it is raising its key rate by a quarter of a percentage point to a target range of 4.75% to 5%. On Friday, federal funds futures were pointing to a 62% chance of that rate hike and a 38% chance of a pause, according to CME FedWatch Tool.
‘Needle Mover’
Liz Ann Sonders, chief investment strategist at Charles Schwab, said in a phone interview that the “needle movement” on whether the Fed raises its benchmark rate by a quarter of a percentage point or makes a pause will be “any further fallout from what is happening in the banking system”.
The Fed will announce its policy decision Wednesday at 2 p.m. EST, with Powell holding a press conference at 2:30 p.m.
See: Fed expected to follow ECB playbook and raise interest rates next week
Not so long ago, Powell, in his March 7 testimony to Congress on monetary policy, opened the door to a possible acceleration in the pace of rate hikes at his next meeting due to fears of inflation.
Now it’s “a complicated situation” due to financial stability issues, Sonders said. She said she expects lending conditions to continue to tighten following the Fed’s aggressive rate hikes over the past year and recent banking woes.
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“It’s easy to argue that credit terms get even tighter from here,” Sonders said. “I think we’re only at the beginning of fundamentally creative destruction.”
Still, the Federal Reserve Bank of Atlanta’s GDPNow tracker estimated on March 16 that the growth rate of real gross domestic product in the first quarter was 3.2%.
Some investors expect a recession to loom following the Fed’s aggressive rate hike campaign, and the economic contraction will help bring inflation down.
Still, to Elliott, the United States looks “at least as far out of recession” as it did three or six months ago. And based on the 100 basis points of “easing” he has seen in the market over the next 12 months, he said even a pause in the current tightening process could lead to a massive bond sell-off. and likely to be “a drag on the stock market.”
Within stocks, Arnott said value stocks look cheap relative to growth stocks and should fare better in an environment of inflationary pressures. But the Russell 1000 Growth Index
RLG
jumped 8.7% this year through Friday, while the Russell 1000 Value Index
RLV
fell 4.4% over the same period.
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The narrative that rates will come back down and stay low has helped fuel the rise in growth stocks, Arnott said, but he described it as a “short-term phenomenon.” Viewed over a longer horizon, value stocks look “very cheap” relative to growth stocks, he said. In addition, inflation, which remains a concern, “works for the benefit of value, not growth”.
While stocks and bonds suffered from rising rates last year, Phil Camporeale, portfolio manager at JPMorgan Chase & Co., told MarketWatch that he’s recently seen fixed-income securities play a role. defensive in the tumult of the banking sector.
Bonds’ ability to “provide ballast and defense in times of equity weakness is something very close to our hearts,” said Camporeale, portfolio manager for JP Morgan Asset’s global allocation strategy, over the phone. Management. “We are really benefiting from the negative correlations between equities and bonds over the past week,” he said.
US stocks ended lower on Friday amid lingering banking sector fears, with the Dow Jones Industrial Average
DJIA
record consecutive weekly losses. The S&P 500
SPX
rose 1.4% for the week, while the tech-heavy Nasdaq Composite
COMP
climbed 4.4% in its biggest weekly percentage gain since January, according to Dow Jones Market Data.
See: Microsoft, Apple and Meta outperform as investors seek protection from SVB chaos in megacap tech stocks
Treasury yields plunge
In the bond market, Treasury yields fell on Friday and fell through the week as they extended their slide from their recent 2023 highs. Bond prices rally when yields fall.
Market Supplement: Why bond market volatility is at its highest since the 2008 financial crisis amid continued bank fallout
The yield on the two-year Treasury bill
TMUBMUSD02Y
fell 74 basis points last week to 3.846% on Friday in its biggest weekly decline since October 1987 based on 3 p.m. Eastern time levels, according to Dow Jones Market Data. Further down the Treasury yield curve, 10-year Treasury rate
TMUBMUSD10Y
posted a weekly decline of 29.9 basis points to 3.395%, the lowest level since January.
“The chances of aggressive rate hikes have been reduced” due to the recent banking turmoil, with the Fed potentially “very close” to the end of its tightening cycle, according to Camporeale.
The tumult in the banking sector may “tighten the Fed’s financial position and has the potential to be disinflationary from a simple business caution standpoint,” he said. For example, regional banks could be more cautious in lending due to the sector’s difficulties, he said.
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But Camporeale, who within fixed income favors longer-duration government debt and higher-quality U.S. corporate bonds, said it was still “too early to declare the end.” of the tightening cycle”. That’s because inflation remains elevated, he said, although “as long as inflation doesn’t run away, we expect the long end of the curve to remain roughly anchored. “.
It is also “premature to expect an easing” of monetary policy from the Fed, according to Camporeale. “I can’t say yet if the Fed will ease in the second half of the year,” he said.
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