Just last Friday there was a pretty strong consensus building that the Fed could hike rates by 50bps, and the terminal rate would end up over 5.5%. That has all changed, to the point that there is increasing doubts about whether the Fed will hike at all at the next meeting. Expectations for the terminal rate have come down to just over 5.0%, with the market already pricing in two rate hikes by the end of the year.
The change, of course, comes from what’s been dominating the news lately: The collapse of three regional banks. So far. The exact details of why these banks specifically collapsed right now are still subject to investigation, and blame is being thrown around, from politics to greed. But the general theme for all of them is that they were under extraordinary pressure due to the abrupt increase in rates by the Fed. Many other banks are facing the same pressure, even if they aren’t in immediate risk of collapse.
What about Powell’s speech?
Expectations shifted the prior week when Fed Chair Powell testified before Congress, saying that the Fed could pick up the pace of rate hikes if the data warranted it. After that, interest rates jumped as the market priced in a 50bps hike. This put increased pressure on the more vulnerable banks, which were forced to sell assets at a loss, triggering the cascade of events leading to the FDIC seizing the banks’ assets.
That’s why many analysts are revising their expectations for the FOMC meeting next week. Just yesterday, nearly all traders were expecting a 25bps hike at the next meeting. This morning, that has dropped to 70%, with the rest expecting no hike at all. Subsequently, the terminal rate and bond yields have come down.
Getting expectations in order
On the one hand, this is a relief for banks that were facing losses from higher interest rates. On the other hand, it undermines the “credibility” of the Fed’s fight against inflation. The theory that is most accepted by central bankers at the moment is that inflation is driven by the market’s confidence in the central bank doing what’s needed to bring inflation down. If the Fed hesitates to keep raising rates while inflation is still high, it might lead to the market seeing the Fed as unwilling to stop inflation. Which in turn could push inflation higher, and weaken the dollar. It would also increase fears of a recession.
Naturally, what would significantly help the Fed at this juncture would be if inflation were to come down substantially. For the moment, that’s not what’s expected. Annual headline inflation is expected to come down, but just by three decimals to 6.1% from 6.4% prior. That is still more than triples the target rate. The monthly reading is expected to remain sticky, staying at a growth of 0.5%.
Where is the policy going?
The core rate, which is what the Fed tracks most in terms of setting policy, is expected to remain unchanged at 5.6%. But the monthly pace is seen accelerating to 0.5% from 0.4%. Under normal circumstances, that would have prompted an expectation of tighter policy by the Fed.
If CPI comes in below expectations, it will likely guarantee a shift towards expecting no rate hike, since it would be a good excuse for the Fed to pause. But if CPI increases, it could cause confusion in the markets, as traders don’t know if the Fed is willing to raise rates anymore. And the Fed is already in its pre-FOMC meeting blackout, so there won’t be any comments from officials until the meeting.
