So far, US banking earnings have been a mixed bag, but have contributed to firming up expectations for what the Fed will do at the next meeting. Traders are now pricing in an 88% chance that the Fed will hike by 25 bps at the next meeting, which is up from 70.4% chance before banks started reporting.
Finding some consensus
It seems that even the Fed can’t agree on what to do after that, though. Just yesterday FOMC member Bullard said he expected there to be at least three more rate hikes before the Fed pauses. That would be a total of 75bps, but he didn’t specify if he expected that to happen over the course of three meetings, or if there was a chance for another 50bps hike.
On the other hand, his fellow FOMC member Bostic said that after another 25 bps, the Fed would be done hiking for this cycle. Both agreed that once the top rate is reached, there would be no cuts for the rest of the year, which contradicts current market expectations of at least 50bps cut somewhere in the final quarter of 2023.
What changed the market?
Since banks started reporting their earnings, yields on US short-term treasuries have increased the gap with longer-term treasuries. This is the “yield curve inversion” which so far has preceded every recession since the 1960s. It’s based on an expectation that the Fed will raise rates in the near term, but will be forced to cut them when the economy turns negative.
But there is a different cause for the yield moves in the last couple of days. The Fed has resumed its QT, which it had reversed during the recent banking crisis. That reversal caused yields to drop and weakened the dollar. In fact, the Fed has sold or rolled off over $115B from its balance sheet since March 21, which is a much faster pace than the $95B/month it was doing before the banking crisis.
A stronger dollar in the future?
The Fed’s actions are leading to higher interest rates across the board, particularly the 2-year bond, which is the most sensitive for market changes. The dollar has gotten stronger as liquidity is pulled out of the banking system. The Fed can be expected to keep up this higher tightening pace for a while, since it has to get back on track to reach its target. As yields keep rising, so should the dollar, unless there is another factor getting in the way.
What the banking results showed is that, aside from a few trouble spots, broadly speaking they were quite resilient in the current market situation. The bigger banks, which are the main worry of the Fed for any systemic problems, did better in the middle of the banking crisis. Regional banks suffered a loss of depositors, but the Fed’s BTFP program is supposed to supply sufficient backstop to help them.
As far as forex traders are concerned, the bank earnings reported so far are making the case that the Fed can go back to its tightening stance that it had before SVB collapsed. That could provide some tailwinds for the dollar – until the next interest-rate induced crisis occurs.
