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Is Federal Reserve reckless to hike interest rates again, as recession and banking fears worsen?

On Wednesday afternoon, we will get the latest episode of the most important show in town: the Federal Reserve and its interest rate policy. At 2 PM Eastern, the Fed will announce whether interest rates will be hiked again or if the long-awaited pivot has come.  

For the first time in quite a while, there is a genuine chance of the latter, even if the market is still viewing a 25 bps hike as by far the most likely possibility. In backing out implied probabilities from Fed futures, as of Wednesday morning, there is an 11% chance of no hike and an 89% chance of a 25 bps hike. 

Although, the below chart shows how the sentiment has shifted in the past week. Last Wednesday, there was a notably higher chance of no hike, at 28%, with 25 bps coming in at a 72% probability. 

Thus, it marks the first meeting in a long while where there is a tangible chance of no hike. This is partially due to the beast that was thought to be slain, before returning like a bad movie villain: the banking crisis. In March, the collapse of Silicon Valley Bank (SVB) triggered a regional bank crisis (which then became not-so-regional when Credit Suisse fell in Europe). 

The crisis was nearly averted until it was revealed last week that First Republic Bank suffered over $1 billion in withdrawals last quarter. It became the latest bank to collapse soon after, its shares delisted on Tuesday, with the trouble now placing even more importance on the Fed’s decision. 

Does banking crisis foreshadow risk of another rate hike?

Which brings us to now. Some fear the Fed’s anticipated 25 bps hike is reckless against this backdrop. 

While the risk management of the fallen banks was unquestionably dire, their collapses were precipitated by the aggressive hiking of rates over the past year. A duration mismatch on the balance sheet of the banks hit hard, as bonds began to sell off as rates rose, banks falling victim to the belief that basement-level interest rates could hold forever. 

Liquidity has already been siphoned substantially out of the system. This time last year, we were only entering the hiking cycle which saw rates rise from near-zero to close to 5% today. It has been a very swift transition, a near 500 bps rise in the blink of an eye. 

There is also the issue of lagged effects of monetary policy. As the chart above shows, we only transitioned into this tight cycle last spring, meaning many of the monetary effects are yet to land, especially as the Fed continues to hike even amid this deep tightening. 

I penned a report in February looking at how global recession fears had usurped inflation as the prime concern for financial markets. Largely, that is what has happened, at least if the trajectory of asset prices since can be believed, as well as inflation trickling down (despite remaining high). 

For the Fed, however, it stayed the course. Powell and co. continue to treat inflation as public enemy number one, something which will be well and truly hammered home if/when this 25 bps hike lands, coming amid a week that has seen yet another banking failure. 

If you go looking for fear, it is easy to find. History suggests the worst may still be to come, especially as the Fed continues to hike as we progress through the tightening cycle. The labour market remains tight, but has begun to loosen. Indeed, weak data on job openings yesterday pushed the probability of a no-hike a little higher. 

We have seen credit squeezes and corporate defaults ramp up from similar conditions in the past – again, with the well-known lag that monetary policy changes come with. And, crucially, we have never seen a tightening cycle this quick before.

One more interest rate hike and then done?

Thus, even beyond the ominous wobbles in the banking sector, there is concern that another hike could go awry down the line. Not to mention, if the market is anticipating a “one-more-and-done” policy, the logic behind a hike right here is harder to get on board with – why not just pause, wait and see what happens with regional banks, before reassessing next month?  

The risk/reward relationship feels a bit awry right here, if that expression can be used to analyse Fed decisions. Because no matter what way you swing it, monetary policy most definitely matters for financial stability, and that appears to be creaking at the moment, to put it mildly.  

Looking ahead to the June meeting somewhat reinforces this. The market now places an 83% chance on the target rate being 25 bps above the current target rate of 5%-5.25%. That is notable when the assumption of a 25 bps Wednesday (for the May meeting) is considered – meaning a cut is very much in play next month, should this week’s 25 bps hike come and go as expected.

For short-term asset prices, movement may depend more on Fed language than the actual hike itself later today, as has been commonplace when a hike is largely priced in. While market activity could easily be subdued today, the difference compared to previous meetings is really the growing line of argument that the Fed should taper off here and assess the lay of the land. 

Like I keep saying, monetary policy operates with a lag. A growing swathe of economic data suggests that the liquidity crunch is now truly feeding through to the economy. The signs of an impending recession are undoubtedly growing. And then there is the much-covered banking crisis. 

Inflation remains well north of the 2% target, even if it has been coming down. But a 25 bps hike feels scary in this spot. I’ve been writing all year about the Fed’s challenge, to toe that line between inflation and recession. It’s getting into crunch time now. 

The post Is Federal Reserve reckless to hike interest rates again, as recession and banking fears worsen? appeared first on Invezz.

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