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All eyes are set on US Federal Reserve which will be presenting its monetary policy on Wednesday. A quarter-point hike is expected in this policy, however, the Fed is in a tough situation for its hawkish policy stance. The reason would be US banks' contagion risks. Fed is expected to be split between financial stability and its fight to tame inflationary pressure. Since last March, Fed has hiked its benchmark overnight interest rate by 450 basis points. And the first to show signs of a rate hike impact would be the banking sector.
Seeking to achieve maximum employment and inflation of 2% over the longer run, the Fed in the previous policy hiked the key federal funds rate between 4.5% to 4.75%. This would be Fed's eighth hike.
Fed's monetary policy aims at promoting effective goals of maximum employment, stable prices, and moderate long-term interest rates. However, inflationary pressure which escalated after Russia struck a war with Ukraine in late February last year, has pushed Fed to hike key rates.
In February 2023, US inflation reached its lowest level since September 2021, at 6%. This was also merrier than what the street had expected. This sparked hopes that the Fed may take a slower pace of hike in key rates and also heightened the possibility of a lesser hawkish stance.
But earlier in the current month, Fed chair Jerome Powell told US lawmakers that there is a need to raise interest rates higher than expected.
However, the situation has changed. It's not inflation that Fed needs to worry about but also banks' contagion risks after the collapse of Silicon Valley Bank, Signature Bank, and Silvergate Capital due to illiquidity.
These banks met their doomsday due to a liquidity crunch which meant that their liabilities were higher than their assets. Also, other lenders such as First Republic Bank and Credit Suisse have also come into the limelight for the same problems. More troubles are likely to follow other US banks.
The Fed rate hike cycle is among one the reasons why the banks came under pressure.
So what will Fed do during March policy?
In its report, Emkay Global said that "we maintain the Fed will go ahead with a 25bps hike, with enough dispersion in the dot plot. Powell will likely distinguish between the inflation fight and supporting financial stability via regulatory tools, in the absence of any systemic event. That said, the FOMC might reckon that speed kills and contagions are difficult to manage. Hence, forward guidance could be hazy despite a likely unchanged 2023 median rate."
Highlighting the banking crisis, Emkay's note said, "we do not see elevated risks of contagion, as we view the recent events as idiosyncratic. While the Fed’s aggressive tightening may have caused some dislocations in certain sectors, this is not a liquidity crisis that is anywhere near comparable to that in 2008 or in 2020. While borrowings at the discount window were at a record high, the credit extended to the financial system in 2008/2020 was much greater, when accounting for various other programs then. The current funding markets remain orderly, MMF AUMs surged (seeing their largest 1-week inflow since Apr-20), Fed funds volumes plummeted and, while CP/CD spreads widened, some spreads are still hovering near their all-time lows."
Explaining in detail about the banking crisis, Centrum analysts in a note said that the banking crisis has sent shockwaves in the financial sector with two banks failing in the span of 2 weeks, the fed has a lot on its plate to make a decision on whether they should opt for a 25 bps rate hike or rather take a breather and keeping the interest rates unchanged for the meeting on Wednesday.
Even though the concern over the banking crisis is valid but Centrum's note also said that "on the macro side the inflation, jobs report, wage growth still indicates that the economy is still going strong. The Feds main focus when it comes to its interest rate decisions is core PCE, which stands at 4.7%, even though slowing down is considered high and sticky at the moment. Now, with both higher costs of borrowing and reduced access to credit, the economy’s growth and inflation is set to lose some steam."
Surprisingly, Centrum believes that the Fed will pause its rate hike for the upcoming meet but in the meetings, after that, they’ll continue with the rate hikes and start rate cuts around the last quarter of the financial year.
Dutch multinational banking, ING believes that one of the problems is that the Fed will struggle to escape the perception that further hikes would make regional banks’ funding position more difficult, and that cuts would help them. And this is without talking about the unrealised losses on their bond holdings.
ING's note said, "We fully expect the Fed to draw the distinction between monetary policy and financial stability but whether that distinction holds depends on the amount of stress the system is under. Above a certain level of stress, the system takes precedence, as the preventive extension of dollar swap lines with foreign central banks has shown." But the European bank still believes that Fed to still be in a position of a 25 bps rate hike.
Meanwhile, Reliance Securities cited that recent U.S. CPI reflected that the inflation was still high despite retail sales numbers eased, suggesting that the U.S. Fed will raise the interest rate further. Also, the US labor market remains tight after the recent spectacular non-farm data in the US rekindled market concerns over Fed interest rate hikes. The non-farm sector added a surprising 517,000 jobs in January and 311,000 in February. In fact, briefly, there were suggestions that the Fed could do a 50-bps hike in March.
However, that changed after the recent banking sector crisis. Reliance Securities note added that "many traders and other market participants speculated that the recent financial market crisis could also prompt the Fed to remain status quo on rates. The banking sector crisis started in the U.S. and spilled over to Europe as well."
Following this, Reliance Sec's note said, "we expect the Fed to ease up on their hawkish rhetoric. They could hike by 25-bps in March and could change their stance to neutral and say that further rates could be data dependent."
Lastly, Danske Bank in its report said, with market sentiment stabilizing, underlying inflation still elevated & systemic crisis risks now seemingly contained, Fed will continue hiking. It also expects Fed to hike the rate by 25 bps in the latest upcoming policy and a terminal rate of 5.00-5.25% by May.
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