Since the start of the banking crisis just a week ago, markets have been recalibrating their expectations for central banks. It’s broadly understood that the main driver of weakness in the banking sector at the moment is higher interest rates. This has led to the natural conclusion that the Fed won’t hike as aggressively, or at all, when it meets next week. But, that could be based on a couple of hasty assumptions.
The Fed might still be in tightening mode
After the last meeting, the Fed essentially communicated that there would be another 25bps hike in March. Evidently it was couched in conditionalities, Powell clearly conveyed the idea that the Fed was getting ready to pause. He explicitly said a “couple” of more hikes, which would presumably include the meetings of March and May.
Since then, speculation of what the Fed would do varied wildly, depending on events. 50bps was first hinted at after the blow-out jobs number in January. It became the dominant theme less than two weeks ago when Powell provided testimony before Congress, suggesting that the Fed could increase the pace of hikes. Now, that has completely reversed, with a 50/50 chance of a 25bps hike or no hike at all.
Too much speculation?
The thing is, all of these changes have been based on reading the tea leaves of what the Fed might think of data points. As far as the Fed’s “narrative” is concerned, 25bps is still the game plan. That’s what was officially conveyed after the meeting, and what officials were talking about right up until the Fed’s blackout period. In other words, if the Fed were to do a quarter point, it wouldn’t be a change from any previous guidance that it has provided.
Enter the ECB, which just yesterday hiked rates by 50bps as expected, with hardly any reaction in the EURUSD. The ECB went through with their telegraphed plan, saying they were focused on inflation, and that other measures would be taken to address the banking issue. This is the separation of the policy and intervention aspects that we mentioned previously. Central banks are generally seen as having two main tools to affect markets: the interest rate, and the balance sheet. While they are the main policy tools, central banks can use other measures to address specific issues. Which is why it might be a little early to assume the Fed will pull back on its efforts to control inflation in order to shore up the banking sector, just as it might have been a little too early to suppose the Fed would hike by 50bps.
The market getting ahead of itself again
Last Sunday, the Fed announced a new mechanism known as BTFP, which would effectively provide unlimited short-term loans for banks that needed liquidity and were affected by high interest rates. Although it didn’t shore up stock traders, and bank shares have fallen dramatically in the last few days, it might be seen as sufficient by Fed officials. Just like the ECB figured that the SNB’s actions to protect Credit Suisse was enough.
The ECB’s use of this principle without any dramatic ill effects – in fact, European bank shares rose following the ECB’s decision – could encourage similar action from the Fed. Maybe not a 50bps hike, since the Fed hasn’t really said that it would do that at the next meeting. But the Fed is likely to be still keen to maintain its inflation-fighting credibility, which it can do by following through on its forecast of a quarter point hike next week.
Now we’ll have to see if the market adjusts to that kind of thinking before Wednesday.