Markets Continue to Expect Rate Cuts, Shrugging Off Powell’s Sternness: Mar. 23, 2023

Federal Reserve Chairman Jerome Powell remained on the inflation fighting path yesterday, despite recent bank failures and financial stability concerns. A unanimous 25-basis point (bp) rate hike by the committee was accompanied by Powell’s stern warnings that a slider could be the next step required for striking out inflation because recent economic data has been hotter than expected.

Powell had to walk a fine line. Raising rates aggressively could have risked worsening the banking crisis, but taking a dovish approach could have had two drawbacks—it would have signaled that the Fed believes the banking system is too fragile to handle the stress of higher interest rates and it would allow strong inflation to continue. When announcing the small rate increase, Powell cautioned that the Fed has to do more to contain inflation, a concern reinforced this morning when the jobless claims report for the week ended March 18 showed that initial claims fell by 1,000 to 191,000 compared to 197,000 applications expected by a Bloomberg survey of analysts.

Despite Powell’s hawkish tone, markets are rallying this morning as investors believe the Fed is finished hiking rates and will begin cutting them as soon as July. Equities are higher, erasing yesterday’s steep losses, with the S&P 500 Index down 1.7% and the tech-heavy, interest rate-sensitive NASDAQ Index rising 2.4%. Short-term yields and the dollar are continuing to build on downside momentum as wagers of a lighter Fed mount. The 2-year Treasury yield is hovering at its lowest level since September, down 7 bps to 3.91% after falling roughly 25 bps yesterday. The Dollar Index is down 0.1% after falling roughly 1% yesterday. Oil prices are attempting to build some momentum after falling to their lowest levels since December 2021. WTI crude oil is up 0.8% to $71.50 a barrel as rising demand from the Chinese reopening offsets the deflationary pressure propelled by abundant supply in the U.S. The 10-year Treasury yield is roughly flat at 3.48%, supported by inflation expectations and higher oil prices.

Yesterday’s steep market selloff occurred after Powell attempted to walk a narrow path between maintaining bank stability and fighting inflation. In doing so, he struck a cautionary tone that dashed investors’ hopes that he would provide a dovish outlook for monetary policy. A few key points included the following:

If the bank failures lead to tightening liquidity conditions, the Fed may not need to continue with rate hikes. It’s likely that a tighter and incrementally cautious regional banking system has the similar effect of a few rate hikes, as capital access to households and businesses become increasingly constrained.

• The Fed’s Summary of Economic Projections calls for both one more rate increase this year and maintaining the resulting terminal rate of 5.13% until sometime in 2024. However, investors continue to expect a rate cut in the coming months.

• The 25-bp increase is necessary to fight inflation, but it is lower than what the Fed would have implemented prior to the recent high-profile bank failures. The increase is intended to help curtail inflation while the Fed assesses the impact of the recent bank failures on liquidity. If the bank failures lead to tightening liquidity conditions, the Fed may not need to continue with rate hikes. It’s likely that a tighter and incrementally cautious regional banking system has the similar effect of a few rate hikes, as capital access to households and businesses become increasingly constrained. With the failures of Silicon Valley Bank and Signature Banking occurring in just the past few weeks and ongoing issues with First Republic Bank, the Fed, the U.S. Treasury and the Federal Deposit Insurance Corp. have yet to fully understand the scope of the issue.
• Powell noted that the banking system as a whole has plenty of liquidity and is well-capitalized. He suggested that the recent boost in the Fed’s balance sheet was a short-term event, and the central bank will continue to wind down its holdings of US Treasury and mortgage-backed securities.
• On an encouraging note, he said goods disinflation is continuing and apartment rental rates are decreasing.
• He added, however, that non-housing services inflation is still too high and it will take time for the tight labor market to become balanced.

Powell said that just a few weeks ago, the Fed was leaning toward taking more aggressive actions to fight inflation because economic data earlier this month was stronger than what the central bank anticipated. Earlier this month, jobs and inflation data remained too hot for the Fed’s liking. However, investors believe that the path of the current Fed will lead to more regional bank failures and a shallow recession at best. For that reason, they don’t believe Powell has the tenacity to follow through on his master plan, and they are pricing in cuts this year as a result.

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