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Priorities: Financial Stability or Disinflation: Mar. 13, 2023

Priorities: Financial Stability or Disinflation: Mar. 13, 2023

Posted March 13, 2023 at 12:25 pm
Jose Torres
IBKR Macroeconomics

Fears about potential bank failures similar to SVB and Signature Bank have sparked an investor stampede into the safety of Treasury securities, while complicating the Federal Reserve’s monetary tightening just months after inflation embarked on a painful resurgence. For the Fed, the crisis comes at a pivotal time—investors are looking ahead to tomorrow’s Consumer Price Index data and releases later this week for retail sales and the PPI to assess whether the recent upswing in inflation is a persistent and widely entrenched issue. Regardless of this week’s economic data, however, it’s likely that the Fed has landed between a rock and a hard place as it must balance financial stability with its efforts to curtail inflation.

Investors flocked to safe-haven assets with yields across the Treasury curve falling like thunderstorm raindrops from the sky. The 2 and 10-year yields are down a significant 44 and 18 basis points, as markets beg the Fed to take it easy while bidding up recession prospects. Equity markets sold-off late last week and this morning; however, the dip buyers show no fear, with the S&P 500 Index recovering from an earlier 1.3% loss to a whopping 1% gain. Significant buying capacity led to a volatility crush as the VIX fell from roughly 31 to 25 since the open. Bets of an easier Fed are weighing on the dollar while recession wagers hamper crude oil. The Dollar Index is down 0.9% to 103.67 while WTI crude oil is down 1.5% to $75.50 per barrel.

In the largest bank failure since 2008, SVB Bank, which reported $172 billion in deposits for 2022, collapsed last week after it was forced to sell long-duration bonds at a loss to meet client withdrawals. Regulators on Sunday then shut down Signature Bank, which has more than $88 billion of deposits. It was hit with billions of dollars of withdrawal requests on Friday. Banking woes continued this morning as exchanges halted trading of certain bank stocks, such as First Republic Bank, that experienced heavy selling of shares. The fears surged despite the Treasury Department, the Federal Reserve and the FDIC stating that SVB and Signature Bank clients will receive their full deposits.

The bank crisis illustrates how quickly investor fear can shift among issues and how the Fed’s efforts to curtail inflation can quickly become complicated by market conditions. Late last month, the Personal Expenditures Price Index (PCE) hit 5.4% year over year (y/y), up from 5.3% in December. With strong inflation and vibrant consumer spending, it sparked fears that the Fed might accelerate its rate hikes, thereby inching the economy closer to recession. Other data this year, such as strong retail spending and strong job creation numbers, combined with Fed Chairman Jerome Powell’s Congressional comments last week regarding the central bank’s willingness to make larger and faster rate increases than previously anticipated, sustained investors’ fears that monetary policy may excessively slow the economy.

If the Fed takes a hawkish approach to inflation at its March 22 meeting, it may face criticism that it is risking further market instability, but if it doesn’t increase its monetary tightening it may be criticized for allowing inflation to continue.

The banking failure, however, now has investors worried about the stability of financial markets, and the Fed now has the challenge of fighting inflation without worsening the sizeable bond and equity losses for regional banks overall. The loss of billions of dollars in assets from regional bank equity and bondholders, of course, is deflationary, and can help the Fed with its inflation battle. On the other hand, stronger-than-anticipated economic data this week may point to the need for further tightening, placing the Fed in a lose-lose situation. If the Fed takes a hawkish approach to inflation at its March 22 meeting, it may face criticism that it is risking further market instability, but if it doesn’t increase its monetary tightening it may be criticized for allowing inflation to continue.

Further complicating matters is that data releases this week cover time periods prior to the bank collapse, so when the Fed members evaluate recent data, it will have to estimate the impact of market instability upon future economic reports and their outlook may differ from investors’ expectations. In fact, investor expectations have shifted significantly in the dovish direction, with investors expecting a peak rate of just 5.13% with interest rate cuts expected by July or September. A radical shift from just last week, when the peak rate expectation was 5.63% with some notable market participants expecting a push up to 6%. Significant decisions affecting asset valuations and economic conditions alongside market moving economic data releases will be digested by the market in short order. 

Visit Traders’ Academy to Learn More about the Consumer Price Index and Other Economic Indicators.

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