Fed to set rates in fraught conditions

The Federal Reserve meets this week amid fraught financial conditions. The collapse of Silicon Valley Bank and a few other mid-sized banks in the US along with the sale of Credit Suisse to UBS in Switzerland has prompted enormous strain in financial markets. US Treasury yields have plummeted as investors seek haven assets: the 2yr UST yield is trading at around 3.7% on March 20, down from more than 5% as recently as March 7. The FRA-OIS spread has widened to almost 50bps from just barely above 3bps earlier in March. The Fed has also  extended swap agreements to central banks in Canada, the UK, the Eurozone, Switzerland and Japan in a reflection of steps taken during the early stages of the pandemic crisis in 2020.

Markets have sharply downgraded their rate expectations for the Fed on the back of these developments. An additional 25bps hike is gingerly priced in for this week’s FOMC meeting before cuts are predicted to take effect with about 100bps of cuts from the current effective Fed funds rate of 4.6% priced in as of the start of this week. That compares with expectations for hikes to as much as 5.6% by mid-year as recently as March 8.

Markets rapidly shifting rate expectations

Source: Emirates NBD Research

Our baseline expectation is that the Fed will still hike by 25bps this week, bringing the Fed Funds rate to 5% on the upper bound. Inflation is still the preeminent economic challenge, affecting all components of the US economy. The February CPI print showed signs of moving in the right direction on the headline level—down to 6.0% y/y from 6.4% a month earlier—but persistently high services price inflation still needs to be dealt with. A well calibrated message, that suggests rate hikes are the tools for inflation while liquidity support can help with strain in financial markets, would match what markets heard from the European Central Bank last week which managed to get a 50bps hike across the line.

If the Fed chooses not to hike it could create concern across markets that they are reversing course rapidly at the first sign of trouble. The rapid pace of tightening that markets have endured in the last year and a half was almost certain to catch out some institutions or industries but rates remain the most effective tool to cool aggregate demand and get inflation back under control. The Fed will need to highlight the alternative tools at its disposal—swap agreements, access to the discount window, the bank term funding programme—that can be used for easing strain in financial markets.

The FOMC will also release its new Summary of Economic Projections (SEP) this week which markets will parse for the next steps the Fed will take. The median in the dots plot of FOMC members’ rate expectations was 5.125% at the December SEP. Where the new median alights, and the distribution of expectations, will give a clue as to whether the Fed is still predominately focused on the inflation challenge or if the stress in markets is encouraging more dovish voices. Earlier in the month, chair Jerome Powell said the Fed would look at the “totality” of data when it sets policy, seeming at that time to mean both the then-upcoming jobs and inflation reports. The fundamentals of the US economy—the employment market and prices—will remain critical in what the Fed does at its May 3 meeting but the current volatility in markets should also qualify as part of the “totality” of data the Fed is examining. Should financial market conditions deteriorate from here, then the calls for an end to rate hikes and even cuts will grow louder.

Source: Federal Reserve, Emirates NBD Research.