US banking crisis limits Fed rate hike to just 25 bps in March

23 Mar 2023 , 10:17 AM

Even ahead of the Fed meeting, the markets had already reconciled that the Fed would limit itself to 25 bps rate hike. This is in sharp contrast to the 50 bps rate hike indicated by the FOMC members in the February 2023 minute. The big event between the February meeting and the March meeting was the aggravation of the banking crisis. Silicon Valley Bank went bust due to a run on its deposits and huge bond losses. This was followed by Silvergate Capital and Signature Bank also folding up. Across the Atlantic, it was Credit Suisse that was sold to UBS, almost for a song, to protect the interests of depositors.

In the run-up to the March FOMC meeting, the question was whether the Fed would opt for Nil rate hike or 50-bps rate hike. Obviously 50 bps rate would be too aggressive when so many small banks were on the brink. Also, Nil rate hike would be like abandoning its inflation battle. Fed wanted to keep its inflation fight and banking crisis separate, since higher rates were just one of the reasons for the failure of these banks. A 25 bps rate hike looked the best compromise; and that is what the Fed did; taking the Fed Funds rate to the range of 4.75% to 5.00%. But the big news is; CME Fedwatch is indicating that terminal rates may be just about 25 bps higher.

What is CME Fedwatch hinting about rate trajectory?

CME Fedwatch reflects implied probabilities of future rate hikes based on Fed futures pricing. The table captures live probabilities of rate levels after each Fed meet for 1 year.

Fed Meet	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
May-23	Nil	Nil	Nil	Nil	Nil	59.1%	10.9%	Nil	Nil
Jun-23	Nil	Nil	Nil	Nil	Nil	16.6%	54.0%	29.4%	Nil
Jul-23	Nil	Nil	Nil	Nil	13.6%	46.6%	34.1%	5.7%	Nil
Sep-23	Nil	Nil	Nil	8.0%	33.0%	39.2%	17.4%	2.3%	Nil
Nov-23	Nil	Nil	3.1%	18.2%	35.7%	30.4%	11.2%	1.4%	Nil
Dec-23	Nil	2.3%	14.3%	31.2%	31.8%	16.2%	3.9%	0.4%	Nil
Jan-24	1.7%	10.8%	26.1%	31.5%	20.8%	7.6%	1.4%	0.1%	Nil
Mar-24	10.4%	22.8%	30.1%	23.0%	10.5%	2.8%	0.4%	Nil	Nil

Data source: CME Fedwatch

The above table has captured probabilities of Fed rate scenarios in the next 8 FOMC meetings, culled from the Fed futures trading data. There is a clearly a huge shift and markets are expecting rates to come down much faster. Here are some very interesting takeaways from the latest Fedwatch trends.

• The banking crisis has apparently restricted the hawkishness of the Fed and the terminal rates are now being pegged at just about 5.25% compared to 5.75% in the February 2023 meeting. Markets are betting on Fed going slow to avoid the banking crisis from spilling over in a big way.

   

• The Fedwatch is pegging rate cuts to start as early as July 2023, which means the market expects the the banking crisis to get a lot worse in the coming months. They are pegging the Fed rates lower by 100 bps by the end of 2023 and by around 200 bps lower from current levels by middle of 2024.

   

• The Fed statement has only hinted at a possible 100 bps cut in rates in the year 2024, but markets are betting that, just like on the upside, the Fed will also have to stretch itself and cut rates rapidly. The banking crisis is likely to put pressure on funding of corporates, so lower rates woule be the next best option.

   

• While the Fed has indicated terminal rates to peak at 5.50%, the markets are expecting the rates to peak at 5.25% itself. That would give the Fed another challenge; how to ensure that higher rates do not become a drag on the recovery in the US economy in the light of the banking crisis?

Unless things improve drastically on the banking front (which looks remote), Fed rates may be very close to its peak terminal rates. Subsequent rate action will be more critical.

8 things we gathered from the Fed March 2023 statement

Here are 8 key takeaways from the Fed statement issued post the FOMC meet, late on 22nd March 2023.

1. The Federal Reserve persisted with its rate hikes in the March meeting. However, the FOMC toned down and maintained its rate hike at just 25 basis points. This takes the Fed rates to the range of 4.75% to 5.00%. 

    

2. The Fed statement was as much about inflation as it was about the banking crisis triggered by the collapse of Silicon Valley Bank. Since higher rates posed a capital valuation problem for bond portfolios, Fed is being more calibrated.

    

3. March 2023 was a typical Fed trade-off. The Fed had to still give the image that it was in charge of the inflation situation and would leave no stone unturned to bring it down to 2%. At the same time, it had to also reassure deposit holders that their deposits with the banks were safe. This was the compromise formula.

    

4. Powell emphasized that the current rate hike did not factor any assumptions on credit slowdown. A banking crisis will make banks less willing to lend and that could trigger a credit crunch in the economy. In such an event, the Fed has assured it would be more than willing to open the credit taps; a statement thatled to dovish expectations.

    

5. Accoridng to Powell, the issue is not  just about a credit crunch, but about the intensity and duration of the credit crunch. Loosening of liquidity can be justified only if the credit crunch was prolonged and intense. The markets are expecting such a situatin to manifest in the next few months.

    

6. The big open question is whether the Fed would also protect uninsured deposits of US banks; and if so to what extent. Powell only mentioned that the Fed would use all necessary tools to protect depositors, without specifying details of strategy.

    

7. One big change between the Fed stance in the last 15 days is the confidence that the Fed had originally shown in keeping rate policy separate from the banking crisis. However, that looks tough, with the overlaps being too intense to ignore.

    

8. Finally, Powell reacted to the CME Fedwatch hinting at rate cuts of 200 bps by mid-2024. Powell emphasised that rate cuts were not on the agenda, at least in 2023, since inflation was still too high to warrant a rate cut. The last word is yet to be said.

It is the banking crisis that appears to have enveloped the Fed statement and that is likely to impact the trajectory of rate hikes; like it or not.

What the Fed statement means for RBI

For now, there is unlikely to be significant in the RBI stance. It had hinted at another rate hike of 25 bps in the April 2023 MPC meet and that would happen. Majority of the MPC members (barring Jayanth Varma and Ashima Goyal) are still veering towards using rate hikes to control inflation expectations. Also, the impact of the banking crisis is still limited to the US and Europe, although rate hikes have impacted corporate operating margins and bond portfolios of banks. At this juncture, the RBI may not want to tinker with its long term perspective and would stick to its 25 bps rate hike in April. However, April may also see a hint from the RBI that, like in the US, that Indian economy was also close to its terminal peak rates of interest. That would surely be good news for markets.