Fed minutes hint at likely recession, rattles markets

13 Apr 2023 , 09:30 AM

If you were wondering whether the banking crisis had an impact on the Fed statement of March 2023, then the answer is right there in the minutes. As is the Fed practice, the Fed issued its policy statement on 22^nd March and the Fed minutes have been published exactly 21 days later on 12^th April. This is, perhaps, for the first time that the Fed minutes have explicitly used the word “recession” in their minutes. It emanates from the discussions that concerns over the banking crisis were quite intense. Against the 50 bps rate hike envisaged by the Fed in March, it went to extent of contemplating status quo on rates, before settling for a 25 bps rate hike. But it is the R-word that really caught the attention of the markets.

In the last one year, the Fed had consistently maintained its stance that despite higher rates, the Fed would manage a soft landing for the US economy. However, that confidence appears to be missing in the minutes, which was one of the reasons for the sharp fall in the markets and in the value of the dollar. In fact, the gist of the discussions has been that the banking crisis could not only worsen from these levels, but could be a much bigger systemic risk for the US economy. That has raised the probability of a rate cut in 2023 itself.

CME Fedwatch points to heightened recession fears

CME Fedwatch reflects implied probabilities of future rate hikes based on Fed futures pricing. It is a market based indicator of hawkishness risk. The table below captures probabilities of different rate levels after the eight Fed meets over the the next one 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	Nil	31.2%	68.8%	Nil
Jun-23	Nil	Nil	Nil	Nil	Nil	Nil	29.1%	63.4%	7.4%
Jul-23	Nil	Nil	Nil	Nil	Nil	16.3%	48.13%	32.2%	3.3%
Sep-23	Nil	Nil	Nil	Nil	12.0%	39.6%	36.3%	11.2%	0.9%
Nov-23	Nil	Nil	Nil	7.5%	29.2%	37.5%	20.7%	4.8%	0.4%
Dec-23	Nil	Nil	6.1%	25.1%	35.9%	23.8%	7.8%	1.2%	0.1%
Jan-24	Nil	4.8%	21.2%	33.7%	26.3%	11.1%	2.5%	0.3%	Nil
Mar-24	4.3%	19.6%	32.5%	27.1%	12.6%	3.4%	0.5%	Nil	Nil

Data source: CME Fedwatch

It is said that in economics, a lot can happen in a month. In November 2022, Fed had turned less hawkish, but that had changed by February 2023. Between March and April, the Fed has once again turned less hawkish in the light of rising recession fears. The CME Fedwatch clearly appears to be hinting at lower terminal rates and more dovishness from here.

• There has been a clear leftward shift in the data as evidenced by the table above. Now, markets are targeting Fed rates in the range of 5.00% to 5.25% as the worst case scenario. That leaves room for just one more rate hike of 25 bps from here.

   

• There still appears to be a disconnect between the Fedwatch data and the Fed pronouncements. Fed continues to rule out rate cuts in 2023, but the CME Fedwatch is pegging rate cuts of 50 bps to 75 bps in year 2023 itself.

   

• With Fed rates currently in the range of 4.75% to 5.00%, the markets are penciling in worse case of 25 bps rate hike from here. Terminal rates now look closer to the range of 5.25% to 5.50%, with a reversal possibility in the second half of 2023.

   

• From front-ending of rate hikes, the question is now whether the Fed will also front-end rate cuts? Markets appear to believe so, but we have to wait and watch as consumer inflation in the US has just about fallen to 5% in March 2023, against the 2% target.

Fedwatch is now factoring in lower terminal rates and even front-ending of rate cuts in 2023. At lot will depend on how the risk of recession plays out in the US economy.

What we read from the March 2023 FOMC minutes

Here is what we read from the minutes of the Fed published on 12th April 2023.

1. The highlight of the FOMC minutes was that the meeting had included a detailed presentation from staff members on potential repercussions from the failure of Silicon Valley Bank and others in the mid-sized banking space, with likely systemic impact.

    

2. Staff economists did not put up as brave a face as the vice chair, admitting that the banking crisis could result in the US economy slipping into recession. The staff economists have projected a mild recession starting from the last quarter of 2023.

    

3. The recession fears are evident from the fact that Fed officials expect GDP growth of just 0.4% for all of 2023. However, the staff economists have been confident of growth picking up again from the first quarter of 2024 onwards.

    

4. What emanates from the minutes is that the the FOMC did consider the possibility of holding rates in March. However, with a view to bring down inflation on an urgent basis, the Fed had settled at a 25 bps rate hike in March. There could be a pause in May 2023.

    

5. The recent inflation for March 2023 at 5% is a full 100 bps lower than February and should give confidence to the Fed to possibly hold rates in May. For now, it looks like the peak rates maybe just about 25 bps away with some front ending of rate cuts later.

    

6. It was clear from the minutes that the original plan was a 50 bps rate hike in March 2023, which was toned down to 25 bps only to factor in the risk of SVB contagion. The 25 bps rate hike in March was effectively a compromise solution.

    

7. Currently, markets are assigning a 70-75% probability of one more 25 basis points rate hike in May before a policy halt. There is also a distinct possibility that if the banking crisis worsens, the Fed may start rate cuts in 2023, instead of waiting for 2024.

    

8. An interesting change in the language is on the rate trajectory. Normally, the Fed uses the term “ongoing increases” to describe rates trajectory. That has been changed this time around to “ hikes that may be appropriate”. It indicates more flexibility.

The underlying theme of the Fed minutes was that recession risk is real in the aftermath of the banking crisis. Rate policy, going ahead, would be flexible enough to adjust to the contrary pulls of rising inflation and worsening banking crisis.

What should India read from the Fed minutes?

Two things emerge from the Fed minutes. Firstly, the banking crisis in the US could be more serious than originally imagined, in terms of its systemic impact. That would mean that the US Fed could be much closer to the peak interest rates. Secondly, the market assessment of rate outcomes seems to be more accurate than the Fed pronouncements. The markets had been pegging rate cuts in 2023 in the aftermath of the banking crisis. Even as the Fed put up a brave face, it now appears the Fed may have to cut rates in 2023 itself.

That brings us to the RBI decision to hold rates in its April 2023 policy. While RBI was largely driven by local funding costs and corporate stress, it is also true that it underlined that RBI was willing to chart its own monetary course. The good news for the RBI is that, with the banking crisis in the US, the upsides to rates look limited. That may suit India’s macro interests too; both in terms of hawkishness and in terms of global portfolio flows.