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Investment Strategy

March 20, 2023

Investment Strategy Brief: Monetary Madness

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Below is a transcript of this week’s video:

With just a few days until the Federal Reserve’s next interest rate decision, U.S. policymakers are sitting between a rock and a hard place. The recent banking sector meltdown, triggered partially by Silicon Valley Bank crumbling under the weight of higher interest rates, has led some analysts to call for a moderation on rate hikes until the industry sorts itself out.

At the same time, February’s inflation data show progress in bringing inflation down, but perhaps less than the Federal Reserve would like to see. The headline and core inflation numbers on a year-over-year basis registered 6.0% and 5.5% gains, respectively. Now both seem to have peaked and have moderated over the last few months, but both remain above the Federal Reserve’s target of 2.0-2.5%.

Now if we look at month-over-month data, we can see that certain components have yet to moderate. Ideally, the Fed would prefer to see monthly inflation fall to (or preferably below) the 0.3% range in the short to medium-term, which if annualized would be roughly consistent with their longer-term target range. Looking at the last 3-month average of month-over-month changes in the subcomponents of goods, shelter and services excluding shelter, we see that, overall, goods price inflation has declined, but other components that are stickier remain above the Fed’s comfort zone. Fed Chair Powell has pointed to “services excluding shelter” as a key subcomponent that will be monitored to gauge embedded inflation trends in the U.S. economy.

In addition to inflation, the Fed is now facing a financial stability issues. As a result of several bank failures, concerns about contagion across the banking sector have largely mounted. The St. Louis Fed Financial Stress index measures the degree of financial stress in the markets. The average value of the index is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values above zero suggest above-average financial market stress. At this point, this index is not yet showing widespread stress.

Still, as concerns were mounting, credit default swaps on various U.S. banks creeped higher last week. Considering that many regional banks have large amounts of uninsured deposits, this has led some to seek their deposits. However, there has been coordinated government action from the FDIC and Treasury as well as the Federal Reserve to alleviate fears of contagion. As Silicon Valley Bank and Signature Bank entered receivership, the FDIC guaranteed all deposits. The Federal Reserve established the Bank Term Funding Program (BTFP) and increased its balance sheet by 300 billion in the last two week. In addition to the Fed’s new emergency lending system, a group of large banks stepped in to shore up First Republic Bank’s balance sheet with a $30 billion lifeline, seen as an effort to stabilize the bank’s deposit base and reinforce confidence in the U.S. banking system. Over the weekend, the FDIC negotiated a deal for NY Community Bancorp to purchase Signature Bank’s assets and continued to shop the assets of Silicon Valley Bank.

In reaction to the fallout from Silicon Valley and Signature Banks, expectations have mounted that the Fed may be less aggressive with its rate hikes to avoid exacerbating stresses in the banking sector. Fed funds futures markets are now pricing in a ~75% probability of a quarter-point rate hike in March, alongside a 25% chance of no change. This is a quick reversal in expectations after Fed Chair Powell’s hawkish commentary prompted markets to price in an over 70% chance of a half percent rate hike just two weeks earlier.

But given all of this, where does that leave the state of monetary policy at this point? Well to start, the fed funds rate remains meaningfully above the neutral level, suggesting that the state of policy is tight. The fed funds futures market at the end of February suggested that investors were pricing in a path of additional rate hikes this year with the curve peaking at 5.3% and no longer see a rate cut as a sure bet in 2023. Now, the futures market anticipates at least a full percentage point of rate cuts by year-end. However, investors should be careful to temper their expectations for premature rate cuts given that inflation does not yet appear to be anywhere near the Fed’s 2% target.

Investors should pay close attention to the FOMC’s dot plot published alongside the standard press release following this week’s meeting, which should give clues as to where the committee’s members see the fed funds rate heading over the next few years.  With that said, it remains to be seen how the Fed will balance the risks associated with high inflation and financial stability.

To summarize, the Federal Reserve faces a challenging trade-off between containing inflation and maintaining financial stability. Recent hotter-than-expected inflation reports did little to relieve worries as stickier items like services and shelter continue to post notable gains AND recent rapid deposit withdrawals and regional bank failures have pushed regulators to act quickly to protect the financial system. While recent bank difficulties are symptomatic of the economic difficulty cause by the Fed’s rate hikes, such rate hikes are necessary to cool inflation. Therefore, the Fed is likely to announce another quarter-point rate hike this week, but has no intention of allowing the financial system to unravel.



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