What will the Fed do next?

In a normal economic environment, the Federal Reserve’s two main objectives are price stability and full employment. Suddenly, this has become the least of its worries. On the 10th of March, we left a ‘normal environment’ when Silicon Valley Bank (SVB) collapsed.

Eric Vanraes, Head of Fixed Income, Bank Eric Sturdza SA summarises,

• Price stability and full employment are no longer the Fed’s main objectives
• We see SVB’s collapse ending the Fed’s policy of large rate hikes
• Even tighter monetary policy risks triggering further finance-sector bankruptcies: we see a turning point in bond markets ahead

For more than a month, many investors have wondered when the next catastrophe would occur. The adage “you can’t make an omelette without breaking eggs,” could be translated into “the Fed can’t hike rates from 0% to 5% without impacting some financial players.” The SVB story now reminds us of two precedents: Washington Mutual, which collapsed in 2008 for the same reasons, and the 1987 US Savings and Loans crisis and its domino effect.

Rather than proceeding with more monetary tightening on the 22nd of March and the 3rd of May, the Fed finds itself in a terrible bind. So what can we expect from the next FOMC meeting? It is highly probable that there will be no 50 basis point increase in Fed funds on the 22nd of March. The worst-case scenario would be a rate cut, but we think it is far too early to contemplate that. We do not yet know the full implications of the SVB scandal – and it is a scandal – nor whether we will experience a systemic crisis or a few quick and cheaply-contained disasters.

Longer term, the tremors in the US banking system in recent days should kill off the Fed’s restrictive monetary policy of large rate hikes. Central bank hawkishness in such an environment would be a reminder of 1992 when the Swedish Riksbank raised rates to break a speculative devaluation of the Swedish Krona. The move successfully defended the currency on foreign exchange markets, at the cost of bankrupting its banking system.

For now, markets are not anticipating a Lehman Brothers-style panic and based on existing information, that is a reasonable response. If we were in a Lehman-style environment, the Fed would have already cut rates. Instead, the Fed knows that any further rate hike could trigger further bankruptcies in banks, hedge funds, pension funds, and the real estate market.

Last week, it still looked plausible that the SVB case would prove a storm in a teacup. It looks now more likely that March and April could provide a turning point in bond markets. Let’s hope that central banks will prove wiser than SVB’s bankers.

Adam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements herein are those of Banque Eric Sturdza SA in their capacity as Investment Advisers to the Strategic Bond Opportunities Fund and are valid as at 13/03/2023 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.