March 25, 2023: Interest rate divide: market expectations vs. Fed projectionsThis week, the Federal Reserve announced its decision to raise its key short-term interest rate by another quarter percentage point. The Fed is anticipating another quarter-point increase to a peak range of 5.00%-5.25%. The current Fed expectation is rates will fall to 4.30% next year. However, the market expectation is the Fed is going to have to cut rates sooner to fight the recession that it helped create. The bond market is pricing in a 1.5% cut in rates within the next two years. This will drop rates to around 3.5%. There is clearly a disconnect between the Fed and the bond market. I believe the bond market has it right and the Fed will cut rates sooner than expected. The bond market has been one step ahead of the Fed the entire time. Even the stock market never sold off much when the Fed warned of higher rates.
While the Fed remains confident in the overall stability of the financial system, it acknowledges that recent developments are likely to result in tighter credit conditions for households and businesses, which will weigh on economic activity, hiring, and inflation. In their statement released after the two-day meeting, Fed officials acknowledged recent strains in the nation’s banks and said it will soften the economy.
The Fed plan all along was to push rates up until something broke. Many market strategists have urged the Fed to pause rate hikes, as they have undermined the value of treasuries and other securities, which are a critical source of capital for most US banks. The collapse of Silicon Valley Bank was a stark reminder of how quickly a liquidity crisis can arise. Despite this, Fed Chair Powell defended the decision to raise interest rates, stating that the crisis was the equivalent of a rate hike and perhaps more significant. He added that “it’s too soon to tell” how much stricter bank lending will hobble the economy and tame inflation, but said it could be more significant than expected, and the Fed “may have less work to do.”
On a more positive note, the yield curve is starting to flatten, and yields are dropping. This should help to alleviate some of the losses on bank balance sheets. It is surprising that many of the Federal Reserve members are also from US commercial banks, and they didn’t adjust or warn other banks to shorten maturity. A few banks such as JP Morgan, PNC, and M&T Bank correctly anticipated higher rates, but many other banks locked in low rates way too soon.
On Friday, Deutsche Bank’s stock dropped as investors worried about which bank could be next to fall. There has been a flight to move money out of the banking system. The troubles overseas look much worse than what is happening in the U.S. Most of the money from the banking sector is going into treasuries and money markets. The two-week increase in outstanding U.S. money market funds had the largest increase since April 2020. Also, the Fed’s balance sheet just expanded the most for a two-week period since May 2020. Bank profits will likely take a big hit in the next few quarters. Bank stocks have lost so much value that they now look much less vulnerable. The large-cap growth sector has been the most resilient. The hardest-hit area is small caps, which are the most sensitive to a recession. If the market cycle repeats, small caps are setting for big gains if there is a recession. The trend continues to be that Investors are buying growth stocks in anticipation of future interest rate cuts by the Fed. There is also a strong case to buy dividend-paying stocks once again as interest rates fall. In the meantime, the problems at Deutsche Bank need to be resolved just as they were last week when UBS took over Credit Suisse. Hopefully, the German government can put together a plan over the next few weeks if that stock starts to drop more in value.
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This week, the Federal Reserve announced its decision to raise its key short-term interest rate by another quarter percentage point. The Fed is anticipating another quarter-point increase to a peak range of 5.00%-5.25%. The current Fed expectation is rates will fall to 4.30% next year. However, the market expectation is the Fed is going to have to cut rates sooner to fight the recession that it helped create. The bond market is pricing in a 1.5% cut in rates within the next two years. This will drop rates to around 3.5%. There is clearly a disconnect between the Fed and the bond market. I believe the bond market has it right and the Fed will cut rates sooner than expected. The bond market has been one step ahead of the Fed the entire time. Even the stock market never sold off much when the Fed warned of higher rates.
While the Fed remains confident in the overall stability of the financial system, it acknowledges that recent developments are likely to result in tighter credit conditions for households and businesses, which will weigh on economic activity, hiring, and inflation. In their statement released after the two-day meeting, Fed officials acknowledged recent strains in the nation’s banks and said it will soften the economy.
The Fed plan all along was to push rates up until something broke. Many market strategists have urged the Fed to pause rate hikes, as they have undermined the value of treasuries and other securities, which are a critical source of capital for most US banks. The collapse of Silicon Valley Bank was a stark reminder of how quickly a liquidity crisis can arise. Despite this, Fed Chair Powell defended the decision to raise interest rates, stating that the crisis was the equivalent of a rate hike and perhaps more significant. He added that “it’s too soon to tell” how much stricter bank lending will hobble the economy and tame inflation, but said it could be more significant than expected, and the Fed “may have less work to do.”
On a more positive note, the yield curve is starting to flatten, and yields are dropping. This should help to alleviate some of the losses on bank balance sheets. It is surprising that many of the Federal Reserve members are also from US commercial banks, and they didn’t adjust or warn other banks to shorten maturity. A few banks such as JP Morgan, PNC, and M&T Bank correctly anticipated higher rates, but many other banks locked in low rates way too soon.
On Friday, Deutsche Bank’s stock dropped as investors worried about which bank could be next to fall. There has been a flight to move money out of the banking system. The troubles overseas look much worse than what is happening in the U.S. Most of the money from the banking sector is going into treasuries and money markets. The two-week increase in outstanding U.S. money market funds had the largest increase since April 2020. Also, the Fed’s balance sheet just expanded the most for a two-week period since May 2020. Bank profits will likely take a big hit in the next few quarters. Bank stocks have lost so much value that they now look much less vulnerable. The large-cap growth sector has been the most resilient. The hardest-hit area is small caps, which are the most sensitive to a recession. If the market cycle repeats, small caps are setting for big gains if there is a recession. The trend continues to be that Investors are buying growth stocks in anticipation of future interest rate cuts by the Fed. There is also a strong case to buy dividend-paying stocks once again as interest rates fall. In the meantime, the problems at Deutsche Bank need to be resolved just as they were last week when UBS took over Credit Suisse. Hopefully, the German government can put together a plan over the next few weeks if that stock starts to drop more in value.