To Hike Or Not To Hike

The fallout from Silicon Valley Bank’s collapse continued last week despite several US authorities racing to contain the crisis. At one point, global financial stocks had lost a whopping $465 billion in market value before rebounding a bit as the week progressed. The latest turbulence is proving to be a major headache for central banks who are trying to contain inflation through higher interest rates but are starting to see cracks in the banking system as a result of those rate hikes. The European Central Bank went ahead anyway with a 50-basis-point hike last week but ditched a previous commitment to continue raising rates significantly at a steady pace. Now, the question is, what will the Fed do when it meets this week? After all, inflation is still rampant in the US, with data out last week showing core consumer prices increasing by 0.5% in February – the most in five months and above economists’ forecasts for a 0.4% gain. Find out more in this week’s review.

Macro

The Fed is in a very tricky position, to say the least. On one hand, its most aggressive rate-hiking campaign in decades has led to heavy losses in banks’ holdings of fixed-income instruments – one of the key factors behind Silicon Valley Bank’s collapse. That’s causing widespread panic in the banking sector and suggests that the Fed should pause or even reverse its rate-hiking campaign when it meets this week. But on the other hand, consumer price gains are still rampant in the US, suggesting that the Fed should stick to its guns and continue raising interest rates until inflation returns to its 2% target.

In fact, the latest inflation report out last Tuesday showed consumer prices increased by 6.0% in February compared to the same time last year. Although that was a step down from the 6.4% pace registered during January, inflation is still elevated and remains three times higher than the Fed’s target. Core consumer prices, which strip out volatile energy and food components, rose 5.5% in February. That was only 0.1 percentage points lower than the 5.6% pace recorded the month before.

On a month-on-month basis, core consumer prices increased by 0.5% – the most in five months and above economists’ forecasts for a 0.4% gain. The acceleration in the monthly core figure leaves the Fed in a tough position as it tries to thwart still-rapid inflation without adding to the turmoil in the banking sector. Just before the crisis came to fruition last week, Fed Chair Jerome Powell had opened the door to reaccelerating the pace of rate hikes, but many economists now expect the central bank to either stick with a smaller 25-basis-point increase or pause entirely when it meets this week. What’s more, interest rate futures were pricing a peak interest rate of about 4.95% after the inflation report, implying that the upcoming rate hike could be the Fed’s last. That’s amazing considering that markets were pricing in a terminal interest rate of around 5.7% just ten days ago…

To assess how the Fed (and Bank of England, which also meets this week) might act, look no further than the European Central Bank (ECB): its interest rate decision last week was seen as a test of policymakers’ appetite to keep raising rates despite the stress in the banking sector, with the ECB going ahead with a planned 50-basis-point hike last Thursday. That took its deposit rate from 2.5% to 3% – its highest level since 2008. But in light of the latest turmoil in the banking sector, the ECB ditched a previous commitment to keep “raising interest rates significantly at a steady pace”. Traders certainly think the ECB will now do less: they’ve pared their bets on the central bank’s peak interest rate to 3.15% from 4.2% a week ago.

Quarterly economic projections that accompanied the ECB’s announcement showed inflation slowing more than previously thought this year, alongside stronger underlying price gains. The central bank lowered its 2023 inflation forecast from 6.3% to 5.3% – but core inflation, which excludes energy and food, is expected to be higher this year at 4.6%, indicating more policy tightening could be required.

Elsewhere, new data out last week pointed at a continued recovery in China’s economy after the country dropped its zero-Covid policies a few months ago. Retail sales in the world’s second-biggest economy rose 3.5% in January and February compared to the same period last year. That’s a marked return to growth after declines in each of the last three months of 2022, and will undoubtedly please policymakers who made boosting domestic demand one of their top economic priorities for this year. The data also showed industrial output rising 2.4% in the first two months of 2023 and fixed-asset investment growing by 5.5%, as local governments increased infrastructure spending to spur the recovery. Still, China’s National Bureau of Statistics warned in a statement that the economic recovery’s foundation was “not yet solid”, and said that the government would take measures to further boost domestic consumption.

Stocks

Several US authorities raced last week to contain the fallout of Silicon Valley Bank’s collapse, which marked the second-biggest US bank failure in history. The Treasury Department, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC) all issued a joint statement on Sunday (12-March) aimed at strengthening confidence in the banking system and stemming contagion to other lenders. The FDIC, which is the body that guarantees customer deposits, said that SVB’s depositors would be fully repaid. That promise was extended to Signature Bank – another lender that failed this month. The Fed, meanwhile, announced a new lending facility aimed at providing extra funding to eligible institutions to ensure that “banks have the ability to meet the needs of all their depositors”.

But all those promises did little to reassure investors the day after, with a selloff in the banking sector resuming at the start of last week. That meant global financial stocks had lost a whopping $465 billion in market value over two trading days by the end of last Monday. Investors are naturally worried about possible contagion to the wider banking sector after the three failures this month (SVB, Silvergate Capital, and Signature Bank). US regional banks were among the hardest hit last Monday, with the KBW Regional Banking Index sinking 7.7% – its sharpest plunge since June 2020.

What’s more, SVB’s fallout is fueling concerns that other financial firms could also be sitting on huge paper losses from their investments in bonds and other fixed-income instruments. These securities have fallen sharply in price as central banks aggressively raised interest rates during the last 12 months. The chart below shows the extent of the damage to banks’ portfolios, and certainly ain’t pretty. The one silver lining from all the turmoil is that it sparked a flight to safety, with Treasury bonds surging last week. That’ll go some way to offsetting some of the banks' investment losses.

This week

• Monday: Nothing major.
• Tuesday: US existing home sales (February). Earnings: Nike. 
• Wednesday: UK inflation (February), Fed interest rate decision.
• Thursday: US new home sales (February), Bank of England interest rate decision, eurozone consumer confidence (March).
• Friday: Japanese inflation (February), UK retail sales (February), and March PMIs for the US, eurozone, and UK.