#124 – Will it change the direction of Federal Reserve policy?

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#124 – Will it change the direction of Federal Reserve policy?

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Federal Reserve – In this article you’ll find:

  • Something broke. How the Fed and Markets could translate it into the economy?
  • Two more hike rates in US. Will be the last two ones?
  • U.S. stocks and economy update
  • Fastest pace of rate hikes in decades since 1980. Are we ready for the consequences?
  • Is a credit crunch looming?
  • Global stocks and economy among the Group of Seven (G7) economies
  • The impact of tighter monetary policy on credit conditions
  • S&P 500 Index Financials industry-level composition

Here you can find other articles:

  1. Market Perspectives – Rising odds of a higher interest rate
  2. Is business come back as normal?
  3. What the Fed wants and what markets want

ENJOY THE ARTICLE

Something broke

Federal Reserve

There’s an old saying about Federal Reserve tightening cycles: The Fed “tightens until something breaks.”

Cracks emerged during the first quarter of this year, as rising rates, tighter lending conditions, and shrinking liquidity weighed on economic growth.

The banking system turmoil that emerged near the end of the quarter was an unsettling addition to investor concerns.

The question is what the central bank will do next.

For Charles Schwab the Fed is trying to thread a needle in balancing the threats associated with the banking crisis and the need to combat still-high inflation.

Fed Chair Jerome Powell made it a point to say there were costs to bringing inflation down to the Fed’s 2% target, but the costs associated with allowing inflation to remain high would be more severe.

Recent events have raised the risk of a credit crunch hitting the economy and also taking care of the inflation problem at the same time.

Nordea Asset Management remains one of more ECB rate hikes, but higher rates also increase such risks longer out further.

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Two more hike rates in US

But despite this volatile market environment, we expect the Fed to hike rates twice more and the ECB three further times, both calls above what the markets are currently pricing in.

This leaves bond yields and interest rate expectations room to rise from current levels.

U.S. stocks and economy

The reality, however, for those trying to guess what the Fed is likely to do, is that recent issues in the banking system will likely continue to be important factors in the Fed’s thinking.

Fastest pace of rate hikes in decades

Federal Reserve

A little recent background: Beginning in 2020, the COVID-19 pandemic and the commensurate epic monetary and fiscal policy response to it led to a surge in money supply and financial system liquidity.

Lending became easier and cheaper, and investors often looked to riskier investments—such as high-yield bonds or “growthier” stocks—in search of higher yields and returns.

However, rising inflation forced a course correction in 2022. During the past year, the Fed has raised the federal funds target rate at the fastest pace in 40 years in an effort to cool the economy and inflation.

Not surprisingly, as the tide of liquidity rolled out and economic growth slowed, investors began to reconsider some of these riskier investments.

Is a credit crunch looming?

The Euro-area credit environment was tightening already before the recent banking worries.

The share of banks tightening credit standards in the ECB’s Q1 Bank Lending Survey was the highest since 2012, and recent developments will probably only accelerate that process.

Bank lending growth has slowed down clearly as well, and for example loans to non-financial companies have fallen in three of the past four months, while also loan growth to households has slowed down considerably.

Such developments are a natural part of the ECB’s attempts to tighten financing conditions and are no surprise in an environment of tighter monetary policy.

According to Nordea Asset Management tighter financing conditions, inturn, are needed to slow down the economy, cool the labour markets and with that act as a brake for wage gains, which in turn will help in pushing inflation rates lower.

Federal Reserve

Global stocks and economy

A key issue for Charles Schwab over the coming months will be the extent to which recent events cause banks to reduce lending.

This in turn would weigh on consumer demand and business investment and therefore accelerate the deterioration in the global economy.

One of the complex aspects of the current economic slowdown has been the rolling aspect of it.

There have been many negative Gross Domestic Product (GDP) quarters lately among the Group of Seven (G7) economies.

Yet Canada’s oil-driven economy has avoided declines as it benefits from rebounding demand and tight supplies, few of the negative quarters have been back-to-back, and the timing has not been synchronized across all the economies.

The impact of tighter monetary policy on credit conditions

The impact of tighter monetary policy on credit conditions is already clearly visible in the data, but the ECB has recently argued that the transmission of higher rates to the real economy may have weakened.

There is a clear case for such arguments, as the share of variable-rate mortgages in the Euro area has fallen, governments have increased the duration of their debt and there are signs that with firms facing labour shortages, they are hoarding labour and reducing hours worked rather than cutting jobs.

This implies that the sensitivity of the labour market to slowing growth has been reduced.

Alarm from the Money Supply numbers

Federal Reserve

Money supply numbers are already sounding the alarm, with M1 money contracting in annual terms for the first time since at least the 1980s.

True, this follows exceptionally rapid growth during the pandemic, and may reflect the flow of deposits to time deposits carrying a higher interest rate.

Furthermore, the broader M3 money growth is not yet at extraordinarily low levels.

We think the majority of the ECB Governing Council members remain concerned about the inflation outlook, and will press for more rate hikes, until there are convincing signs that inflation is firmly on the way towards the target.

Risks have increased that the costs of this process will be to tip the economy into more than a modest recession.

S&P 500 Index Financials industry-level composition

As the turmoil in banking eventually subsides, there is likely renewed interest in supervision and regulation of banking institutions.

The regulatory scrutiny of smaller banks probably rises with calls for them to hold more on-balance-sheet liquidity, as well as more capital.

Wells Fargo sees the higher liquidity and capital requirements, plus greater regulatory and supervisory expenses combining to reduce the return-on-equity potential of regional banks.

This diminishes their investment appeal, we think, especially since a new and perhaps more interesting sub-industry, Transaction and Payment Processing Services, joined the sector this month.

Constituents of this new sub-industry are imports from the Information Technology sector.

Given their businesses are both established and new payments technologies, we believe these companies should have naturally higher growth rates than most current Financials sector names.

Even though that growth may come with a higher volatility profile, these additions to the sector may be an option for investors wanting to take a fresh look at exposures in financial services.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.

In doing so he shares with you the most interesting charts and comments.

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