Markets took a deep breath yesterday, reversing higher to a large degree despite the ongoing fallout in the banking system. The side effects to big changes in interest rates, along with extremely volatile yield curve moves one week after a severe inversion, have manifested into stressed financial conditions in the banking system. Two-year Treasury yields have fallen off by 90 basis points in one week, suggesting the Fed may pivot towards a relaxed monetary policy this year. However, solid economic data such as lower than expected unemployment claims, better than expected housing starts, and Consumer Price Index numbers that are still three times the Fed target of 2% have given investors a chance to get back to worrying about inflation.
The Fed has quite a dilemma in choosing to fight inflation by staying the course with another 25 bp rate hike next week, or risk fueling another resurgent rise in inflation. According to Fed funds probability from the CME Group, there is a nearly 80% probability of a 25 bp hike next week and a 62% probability in of another 25 bp hike in May. Much like the European Central Bank, which recently lifted rates by half a percentage point despite instability in the banking system, it appears the Fed is still under pressure to emphasize concerns about price stability rather than easing rates for the sake of financial stability.
To deal will financial instability, the Fed has once again increased the size of the balance sheet by nearly 300 billion dollars in a week to ensure ample liquidity is available to banks under funding duress via discount lending. Any need for additional central bank credit extended through backstop lending indicates the banking system remains stressed, and banks will be more cautions on lending standards as the situation plays out over time. With that said, even as the Fed continues to raise interest rates for the sake of stemming inflation it is important to consider that any increase in the Fed’s balance sheet represents a de facto quantitative easing (QE). Based on the strong price action in equities yesterday on the back news of the larger balance sheet, perhaps the recent banking crisis ignited the beginning of the next cycle of QE which may be supportive of equities in the near-term.
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