by Blaine Dickason Senior Vice President Trading and Fixed Income Portfolio Management
One year ago this week, the Federal Reserve raised interest rates for the first time since the pandemic began. After two years of holding rates near zero, this first hike to combat rising inflation only raised the policy rate by a mere 0.25%. We’ve always noted that the Fed’s monetary policy has a long and variable lag before it begins to bite the real economy. In fact, it likely takes a year or more for the full economic impact of a rate hike to be felt. As if on cue, the one-year anniversary of that first hike coincided with the first significant turmoil caused by higher interest rates, namely the failure of Silicon Valley Bank (SVB). This obviously gave credence to prior estimates of a one-year lag, but also begs the question: what other lagged effects from higher rates are yet to materialize? The volatility across both stock and bond markets this past week certainly gave new meaning to the term ‘March Madness,’ usually only associated with the annual college basketball tournament also beginning this week.
Every rate hike cycle is accompanied by questions about what might ‘break’ as the ‘brakes’ are applied to the economy. The Federal Reserve increases interest rates to tighten financial conditions and raise the cost of money in an effort to wring inflationary excesses out of the economy. We began 2023 with inflation in decline but still quite elevated. Stronger economic data in January and February raised concerns at the Federal Reserve that inflation might remain stubbornly above target. This directly contributed to a more hawkish testimony by Fed Chair Jerome Powell in front of Congress last week. The subsequent market reaction, which was then pricing in a significantly higher peak rate by the Fed, may have been the proverbial straw that broke the camel’s back, as immediate ripple effects were transmitted throughout the banking system.
Over the last 10 days, financial conditions have tightened at every level. Turmoil in the banking sector will result in tighter lending standards and greater caution throughout the financial plumbing of the economy. These dynamics will contribute to the cumulative effects of this tightening cycle, as they manifest in slower economic output and activity. The market has already issued its forward-looking verdict with expectations for a ‘cut’ to interest rates being increasingly priced into bond yields later this year, despite this past week’s Consumer Price Index (CPI) report showing inflation still uncomfortably above target.
The Fed meets again next week with a rate decision to be issued midday Wednesday. The events of the last week, coupled with the market’s dramatic and abrupt reassessment for lower interest rates, have all added pressure on the Fed to pause. Despite this, and as of this writing, there remains a strong likelihood of a final 0.25% rate increase. As we have learned from both living and studying economic history, this cycle rhymes if not outright repeats itself.
Something finally broke in response to the past year of interest rate hikes. While sometimes ugly, this is how a tightening cycle works. It is always hard to predict what will break in advance, and how long it takes for the cumulative pressures to build. Next week, we will learn how the Fed prioritizes their explicit mandate to curb inflation, with their implicit mandate to ensure financial stability.
Takeaways for the Week:
This past week, the yield on a 2-year U.S. Treasury dropped by the greatest amount since 1987, as the bond markets pivoted from anticipating more rate hikes to new rate cuts later this year.
After nearly a year of steadily shrinking, the Federal Reserve’s balance sheet grew by $298 billion this week due to loans made to other financial institutions at the discount window as well as new funding for SVB and Signature Banks now under FDIC receivership.