Macro Insights: The Fed question lingers - to hike or not to hike

Using the right tools for the right cause

There is no doubt that the risks of a financial crisis have further complicated the monetary policy response function in the US. But looking at the response of the authorities to the financial risks, there is reason to believe that they have maintained the room to continue their fight against inflation. A pause or a cut at the March meeting, despite market remaining orderly from here, would spell panic for investors who would sense this as the Fed potentially still being cautious of systemic risks. Inflation print isn’t spelling relief yet, and the Fed will need to maintain its inflation-fighting credibility.

It will therefore be important for the Fed to decouple monetary policy from financial risks, while standing ready to respond to any market disorders to avoid creating further panic. The Bank of England, in a similar move in September, had to respond to market disorders by adding short-term liquidity but the monetary policy stayed focus on the price pressures and we have seen 175bps of rate hikes since then.

Credit risks on watch

The credit market remains key to monitor to asses any further stress in the system. Our Head of Equity Strategy, Peter Garnry, has noted the key indicators to watch in this piece. The FRA/OIS spread, or the spread between the U.S 3-month forward rate agreement and the 3-month overnight index swap rate, is a key funding stress indicator. The measure expanded to its widest since March 2020, although has cooled somewhat now. But there are still a lot of uncertainties ahead and this indicator remains key to monitor. If it rises again or remains elevated, it would suggest that the system remains fragile and vulnerable to further shocks.

The mass credit rating downgrades in the US banking sector yesterday are a further cause of concern. Moody’s has cut the outlook for the US banking system to negative from stable and placed six US lenders on review for downgrade. The S&P also placed First Republic on Negative Creditwatch.

The other key indicator to track will be the financial conditions in the US, which have tightened the most for this cycle mostly due to the widening in credit spreads. This can be significantly more impactful for growth outlook or the outlook for the equity markets rather than a large interest rate hike which takes time to trickle down to the economy.

Implications

Even if the Fed stays focused on inflation in the near-term, the longer-run path is now quite uncertain. Growth concerns have risen with banks likely to tighten lending standards which could have a larger and quicker impact on the real economy compared to a rate hike. But with inflation still remaining uncomfortably high, and potentially boosted further by China reopening and the Fed’s added liquidity measures, this means we might be now heading towards Stagflation.

Another key thing to consider is that corporate margins could squeeze further, and the impact may be invariably larger for the smaller enterprises (best represented by RUSSELL 2000) as bank failures dent sentiment. The NFIB survey released yesterday also indicated that inflation remains the biggest problem for small enterprises in February in the US.

So in a way, rising risks of growth slowdown could bring yields lower, but the risk premium is likely to rise. Near-term yields could remain highly volatile as growth, inflation and market risk dynamics are interpreted. But flight to quality will likely prevail as we are getting into a tougher economic environment.