Midweek calm a case of being in the eye of the storm?

Ironically, the Fed’s loan program could support interest rate expectations enough to trigger another sharemarket sell-off, prompting the Fed to wave a bigger stick at the market.

Federal Reserve chair Jerome Powell. Picture: Getty Images

As US bank shares stabilised, interest rate rises began to be priced back in by markets.

A day earlier, shares of the big US money centre banks fell about 5 per cent and some regional banks suffered high-double digit percentage falls, with the KBW Bank index diving 11 per cent.

Market pricing of rate increases may not get all the way back up to highs seen before the collapse of Silicon Valley Bank, which triggered huge falls in US regional banks and contagion effects globally.

The midweek calm may yet prove to be the eye of the storm. But having seen the pandemic response from central banks, even young investors know the playbook for systemic risk.

Central banks, led by the Fed, won’t allow regional bank strife to cause sustained falls in the share market. If regional banks dive again this week, the Fed will almost certainly upscale the $US25bn ($32bn) backstop to its newly implemented Bank Term Funding Program.

The BTFP is effectively quantitative easing: there’s nothing to stop US banks buying cheap US Treasuries and parking them with the Fed for a year – at par value – and getting cash to invest.

It’s just not unlimited quantitative easing at this stage. But the Fed will get there if pushed by a sharemarket crash caused by fear of what else might be uncovered by the tide of easy money receding.

The short-term “reaction function” is that financial instability concerns trump inflation concerns.

“The message is clear – ‘higher-for-longer’ (interest rates) lead to financial instability,” said Macquarie Equities head of global strategy Victor Shvets.

The collapse in rate rise expectations was “extreme” but “the deregulation impulse” that tends to dominate the US business-oriented culture during periods of calm, is “firmly back in reverse gear.”

While the hastily created Fed loan program should restore depositor confidence — almost any asset can be accepted at face value, irrespective of market prices – Shvets thinks the upheaval may boost the long-term positioning and profitability of the largest banks.at the expense of smaller ones.

“Our highly leveraged and financialised world has also sent an unequivocal message to the Fed: the idea of higher-for-longer (interest rates) to erode aggregate demand and capital values in order to bring down inflation is a recipe for potentially catastrophic outcomes,” he said.

As deposits fall, and yield curves get more inverted, he worries that capital might freeze and refuse to lubricate the most vulnerable parts of the system, “forcing the Fed into various forms of QE, ‘bailouts’, emergency lines (of credit) and the like.”

In his view the “extremely hawkish and open-ended turn by the Fed” over the last 10 days precipitated the crisis for fragile smaller banks, and the subsequent repricing of the Fed’s terminal rate from 4.8 per cent in early February to 5.7 per cent last week was the “tipping point.”

Highlighting the importance of financial stability, the Fed announced Monday that vice chair for supervision Michael Barr is leading a review of the supervision and regulation of Silicon Valley Bank, in light of its failure, with the review due to be publicly released by May 1.

“The events surrounding Silicon Valley Bank demand a thorough, transparent, and swift review by the Federal Reserve,” said Fed chair Jerome Powell.

“We need to have humility, and conduct a careful and thorough review of how we supervised and regulated this firm, and what we should learn from this experience,” said vice chair Barr.

The Reserve Bank led Council of Financial Regulators echoed such concerns, as minutes of last Friday’s meeting on the impact of high inflation and interest rates on Australian households and financial systems revealing the CFR reconvened to discuss the fallout of the collapse of SVB.

The CFR said it met to discuss the regulatory response in the United States, with APRA noting it would “continue to closely monitor the situation through its intensive supervision of the Australian banking system, which remains strongly capitalised and highly liquid”.

But stubbornly high US inflation may not go away without even higher interest rates.

The Fed’s new BTFP loan/QE program could even add to US inflationary pressure.

February US core CPI print of 0.5 per cent on-month versus 0.4 per cent expected, core services inflation ex-services hitting a five-month high of 0.5 per cent, and the annualised three-month average of core inflation rising to 5.1 per cent versus the six-month month average of 5.2 per cent.

As of Wednesday, the thought was that, having stopped the bleeding in US banks with its loans program, the Fed can go ahead and lift by 25 basis points at 5am AEDT next Thursday.

As with the interest rate decision, the Fed official’s interest rate projections will also be potentially market-moving, but as usual, won’t be a useful guide to what actually happens to Fed funds.

Currently, the Fed’s “dot-plot” projections show Fed funds rate midpoints of 5.125 per cent, 4.125 per cent and 4.375 per cent for year ends out to 2025, and a long-term rate of 2.5 per cent.

Maintaining those projections despite inflation pressures, or lowering the shorter-term projections would be a low-cost way of signalling that the Fed is very serious on financial stability, even as inflation remains excessively high, and still the number one problem for the Biden Administration.

The US market was 75 per cent priced for a 25 basis point Fed rate lift in March and had 34 basis points priced in for May, up from 20 basis points a day earlier.

But ironically, the Fed’s BTFP loan program could support interest rate expectations enough to trigger another share market sell-off, prompting the Fed to wave a bigger stick at the market.

The Australian market couldn’t quite bring itself to price another rate lift after being forced into such a U-turn by the capitulation of US bond market bears this week, but rate rises were priced out.

Australian shares tracked the US rebound, with defensive growth companies in demand, and investors were encouraged by the fact that the ASX 200 index regained its 200-day average.