More hikes may worsen crisis

Fed Reserve Chair Jerome Powell is likely to back away from his hawkish testimony on higher terminal rates while reiterating the Fed’s commitment to containing inflation. (Photo by Win McNamee / Getty Images via AFP)

Stubbornly-high inflation and a tight US labour market is expected to lead the Fed to deliver another rate hike early Thursday Australian time despite a nascent crisis that’s slammed US regional banks, forced a “merger” between Credit Suisse and UBS, and led to emergency loans and liquidity support measures from central banks in the US and EU, all in under two weeks.

But after the fastest interest rate hiking cycle in decades, more rate hikes will worsen the current crisis and catalyse other unintended consequences of hikes, thereby accelerating a shift to cuts.

J.P. Morgan’s head of global strategy, Marko Kolanovic, said the Fed is “likely already past the point of no return – a soft landing now looks unlikely, with the aeroplane in a tailspin (lack of market confidence) and engines about to turn off (bank lending).”

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The crisis has been bad for risky assets like shares, the Australian dollar and industrial commodities and good for safe-havens like gold, government bonds and the Japanese yen.

But with mega-cap US growth stocks rebounding as US interest rate bets imploded last week, the S & P 500 was only 1 per cent below its level before the Silicon Valley Bank hit the headlines.

Australia’s S & P/ASX 200 index almost 5 per cent below its equivalent pre-SVB crisis level, owing to its high concentration of banks and large economically-sensitive stocks in the resources sectors.

After the ECB hiked by 50 basis points last Thursday – without immediately worsening the banking crisis – US interest rate futures were 72 per cent priced for a 25bp Fed hike, although that was still well down on the near certainty of a 50bp hike that had been expected earlier this month.

The market-implied Fed funds rate was 50bp lower by November, implying three cuts from a peak range of 4.75-5.00 per cent versus 4.50-4.75 per cent now.

Australian rates market pricing now implies 50bp of cuts by year end.

It came as the WSJ said JPM CEO Jamie Dijmon lead efforts to craft a new First Republic Bank rescue plan after a $US30bn ($45bn) deposit by the biggest US banks last Thursday failed to stop investors driving down the share price of the troubled regional bank by 47 per cent on Monday.

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On Bloomberg TV, JPM’s Mr Kolanovic went on to say that bank failure, market turmoil and ongoing economic uncertainty have increased the chance of a “Minsky moment” – the end of a speculative boom that sees investors take on so much risk that lending exceeds what borrowers can repay.

No doubt, years of quantitative easing and record low interest rates – in some places negative – pressured investors to take risks.

That was evident with the complete writedown of Credit Suisse contingent convertible bonds.

“And of course even more perversely, this is yet-another negative consequence of the past ‘bad’ behaviour of central banks, as it was their very own experimentation with negative interest rates and ‘perpetual’ large-scale asset purchases/market activism which then incentivised the brainless pursuit of/ demand for- AT1’s (additional tier one bonds) from yield-starved investors just a few years ago,” said Nomura head of equity derivatives sales and strategy, Charlie McElligott.

As may have been part of the ECB’s thinking last week, the Fed may want to deliver at least one more 25bp hike to indicate – as ECB President Christine Lagarde has done – that the current crisis isn’t serious enough to lead central banks to prioritise financial stability over lowering inflation.

“Price stability goes with financial stability, and they are both present and come together — but there is no trade off,” Ms Lagarde said.

But the ECB scrapped its guidance and Ms Lagarde acknowledged that “financial stability, to the extent that it impacts the economic situation, to the extent that it impacts our projections, has an impact on how we see the situation from a macroeconomic point of view.”

It would not be the first time a central bank has kept hiking into the teeth of a storm, only to cut the very next month, as the Reserve Bank did under former Governor Glenn Stevens in 2008.

BlackRock said the current US and European bank “tumult” is the latest sign rapid rate hikes are causing ‘financial cracks” that will “crimp bank lending”, reinforcing the case for recessions. Picture: Michael M. Santiago/Getty Images/AFP

JPM’s Kolanovic worries that the current banking “stress” has increased the risk of a US recession.

He says this “outbreak of financial market stress” is set to have a “material effect on monetary policy for some time to come”, as “risks to the outlook have changed.”

“In particular, concerns are rising that the speed of the current adjustment is itself a source of instability; and even if central bankers successfully contain contagion, credit conditions look set to tighten more rapidly because of pressure from both markets and regulators,” he said.

JPM expects the Fed to substitute strongly-hawkish forward guidance that “ongoing increases … will be appropriate” with an indication that a tightening bias still persists.

Chair Jerome Powell is likely to back away from his hawkish testimony on higher terminal rates while reiterating the Fed’s commitment to containing inflation. The “dot-plot” is likely to come down.

Mr Kolanovic says an early slide into recession would validate market expectations for easing, but a pause in US rate hikes and economic resilience would see hikes resume later this year.

BlackRock said the current US and European bank “tumult” is the latest sign rapid rate hikes are causing ‘financial cracks” that will “crimp bank lending”, reinforcing the case for recessions.

But central banks will “keep hiking to fight higher inflation – not come to the rescue.”

“We have argued that bringing inflation down would be costly, creating economic damage and cracks in the financial system,” says BlackRock Investment Institute head, Jean Bolvin.

While market expectations for peak rates plummeted amid hopes that central banks will come to the rescue and cut rates as they did in the past.

“Central banks are set to keep fighting stubbornly higher inflation, and use other tools to safeguard financial stability,” Mr Bolvin said.

“Investors need a new investment playbook and to stay nimble in this new market regime.”