The US Federal Reserve (Fed) and the European Central Bank have again raised their policy rates. There are good grounds for believing this cycle of rate hikes is now over in the US, while in Europe there is further to go. Attention is now turning to the impact on financial conditions of the very significant tightening of monetary policy in the US and Europe. As previously, the challenge for central banks is completing the cycle of policy rate increases to ensure price stability without undermining financial stability.
Is the Fed done with raising policy rates?
On 3 May, the Federal Reserve raised its benchmark interest rate by 0.25%, its tenth consecutive increase since March 2022, but signalled it could soon pause its aggressive tightening of monetary policy.
The Federal Open Market Committee’s (FOMC) latest rate hike, which had unanimous support from policymakers, brings the federal funds rate to a new target range of 5.00% to 5.25%, the highest level since mid-2007.
In a statement released after the meeting, the central bank removed guidance it provided in March, when it observed that “some additional policy firming may be appropriate” to bring inflation under control.
The FOMC now says that it will be assessing the impact of its rate rises so far — and the fact they would take time to feed through to the economy — when “determining the extent to which” further increases “may be appropriate”. It also said it would be guided by future economic data.
Why pause now?
The Fed’s preferred measure of inflation, the core Personal Consumption Expenditures price index is still running at 4.6%, well above the Fed’s target of 2%. Over the last 18 months, core inflation has consistently been between 4%- 5%. The Fed expects it will still be above 3.5% at the end of 2023. This begs the question why the Fed does not tighten monetary policy further.
The answer yesterday from Fed Chair Jay Powell came in the form of a warning that the recent banking turmoil appeared to be “resulting in even tighter credit conditions for households and businesses”, which was likely to weigh on economic activity and the labour market. He added: “In light of these uncertain headwinds, along with monetary policy restraint we put in place, our future policy actions will depend on how events unfold.”
Events this week saw, on 1 May, First Republic Bank become the third bank to be taken over by US regulators in the past two months, with the Federal Deposit Insurance Corporation (FDIC) brokering a takeover by JP Morgan.
US regional banks remain under pressure
The sale of First Republic to JPMorgan Chase does not appear to have drawn a line under the US banking crisis that began with the collapse of Silicon Valley Bank in March. Valuations of US regional banks remain under pressure (see Exhibit 1). Market pricing suggests there is a significant probability the FOMC will cut policy rates as early as July. This may be predicated on the assumption that the Fed has tightened too far, too fast and that future events may force it to moderate its hawkish stance. We do not share this view, but as recent events have shown, the impact of raising policy rates by 5% in just over a year creates the potential for stress in financial markets. We expect the first rate cut from the Fed in December 2023 at the earliest.
In the wake of the FOMC meeting, the yield on the two-year US Treasury note fell by 11 basis points to 3.86%, its lowest in a month, as investors appear to integrate the end of the Fed’s current cycle.
Release of the Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) on bank lending practices is scheduled for 8 May. It is expected to show continued tightening in lending standards. This would do some of the heavy lifting for the Fed and arguably alleviate the need for tighter monetary policy. Hence the FOMC’s decision to wait and see.
ECB is not done yet
As expected, the European Central Bank (ECB) raised its deposit rate to 3.25% from 3.00% on 4 May. This latest hike comes in the wake of data released this week showing that the headline rate of eurozone inflation increased for the first time in six months to 7% in the year to April, up from 6.9% in March. However, the core inflation reading dipped to 5.6 % in the year to April, down from a eurozone record of 5.7 % in March — its first decline since June 2022. Core inflation in the eurozone continues to be buoyed by robust demand for services amid wage gains.
The ECB has now increased its deposit rate from negative 0.5 % last summer to +3.25%. Given the high rate of core inflation, we expect further tightening of monetary policy from the ECB.
Bank lending contracts in the eurozone
The European Central Bank’s quarterly Bank Lending Survey (BLS), published on 2 May showed lending standards to companies across the eurozone tightened more in the first quarter of 2023 than had been expected in the prior quarter. According to the report, the pace of net tightening in credit standards remained at its highest since the eurozone debt crisis in 2011. The net percentage of banks reporting a tightening of their criteria for lending stood at 27%. Banks also reported a further substantial tightening of credit standards for loans to households for household purchases, while further net tightening became less pronounced for consumer credit and other lending to households.
Eurozone banks also indicated that the ongoing phasing out, by the ECB, of its targeted longer-term refinancing operations (TLTROs) has had a negative impact on their liquidity positions, profitability and overall funding conditions over the past six months.
The ECB has been reducing its EUR 4.9 trillion portfolio of bonds by not replacing EUR 15 billion of those maturing each month. This amount could be increased by the ECB to about EUR 25 billion from July. Markets will be watching closely how this, combined with the planned withdrawal of EUR 480 billion of ultra-cheap funding from eurozone banks in June, will impact bank lending.
A solid earnings season
First quarter 2023 earnings for both US and European companies have been solid overall so far. In Europe, half of the STOXX 600 (by market capitalisation) has reported, with three-quarters of companies beating expectations by an average of 240bp. For those reporting earnings, the bottom line has come in well ahead of expectations. Compared to the historical average, the beat ratio is on the higher end. However, this has not correlated with share price performance.
In the US, both the number of companies reporting positive earnings-per-share (EPS) surprises and the size of these earnings surprises are above their 10-year averages. The expected earnings decline for the S&P 500 in first quarter 2023 is currently negative 3.7% versus 6.7% at the end of March.
X-date for US debt ceiling is approaching
On 1 May, US Treasury Secretary Yellen released a letter to Congress warning that the US will hit its USD 31.4 trillion borrowing limit sooner than expected. She updated her projections of when the ‘x-date’ may be reached to “as early as 1 June”.
This is earlier than in her prior 13 January letter, in which Yellen said it was ‘unlikely’ that cash and extraordinary measures would be exhausted before early June. This issue and the risk of a damaging debt default is fast becoming a key driver of risk premia, as already highlighted by movements in a range of instruments including US credit default swaps (CDS), US Treasury Bills and the VIX future curve.
Release of the US non-farm-payrolls report tomorrow (5 May) will give a first steer on whether conditions are easing in the US labour market. We expect a deceleration in the growth of payrolls from the previous data of 236,000 This would be the third consecutive decline in the pace and support the idea that the Fed’s cycle of rate hikes is now over. Weakening consumer and business spending implies possible layoffs in retail, transportation and manufacturing, while banking sector developments could weigh on financial sector employment.