Major central banks have signalled that they could be approaching the end of their rate rising cycles. The US Federal Reserve (Fed) hinted at a possible pause – though it didn’t commit to it – and markets appear to be believe the ECB is only one or two steps away from a pause, too. Some market players are already expecting rate cuts by the Fed in the second half of this year. We think that may be too early, but a rate peak in the US could be near.
The stress in US regional banks remains high, as seen in the sustained losses by the S&P 500 Financial index (Exhibit 1). This is despite Fed Chair Powell’s assurance following last week’s Federal Open Market Committee meeting that the US banking system was ‘sound and resilient’.
Investor expectations that the Fed might soon cut interest rates are based on concerns that the mid-sized bank problems seen so far are not the end of the story and that the sector more broadly could be at risk. There is, however, so far no evidence of systemic risk and hence the Fed has not committed to any rate cut decisions. We believe it is more plausible that the central bank will opt for a ‘conditional pause’ rather than cutting interest rates outright. Such a pause could be lengthy as inflation falls slowly; Core inflation has oscillated between 5.5% and 5.6% over the last four months.
The US banking turmoil is partly the result of the ultra-easy monetary regime from 2020 to 2022 resulting from the Covid pandemic. Banks received a flood of deposits as government stimulus checks were saved. Banks invested the cash in safe US Treasury securities at low interest rates. Not all banks properly hedged this interest rate exposure, however, and the value of their Treasury holdings has fallen as rates rose.
Smaller banks now face deposit outflows, though we should note that the most serious deposit losses have occurred at a limited number of regional banks, namely, those with significant uninsured deposits. Some large money centre banks have seen deposits rise. To attract new deposits, smaller banks are having to raise the interest rate they pay on their customers’ accounts. To boost their capital ratios, banks have been tightening lending standards, which are anyway becoming more strict due to the deteriorating economic outlook. Tighter regulation is likely to come.
The latest US Senior Loan Officer Opinion Survey, released on 8 May, showed weaker demand and tighter standards in all loan categories for the first time since Q1 2009 (Exhibit 2). Slower loan demand will contribute to the Fed’s desired economic slowdown, though how quickly and how far is unclear.
In Europe, there is no comparable banking stress, although the latest ECB bank lending survey did show that credit conditions tightened sharply in Q1 2023, with the biggest fall in net loan demand since the 2008/09 Global Financial Crisis.
Not slow enough yet
Despite signs of an economic slowdown, activity and inflation are not decelerating fast enough to prompt the Fed and the ECB to change course. The latest data suggests that US inflation and the labour market are still too hot for the Fed’s comfort. April data showed core and headline consumer price index (CPI) inflation still rising by around 5% year-on-year, the economy adding more than half a million jobs, the unemployment rate falling to near historically low levels, and wages growing at 4.4% year-on-year (YoY) – faster than in the previous month.
Meanwhile in Europe, the ECB’s corporate sector survey showed both producers and consumers feeling the heat from tighter credit conditions. The eurozone labour market nonetheless remained strong, with the unemployment rate falling to an historical low of 6.5%. Leading economic indicators such as the purchasing managers’ index (PMI) rose further in April to 54.1. This suggests the unemployment rate might not be bottoming out yet.
Such strong figures are consistent with the flash eurozone GDP estimate of 0.3% quarter-on-quarter growth versus a flat or even negative growth expectation and sticky core inflation at 5.6% YoY in April.
We can expect the view that rates will be cut sooner rather than later to be tested. Much like the Bank of Canada’s ‘conditional pause’, a rate hike time out by the Fed would depend on it seeing further tangible slowing in the economy and inflation.
Note that before the US banking stress, the market view (and even the Fed’s) was that the peak rate could be close to 6%. This then dropped to a little over 5%. The volatility in the US 2-year Treasury yield reflects how frequently expectations have changed since the beginning of the year.
We do not expect to see an interest rate cut by the Fed anytime soon, even though rates might be near the peak. The ECB is now more hawkish than the Fed as core inflation is proving stubborn in Europe, so it is likely that monetary policy will remain tighter for longer in Europe than in the US.
All else being equal, such a policy divergence could mean a stronger euro, but also an underperformance of European equities relative to their US counterparts.