Shane O'Neill, Head of Interest Rate Trading
The last several weeks have seen the markets shift focus from the fundamentals in the economy and central bankers’ response, to the banking market at large and the fault lines within. The banking crisis started with Silicon Valley Bank, spread to Credit Suisse, and has seen its latest casualty in the form of First Republic going into receivership and being taken over by JP Morgan in a government-backed deal worth $10.6bn.
With this acquisition, Jamie Dimon, JP Morgan’s CEO, declared this part of the banking crisis as “over” and, although some smaller banks may still be at risk, his firm’s actions over that weekend have allowed everyone a chance to “take a deep breath”.
Whilst this may be a little premature – namely looking at PacWest shares in recent trading – it coincides with two central bank meetings and presents a good opportunity to re-assess where they stand and how things have changed from their perspective over the last month or so.
As markets expected, the Fed hiked rates by 25bps – taking the upper bound to 5.25%. Alongside the hike, however, there were hints suggesting a pause in tightening. Indeed, a line from previous statements – the committee “anticipates that some additional policy firming may be appropriate” – was omitted and it acknowledged that the cumulative tightening of monetary policy takes time to feed into the real economy. Following some 500bps of hikes over the last 15 months, the policy rate is now at the level Fed officials expect, according to their dot plot, to be the peak – so a pause at this point is hardly a shock.
Given that this may well have been the last hike of this cycle – banking stress, continuing quantitative tightening and a policy rate of 5.25% are all weighing on financial conditions – should those exposed to higher floating rates rest easy? There is a strong argument that they should not, and indeed there remains a potential opportunity for risk managers to take advantage of.
Chair Powell was adamant that cutting rates this year, according to the Fed’s current assessments, would not be appropriate. As we have pointed out previously (Disconnect between markets and the Fed continues), this is at odds with the market, which is currently pricing in 100bps of cuts by January 2024. Recent employment and inflation data supports the Fed’s stance. Core inflation, as measured by Core PCE, climbed in the first quarter of this year – coming in at 4.9% versus 4.7% expected. April’s non-farm payroll numbers surprised to the upside, again. The data showed an additional 253k jobs added for the month versus 185k expected. The unemployment rate also fell to 3.4%, contrary to market expectations for a climb to 3.6%. If financial conditions make further hikes difficult to warrant based on potential impacts to the economy, the current employment/inflation dynamic make cuts just as, if not more, difficult to justify.
What does this mean for risk managers? If these cuts are fully priced out, coming back in line with what the Fed expects, we could see the premium for a 3-year cap struck at 3% increasing by more than 50%. And over the last two years, those who have implemented a wait-and-see approach have, more often than not, lost out.
The ECB, meanwhile, struck a very different tone – with no pauses on the agenda as the risks presented by inflation remain “significant.” A divergence from Fed policy has no historical precedent – the ECB has never hiked in a sustained manner whilst the Fed has done nothing. President Lagarde was clearly aware of this point and addressed it: “Whatever the decision of the Fed is in the next few weeks, months, we are going to be riveted to our objective.”
Market pricing is onboard – sort of. Alongside the 25bps added in May, markets are pricing a further 50bps of tightening by Q3, with the rate peaking at 3.75%. However, this will be quickly unwound, with a 25bps cut priced in by the start of 2024. Such a rapid reversal of hikes would, again, be unusual and at present there is no data to warrant the move. Core inflation continues to be stubbornly high at 5.7% and, as Lagarde pointed out, the regional banking crisis which is shaking the US and tightening financial conditions over there, is not posing a problem in the same way in Europe. So, without that (undesirable) lever tightening conditions, the ECB will have to step up. What’s more, the Fed has hiked considerably more than the ECB for now (500bps vs. 375bps) – so there is an element of catch up to be played. As ever, it remains to be seen whether the ECB can ensure a uniform transition of financial conditions across the bloc – but for now peripheral spreads remain calm.
As we quickly approach the middle of the year, we are clearly entering a new phase for rates markets and rates hedging. In the US, we continue to have a central bank whose messaging is at odds with market pricing and economic fundamentals which continue to present challenges. In Europe, meanwhile, we have a central bank engaging in rhetoric (if yet to become action) with no historical precedent – and potentially wide-ranging impacts not just on rates markets but FX and beyond. After a decade in the doldrums, interest markets continue to be front of mind for risk managers in new and complex ways.
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