Banking Crisis, will FED brake ECB?

The Fed held its March FOMC meeting last week. In the first meeting after the banking crisis, the FED increased interest rates by 25 basis points in line with market expectations. The most striking change in the policy text is the removal of the word "ongoing increases rate" from the previous texts in this month's resolution text. But this sign alone is not enough to say "Hawkish". Because both the statements added to the policy text and, as Powell said at the press conference, "to what extent the banking crisis will create a credit contraction in the economy" will be the main determining factor in the interest rate hike in the next period, According to one analysis, the banking crisis could cause a credit crunch as severe as a 75 basis point rate hike. However, if the credit contraction is not strong, the FED will continue to increase interest rates. When we look at both the 5.1% ceiling interest expectation of the FED and the verbal guidance, we understand that, if necessary, a maximum of 2 more 25-basis-point interest rate hikes can be made. As a result, an uncertain FED awaits us.

Will there be a recession in the USA?

In this month's projection, the FED reduced the 2023 growth rate from 0.5% to 0.4%. It also revised inflation upward and unemployment downward. We understand that growth has been revised down due to the banking crisis. With this revision, the market began to price the "expectation that the US economy will enter a recession" more strongly. On the other hand, the downward revision of unemployment also shows us that the Fed thinks the labor market will remain tight and strong this year. Despite the downward revision in growth, the reason for the upward revision in inflation is that there may be an expectation of wage increases stemming from the tight labor market. At this point, since the FED expected a rigidity in inflation, it may have revised inflation upwards despite the slowdown in growth. The FED did not make any changes in the previous 5.1% ceiling rate revision. In other words, it would not be wrong to say that the FED put some brakes on interest rate hikes due to the banking crisis. Because if the banking crisis did not exist, we would have been talking about interest rates above 5.50% as well as 50 basis point rate hikes all at once.

FED March 2023 Economic Projections

Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230322.pdf

FED 2024 INTEREST EXPECTATIONS

Looking at the chart below, it is noteworthy that the FOMC members' interest rate expectations for 2024 are spread over a wide range. While those who expect a stronger recession expect interest rates to be lower, those who do not have strong recession expectations and who say "fighting against inflation should be on the table" despite everything seem to expect higher interest rates. In projections, 2024 growth has been revised down to 0.4%. The Fed may think that the banking crisis will not have much impact on the economy.

Dot Graph of FOMC Members' Interest Rate Expectations

  Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230322.pdf
 

POWELL: BANKING CRISIS BRINGS UNCERTAINTY

Let's come to Powell's press conference. Although the main emphasis of his speech was on inflation, he also gave wide coverage to financial stability and the banking crisis. He spoke cautiously at some points stemming from the banking crisis. He stressed that the banking system in the United States is sound. However, he stated that there is "uncertainty" about the effect of the banking crisis on production, consumption, and employment in the next period. On the other hand, Powell's statement that "we will continue to increase interest rates based on credit tightening" is not a dovish one. Adaptation of conditions He has already confirmed this by saying, "We are not in the conditions of December." Powell's brief message of "uncertainty" makes us think that he is more anxious for the short term. After that, the leading indicators of growth became much more important. At this point, it is more likely that "good (or "bad) data will create a good (or "bad) market" in the near term.

Market and Fed separation is back on the table

The market, on the other hand, thinks that the Fed's 25 basis point increase is the last. On the swap side, the ceiling interest was set at a range of 4.75–5.00. Markets: He thinks that the FED will pass in the May and June meetings and will cut interest rates by 25 basis points in July, September, November, and December, for a total of 100 basis points. However, both the ceiling rate and the pricing of the "FED to lower interest rates" in the second half of the year

are not realistic. Powell openly stated at the press conference that they do not plan to cut interest rates in 2023. Because the market doesn't believe it, it's pricing the discount. After the banking crisis, the market-FED split is on the agenda again. This indicates that the market will be more volatile.

December 2023 FED Rate Probabilities

Source: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

WHAT IS HAPPENING WITH THE ECB?

On the ECB side, hawkish statements came from Lagarde and ECB Chief Economist Philip Lane last week. They stated that they will continue to increase interest rates due to high inflation. With these statements, the expectation of an interest rate hike for the ECB until July began to emerge on the swap side. Again, both ECB members and Bundesbank Chairman Joachim Nagel stated that the ECB should continue to increase interest rates and that they should be kept high for a long time after reaching the ceiling interest rate. These statements supported the euro. However, after Deutsche Bank's strong rise in CDS premiums and a decline of up to 14% in its shares, the expectation that "the banking crisis is on the agenda again and the ECB cannot raise interest rates" increased. Both the interest rate projections and the euro fell. After German Chancellor Olaf Scholz announced that Deutsche Bank is a strong bank in terms of both liquidity and profitability, some relief was observed in the market. However, EU banking stocks remain under pressure. Eyes on the news feeds from Delaware Bank this week. If the news gets worse, the market may continue to rise, and the ECB will have to become more dovish as well.