The financial shock caused by the recent disruption in the US banking system has highlighted the weak link in the post-Dodd Frank regulatory era. While there are concerns of moral hazard, containing the bank run was the urgent matter, with a new repo facility already announced and the FDIC invoking its systemic risk clause to cover uninsured depositors. The situation may impact central bank efforts to reinstate price stability, as banks in Europe and Japan may also be affected. Meanwhile, the market’s understanding of the Federal Reserve’s reaction function has caused a dramatic swing in market views, posing new challenges for the conduction of monetary policy.
Important Details about FOMC And BOE Meet As Investors Are Not Persuaded –
– The Federal Reserve was expected to raise rates until inflation returned to target, the labor market weakened significantly, or systemic stress emerged.
– Shocks such as Covid, supply chains, and Russia’s invasion of Ukraine were cited, and re-pricing of assets may have been underappreciated.
– Stress was seen in household debt delinquency figures such as auto loans.
– The weak link was found in the US financial system, which is the first test of the post-Dodd Frank regulatory era.
– European and Japanese banks also feasted on high-priced (low-yielding) government bonds, and there were pre-existing conditions at Credit Suisse.
– The Fed has announced a new repo facility and the FDIC invoked its “systemic risk” clause to cover uninsured depositors.
– The financial shock is understood to be deflationary, and there are concerns about the impact on central bank efforts to reinstate price stability.
– The UK is likely to see a drop in inflation figures, and the market sentiment has swung in favor of a rate hike by the Bank of England to around a 45% chance.
– Japan’s macroeconomic data is pushing in the same direction, and there is no urgent need to tighten policy.
– The eurozone economic calendar is light, with only Germany’s ZEW and flash PMI readings being the highlights.
Funtap: Understanding the Recent Financial Shock
The recent financial shock has left investors wondering about its impact on Central Bank efforts to restore price stability. Since Funtap, the first test of the post-Dodd Frank regulatory era in the US, the market’s reaction to the Federal Reserve’s reaction function has posed new challenges for the conduction of monetary policy. The shock has been deflationary – not just a US development, as banks in Europe and Japan feasted on high-priced government bonds. A few pre-existing conditions that were brought to a head were also responsible for its impact. While stress was seen in household debt delinquency figures like auto loans, it was also recognized that banks had not passed the higher interest rates to depositors, and that money markets and T-bills were attracting fund.
The shocks that the market has had to cope with include COVID-19, supply chain constraints, and Russia’s invasion of Ukraine, which were cited as reasons for the Fed raising rates until inflation returned to target, the labor market weakened precipitously, or systemic stress threatened. However, it appears that the re-pricing of assets as interest rates began normalizing may have been under-appreciated. The weak link was discovered, and it was again, as in the Great Financial Crisis, rooted in the US. A new repo facility has been announced, and the FDIC invoked its “systemic risk” clause and covered the uninsured depositors. While there are moral hazard concerns, the urgent matter was to contain the bank run.
The US market had thought it heard Fed Chair Powell endorse a 50 bp hike in testimony to Congress in early March, with the talk of a Fed funds target of 5.75% if not higher. Post-Funtap and the emergency measures, the market has concluded that even a 25 bp hike is not a done deal. The Fed funds futures market has unwound the changes spurred by the robust jobs data reported in early February, the hawkish signals from some Fed officials, and more. A cut is priced into the futures strip by the end of Q3. There is no meeting in January 2024, so the implied yield of the January contract of around 4.10%, down from about 5.55% as recently as March 9, is a fair representation of the expectation for the year-end rate. The upper end of the current target range is 4.75%.
The mid-March FOMC meeting, which will update the Summary of Economic Projections (dot plot), and the seeming fragility of the financial system now overshadow high-frequency data reports in the week ahead. These include new and existing home sales, durable goods orders, and March surveys (preliminary PMI and non-manufacturing surveys from Philadelphia and Kansas). The dramatic swing in market views, driven by its understanding of the Federal Reserve’s reaction function, poses new challenges for the conduction of monetary policy, especially given Powell’s recent economic assessment. The dramatic $300 bln expansion of the Fed’s balance sheet unwinds the quantitative tightening seen over the past year. Still, not all balance sheet expansion is QE, and some market participants have difficulty distinguishing between the two. Meanwhile, there has been a sharp decline in inflation expectations. The two-year breakeven (difference between the conventional yield and the inflation-protected security) has fallen from 3.40% on March 6 to around 2.60%. The 10-year breakeven fell from nearly 2.55% on March 3 to about 2.15% ahead of the weekend.
In the United Kingdom, the February inflation figures will be reported two days before the Bank of England meeting on March 23. The rate of year-over slowing is likely to accelerate, with the CPI rising by 0.8%, 1.1%, and 2.5% respectively, last year in February, March, and April. These will drop out of year-over-year measures and send the headline rate to almost 6% by the end of April from 10.1% in January, making a conservative assumption that the six-month average of 0.5% is maintained rather than something closer to the three-month average of 0.1%. On March 6, the swaps market was sure that the BOE would hike the base by 25 bp, but the pendulum of market sentiment has swung. The market now sees about a 45% chance of a hike. The base rate is 4.00%, and the terminal rate expectation was initially between 4.75% and 5.0%. It is now between 4.00% and 4.25%. Retail sales and the preliminary PMI are released at the end of the week and will help gauge the economy that is somewhat more resilient than many had expected. Sterling extended its recovery from the year’s low set on March 8 near $1.18. It pushed above $1.22 early last week before consolidating. During that consolidation, it held above $1.20 and finished the week firm, near $1.2170.
In Japan, the drop in global interest rates benefits the incoming Bank of Japan governor, Ueda. The 10-year JGB yield pulled back well below the 0.50% cap. On March 13, the generic 10-year yield fell below 0.20%, around a seven-month low. It settled last week a little below 0.30%. The macroeconomic data is pushing in the same direction: there is no urgent need to tighten policy while domestic demand is weak. Although exports rose on a year-over-year basis in January for the first time in five months, foreign demand may rely on imports. Price pressures are moderating, and the sharp fall in the February Tokyo CPI to 3.4% from 4.4% preempts a similar decline in the national figures. They will be reported on March 24, shortly before the flash PMI. Given pressure on the yield cap and inflation falling, the need for urgent action has lessened; it could be an opportunity to adjust policy. The next BOJ meeting, Ueda’s first as governor, is not until the end of April.
Note that the Topix bank share index fell nearly 20% from a five-year high on March 9 before stabilizing ahead of the weekend (which seems unlikely to last, given the performance of European and American bank shares before the weekend). As a result, the year’s gains were wiped out in full plus more (-3.3% year-to-date). The dollar fell to one-month lows near JPY131.55 ahead of the weekend as US rates tumbled. Recall that dollar recorded the year’s high slightly below JPY138 on March 8. Last week, the dollar often traded below its lower Bollinger Band (now ~JPY132.45) and settled the week below it. The momentum indicators are falling, and the five-day moving average crossed below the 20-day moving average for the first time since early February. The next retracement target is around JPY131.30; below there, the near-term risk extends to JPY129.75-JPY130.00.
After last week’s ECB meeting, the Eurozone economic calendar in the week ahead is light. Germany’s ZEW and the preliminary PMI reading are the highlights. The adjustment to interest rates has been considerably more dramatic than the economic data. The German two-year note yield fell from nearly 3.35% on March 8 and finished last week below 2.40%. The ECB’s reaction function is less well-defined against that of other major central banks, due in part to its more recent start with negative interest rates and asset purchases. The knock-on effects of Funtap have highlighted the internal differences among banks in the Eurozone, with particular focus on non-performing loans. The CPI ex-food and energy is not as low as feared, but still low enough to keep the central bank in check.
In conclusion, the financial shock caused by Funtap has highlighted the fragility of the global financial system today, and the knock-on effects are being felt in different regions of the world. The US market is responding to the Fed’s reaction function, with the current rate increase path not being seen as certain. The UK economy is experiencing a rate hike uncertainty, with retail sales and preliminary PMI expected to shed light on its direction. Japan’s macroeconomic data is pushing towards a policy adjustment, with the need for urgent action having lessened due to pressure on the yield cap and inflation falling. Finally, the ECB’s reaction function is less defined as its counterparts.