Fed Expected to Hike by 25bps

Expectations for what the Fed will do tomorrow have swung wildly in the last few days. Investors have been trying to recalibrate around the implications for the recent bank collapses. One of the main themes is that the increase in risk aversion has pushed up the cost of borrowing among financial institutions. That, in turn, is equivalent to the central bank raising rates in terms of the impact on inflation.

The thought is that it provides another reason for the Fed (and other central banks) to not hike, or to curtail the amount of hikes before reaching the terminal rate. Banks are being put under enormous pressure because of the higher interest rates, as well.

Where there are worries

In the specific case of the US, there is a lot of worry about First Republic Bank, which is still trading down well over 50% from its normal price. One of the reasons for this is that it likely can’t access the backstop being provided by the Fed to banks. That’s because the Fed set up a mechanism that would allow banks to borrow money on their MBS and Treasury holdings at par value, and eliminate the problem of unrealized losses that led to the collapse of SVB and was putting pressure on other banks.But First Republic’s problem is that it doesn’t have a lot of MBS or Treasuries. It is suffering a loss of deposits based on public perception, not because it was having difficulties like the other banks that were closed. On the one hand, that means it’s in a unique situation, and if it were to collapse, there would be less risk of contagion. On the other, it is at a much higher risk of collapse, which could shake investor confidence in the sector again.

What can the Fed do?

So far, central banks have been trying to separate monetary policy and intervention to save banks. That means they can keep raising rates to fight inflation, while using other mechanisms to support banks that could be affected by the higher rates. Such as the Fed’s BTFP program. Under that logic, after Powell signaled after the last meeting that there were a “couple” more rate hikes coming, the Fed would hike by a quarter of a point.

Over 80% of traders now expect 25bps hike, a significant strengthening of the consensus from just a few days ago when it was near 50-50 that there would be a rate hike. After a week in which banks were able to consolidate, and there were no new bank failures, the market seems to be coming back to expecting further hikes. Futures markets are now pricing in a terminal rate of 5.5% for the Fed, which implies three more quarter-point hikes by the end of the year.

The banking sector is still the focus

The Fed has been in a blackout period since the collapse of SVB, and therefore there haven’t been any public statements from officials on the banking situation. So, there is a lot of expectation on Powell’s post-rate press conference, since he will undoubtedly be asked about the banking situation. And it could be an opportunity to tweak some of the language around programs, which could also shake up markets.

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• Source: https://www.orbex.com/blog/en/2023/03/fed-expected-to-hike-by-25bps