Financial market stability is now on the tangent as well – The question of trade-off between achieving price stability and financial market stability arose during most part of March 2023, precisely after the failure of mid-tier US regional banks which was later followed by UBS buying over Credit Suisse after a near collapse of the latter. This came on the back of monetary policy tightening that had taken place since last year, witnessing the US benchmark interest rate rising 475 bps in the quest to bring inflation down towards the target level of 2.0%. Back to banking turmoil, anxiety over contagion risk from the current crisis persists even after all liquidity measures imposed, partly driven by the fact that Additional Tier-1 (AT-1) bonds of Credit Suisse were written off post-merger hence, spooking the market i.e., second order effect (thus far).

Once again, the divergence between what market wants and what the US Fed envisages resurfacing – As a result of the crisis, financial market once again began to price in rate cut by the US Federal Reserve (Fed) while the Federal Open Market Committee (FOMC) on 22nd March went on to raise the Fed Funds Rate (FFR) by 25 bps. Further to that, in their quarterly dot-plot projections, the 2023 year-end forecast for core Personal Consumption Expenditure (PCE) inflation was revised higher yet again and GDP growth target was revised lower. Given the new forecast update came after the banking crisis already in play, we view that the Fed would continue to proceed with its inflation-fighting agenda to restore price stability in the economy while banking crisis related issues are to be tackled using specific tools (e.g.: the recent Bank Term Funding Programme). Core PCE came in slightly below market expectation at 4.6% in February 2023, but it remains high even in the context of Fed’s year-end forecast of 3.6%, let alone the 2.0% target.

This is not the 2008 Credit Crunch – We do not see the present banking crisis as similar to the one that happened in 2008 which was mainly about credit risk across major names. As such, the same monetary policy reactions that we saw then are highly unlikely to be replicated now. The key difference is that inflation remains stubbornly high in present cycle and overheating job market continues to be in place. In addition to that, we also noticed after the monetary policy meetings in March 2023 (post-SVB collapse) concluded, the Fed and other central banks in Europe have not said that this banking turmoil would prevent any further tightening going forward. This a clear manifestation that for now, inflation remains as the key agenda while financial stability measures (if required further) are unlikely to be in the form of interest rate cut but rather direct liquidity measures as shown what have been introduced by authorities since this crisis started.

Fed Funds to peak at 5.00% - 5.25% by June 2023 – We observed that the S&P500 aggregate index has not fallen as sharp as the financial index, another perspective that differentiates between present banking crisis and the one in 2008 back then as it was a broad-base decline even before the bankruptcy of Lehman Brothers. Factoring in all these information flow, we still expect another 25 bps hike and FFR is seen peaking at 5.00% - 5.25% by June 2023. We still see limited possibility for rate cut unless inflation unexpectedly decline at rapid pace. If read between the line, latest dot plot forecast which sees further divergence between core PCE (heading north) and GDP (heading south) indirectly tells us that inflation is the main focus even if it comes at the price of recession. Granted that the signals of rate hike cycle nearing its end are getting clearer but that does not mean rate cuts to follow suit as quick as what the market is envisaging now.

Source: AmInvest Research - 5 Apr 2023