The Federal Reserve will likely have to cut its benchmark lending rate before summer, Wall Street traders are indicating Friday, as the fallout from the U.S. banking crisis triggers a potential credit crunch that could threaten broader economic growth.
With markets reacting indiscriminately in the wake of the collapse of SVB Financial, the closure of Signature Bank and the ongoing stresses at First Republic, bank stocks in Europe were marked sharply lower on Friday while U.S. markets continue to count the cost of slower loan growth as a result of the simmering crisis.
Fed Chairman Jerome Powell told reporters in Washington on Wednesday that tighter financial conditions, linked to the banking crisis, could be "the equivalent of a rate hike or perhaps more than that." But he stressed that "it's not possible to make that assessment today with any precision whatsoever."
U.S. banks trimmed their borrowing from the Federal Reserve's various lending programs this week, but the levels of support remain elevated amid ongoing concern for the health of the nation's regional bank deposit base.
Banks borrowed $110.2 billion from the Fed's main discount window over the seven-day period ending on Wednesday, according to Fed data, down $42.7 billion from the record $152.8 billion drawn over the prior time frame.
Borrowing from the Fed's new Bank Term Funding Program, which enables banks to exchange high-quality assets for one-year loans, rose nearly fourfold to $53.7 billion.
Bank of America's weekly "Flow Show" report, meanwhile, suggested money-market funds have added more than $300 billion over the past month, taking the overall tally to a record $5.1 trillion. That's as savers seek higher rates from government-backed securities while removing deposits from institutions that may not receive the kind of extended backstop that the Treasury offered to Silicon Valley Bank.
Deposit flight, along with unrealized losses in securities portfolios as a result of the Fed's relentless rate hiking cycling -- however well-telegraphed -- has result in accelerated asset sales and a pullback in new loan writing.
That has major implications for any credit-driven economy. But it's even more of an acute concern in the U.S. where smaller banks (with assets under $250 billion) provide around 43% of overall commercial lending -- much of it to smaller firms -- and nearly two-thirds of all loans to the commercial real estate sector.
"This matters, because firms with fewer than 500 staff employ about 73M people; that’s 58% of the private employed workforce. If these firms are seriously credit-starved, the labor market will suffer," said Ian Shepherdson of Pantheon Macroeconomics.
"We realize this idea is hard to square with the recent payroll data, but the point about unexpected events is that they can change previously stable trajectories."
That risk has certainly affected trading in the bond market, where benchmark 2-year Treasury note yields, the most-sensitive to interest rate risk, were last seen trading at 3.702%, some 135 basis points south of levels seen just before the SVB Financial collapse on March 10.
The moves in 2-year notes reflect changes in interest rate forecasts, while the decline in 10-year note yields, which are down around 60 basis points from pre-banking crisis levels, are more about the anticipated pressure on economic growth from tighter credit conditions.
"Higher borrowing costs and reduced access to credit mean a greater chance of a hard landing for the U.S. economy," said ING's global head of macro, Carsten Brzeski. "This will help to get inflation lower more quickly than would otherwise have happened."
"Rate cuts, which we have long predicted, are likely to be the key theme for the second half of 2023, and we are favoring 75 basis points of easing in the fourth quarter of this year," he added.
Fed Steps In With Massive Bank Lending Plan to Stem Contagion From SVB Collapse
CME Group's FedWatch is suggesting a 58.4% chance that the Fed will lower its benchmark federal funds rate by 25 basis points (0.25 percentage point) at its policy meeting in June, with bets on a hold at its next meeting in May essentially locked in at 92.7%.
A full 25-basis-point rate cut is expected in July, with the odds of a 50-basis-point reduction rising to 53.2%.
Powell indicated Wednesday that while financial conditions have definitely tightened, the mainstream measures aren't always the best reflection of impact.
"There's a fair amount of research about how (tighter conditions) works its way into the economy over what period of time," he said.
"And so, we'll be looking to see how serious is this, and does it look like it's going to be sustained, and if it is, it could easily have a significant macroeconomic affect and we would factor that into our policy decisions."
Rate cuts, however, "are not in our base case, and so, that's all I have to say," Powell added.
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