Is the Fed as dovish as the market thinks it is?
Market turbulence ignited by the banking scare has sparked speculation that the U.S. Federal Reserve would choose to prioritize financial stability over price stability. The central bank's communication on March 22 also seems to suggest that. Or did it?
Events of the past quarter have strengthened our conviction on several of the team’s core economic views.
- To be cautious about the risk-on price action in January given we had expected H1 to be bumpy
- The full impact of prior policy tightening has yet to filter through to the real economy
- A global recession is likely within the next 12 months
- Investors may need to reassess their belief that the U.S. Federal Reserve (Fed) will always come to the market's rescue
At this point, we believe it’s crucial to reassess how we should be thinking about the Fed’s approach to policy making, especially in the context of the second biggest bank failure in U.S. history, which has raised doubts about the health of the U.S. banking system.
Moving fast and breaking things
The old market adage is that central banks tend to hike rates until something breaks. Well, we’re at a point where things appear to be breaking.
The strain in global financial markets as a result of the ongoing tightening in financial conditions and the marked deterioration in market liquidity across key asset classes have crossed important thresholds. In some ways, this shouldn't come as a surprise: The current tightening cycle in advanced economies is the most aggressive in decades.
GDP-weighted developed-market policy rate (%)
Steep rises in policy rates typically correspond with historical episodes of recessions and systemic crises
In particular, the closure of two tech-focused lenders in March led to a massive spike in volatility in the bond markets. Yields on the two-year U.S. Treasury bill fell 102 basis points (bps) in the days after.
For context, this represented the largest move in yields since the week of Black Monday in 1987, surpassing declines seen when Lehman Brothers collapsed in 2008, the pandemic meltdown in 2021, and when the dot-com bubble burst in 2001.¹
Change in two-year U.S. Treasury yield (bps)
Unsurprisingly, as these events unfolded, markets changed their medium-term pricing of terminal federal funds rates. Over the course of three days, between March 10 and March 13, market pricing of terminal rates fell from 5.70% to 4.75%, before settling at 4.95% going into the March 22 Federal Open Market Committee meeting.¹
In our view, the market’s initial belief that trouble in the U.S. banking sector and mounting concerns about financial instability would dramatically change the Fed's thinking was misguided. That perspective hinges on two assumptions:
1 The idea that the Fed would need to combat financial stress by adjusting its interest-rate policy
2 The Fed would prefer to avoid financial stress at all costs
We take issue with both assumptions.
Balancing the Fed’s implied triple mandate: the right tools for the right job
In assessing what could be construed as the Fed’s appropriate monetary policy response to the ongoing malaise, we note that former Fed Chair Ben Bernanke said on many occasions that in order to achieve different policy objectives, central banks can and should use the right tool for the right job. In other words:
- Monetary policy tools should be used to manage the demand-side of an economy (e.g., interest rates in most advanced economies)
- Micro-prudential tools should be used to promote the stability of individual financial institutions (e.g., through capital requirements and disclosure)
- Macro-prudential tools should be used to address wider systemic risks (e.g., loan-to-value restrictions in the mortgage market and core funding ratios for banks)
Markets might need to get used to the view that some level of financial stress is a feature and not a bug of central bank thinking.
Having different tools at their disposal enables central banks to be more flexible and formulate appropriate policies to support the economy, particularly in an environment in which the financial and business cycles are out of sync.
Indeed, the Fed demonstrated the breadth of its tool kit in March when it introduced its Bank Term Funding Program. At the same time, the U.S. Treasury, along with the Federal Deposit Insurance Corporation, pledged to make good on all deposits at the two lenders that were closed by regulators, including deposits that were uninsured. In policy terms, many would agree that these were highly surgical tools meant to address a specific risk in specific circumstances.
The actions taken by policymakers suggest that U.S. depositors may no longer need to fear a banking crisis. The announced measures imply that regulators could step in to resolve liquidity and solvency problems at banks with questionable risk management practices to eliminate the risk of cascading bank runs. But this ain’t no free lunch: The inference here is that there will be increased regulation and oversight, which could translate into a cap on risk-taking activities and, potentially, lower profits. On the other hand, banks may also need to increase the interest they offer depositors to prevent deposit outflows—again, a development that could dent profit margins.
The way we see it, the regulators’ response was substantially more effective than cutting interest rates, which wouldn’t have cured the underlying problem and could have exacerbated other existing challenges.
Is the Fed increasingly comfortable with financial instability?
If this can indeed be read as the Fed’s default approach to addressing banking crises, the market’s going to need to adjust to the idea that central banks may be much more comfortable with financial instability than in the past. In addition, markets may also need to get used to the view that some level of financial stress—particularly when it’s able to help alleviate some excesses—is a feature and not a bug of central bank thinking.
First, while pausing interest-rate hikes (or cutting rates) in response to financial instability might temporarily alleviate some immediate stress, it also risks reinvigorating the concept of the Fed put, which can inflate excesses. It’s a phenomenon that crept in after the global financial crisis that likely contributed (in part, at least) to current policy dilemmas; in other words, trimming rates may solve a short-term problem but could well exacerbate a longer-term one.
Second, there remains a large gap between market expectations of what the Fed will do and what the Fed tells the market it expects to do.¹ This credibility gap poses a problem for any central bank since the expectations channel is an important transmission channel for monetary policy. In our view, this gap is largely a function of the market’s belief that central banks are more likely than not to put a floor under the prices of financial assets. We think it’s likely that the Fed will act to close the residual gap in expectations with more hawkish communication.
Third, Fed Chair Jerome Powell has repeatedly highlighted financial conditions as an important indicator to monitor. Since February, traditional market proxies for financial conditions in the United States have diverged from the Fed ’s own Financial Conditions Index (FCI). The widely used Goldman Sachs FCI shows that after a period of sustained tightening, financial conditions eased from September/October into January and have subsequently straddled neutral territory.
Federal funds rate vs. the Fed’s SEP dot plot projections (%)
The Fed may not be as dovish as it seems
Chair Powell appeared to validate this view in his post-March FOMC press conference. He noted that the recent banking turmoil was likely to tighten financial conditions in a way that was equivalent to a 25bps rate hike, and possibly even more than that. Yet the Fed’s closely watched dot plot—contained within its quarterly summary of economic projections—remained largely unchanged relative to December, save for the median point for projected federal funds rates for 2024, which was revised higher by 12.5bps.
Moreover, Mr. Powell noted several times at the press conference that interest-rate cuts aren’t in the Fed’s base case. We may have moved closer to the end of the Fed’s rate hiking cycle, but the central bank took pains to make clear that it retained the right to raise rates further if it deems fit. The option to raise interest rates remains on the table, and the idea of imminent rate cuts seems misplaced to us.
A new Fed normal?
Recent developments are pointing to the increased likelihood that the Fed could be more comfortable with the idea of financial volatility. We believe the central bank’s recent surgical approach to instilling financial stability in the aftermath of the U.S. regional banks’ fallout points to that. Understandably, that wouldn’t be welcome news for global markets, which would have to let go of their long-held assumption that the Fed will always step in to save the day. In our view, a reset in investors’ mindset could be warranted.
From an investment perspective, we continue to focus on more defensive positioning and a risk-off bias. That, however, doesn’t preclude other opportunities in the global macro environment, and our Q2 2023 outlook highlights several of them. That said, it does mean that market participants may have to dig deeper and be more selective as they absorb the implications of what could be the Fed’s new decision-making function.
1 Bloomberg, as of March 23, 2023.
This is an excerpt of Manulife Investment Management's Q2 2023 Global Macro Outlook: navigating turbulence. Download the full 29-page report.
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