Why the Fed might stop raising rates

Earlier this March, the US Federal Reserve (Fed) raised rates by another 25 basis points (bps) to 5 percent, bringing its total rate increases to 475 bps for this cycle.

Although the Fed guided that it would raise rates by another 25 bps in May, and that it would keep rates unchanged for the rest of the year, the market thinks that the March increase was the last, and that the Fed would cut rates by 50 basis points in the second half of the year.

Personally, I agree with the market that the Fed will pause in May and start cutting rates in the second half of the year notwithstanding its more hawkish guidance.

The main reason why I agree with the market is the negative impact of further rate hikes on the US banking sector and the economy.

Because of the Fed’s aggressive tightening which began last year, the yield differential between bank deposits and money market funds increased significantly to around 400 bps currently. Because of the huge differential, more money shifted away from deposits into money market funds, negatively affecting banks’ liquidity position.

The Fed’s aggressive rate hikes also caused bond prices to go down sharply resulting in banks suffering from significant mark-to-market losses on their investment portfolios.

According to the Federal Deposit Insurance Corp., the combined losses of banks on their available-for-sale and held-to-maturity securities portfolios is around $650 to $750 billion.

If banks are forced to sell their bond holdings to address their liquidity problems, they would have to realize significant losses, potentially requiring them to raise fresh capital. This would be very difficult to accomplish given the negative sentiment toward banks.

Shrinking deposits and huge losses on investment portfolios were largely responsible for recent closures of Silicon Valley Bank and Signature Bank. To make matters worse, the two banks’ collapse triggered an even larger deposit withdrawals from smaller banks as the public lost confidence in them.

If the Fed continues to raise rates, the yield differential between deposits and money market funds would increase further, encouraging even more deposit withdrawals.

Although the newly created “Bank Term Funding Program” would help as it provides loans to depository institutions that suffer from liquidity pressures, the cost of these funds is very high and will most likely increase further if the Fed hikes interest rates.

Understandably, the Fed wants to continue tightening because inflation remains elevated. However, there are numerous signs that inflation is headed lower.

For example, headline inflation in the United States already peaked in June last year, while core inflation has been going down since September. Prices of oil and other commodities are already falling, while the reopening of China should help address some of the supply bottlenecks that are causing higher prices. Although housing inflation remains sticky, it should also start to head lower as housing prices are already going down.

Finally, the ongoing banking crisis will inevitably lead to weaker economic growth, higher unemployment and lower inflation. Given the numerous challenges facing banks, they are expected to tighten their credit standards, making it more difficult for both households and businesses to borrow money.

In fact, the Fed recognizes this, stating in its latest policy statement that “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring and inflation.” With less access to credit, consumers and businesses have no choice but to tighten their belts, which should lead to lower demand for everything, more layoffs and lower inflation.

Unfortunately, it is unclear if the stock market will go up if the Fed indeed decides to pause and pivot. After all, compared to the start of the year, the outlook for the US economy has deteriorated. This means that there is a higher probability that profits of listed companies would disappoint, which is not good for the stock market as earnings need to grow for the market to move higher. INQ