The Federal Reserve is meeting next Wednesday for its latest monetary policy announcement. Focus upon the event has been immense. However, given the turmoil in the financial sector created by the forced sales of both Silicon Valley Bank and Signature Bank last week, speculation over the rate decision has been increasingly predicated upon the potential fallout from this episode of financial vulnerability. Over the past few days, bond yields have been declining as investors flock to the safety of government backed paper. Part of the decline in yields has been driven by increased demand but also by speculation that the Federal Reserve will have to pause or even back track on its pursuit of lower levels of inflation via money policy adjustment.
Silicon Valley Bank’s collapse wasn’t just due to the adjustment and arrival at a high interest rate environment. But it certainly didn’t help. The selloff in banking stocks that we have seen since late last week globally is a signal to the Fed of the stresses being created at banking institutions by the rapid adjustment to present rates of interest. As a result, the expectation is growing that the Fed may have to take its foot off the pedal on Wednesday for fear of choking the current environment of banking risk into a full-blown financial crisis. This in turn could threaten and preclude an economic crisis. Before the implosion of SVB, markets had been betting on a 25-50 basis point hike from the Reserve next Wednesday as persistent inflation and low unemployment showed further monetary action was necessary. As of yesterday, there were calls from some analysts expecting a 25-basis point cut to rates. This view remains an outlier but it exists nonetheless with other forecasts predicting a pause or even a blinkered 25 basis point hike.
The impact on FX has been limited with some vulnerabilities in emerging market assets on the back of the diversion away from risk assets. Eventually, should the present stresses be contained, emerging market FX could be a beneficiary of the curtailed hiking cycle across many developed economies, helping to support appetite for the so-called carry trade. The biggest impact has been within the FX swap market with the bid offer spread on shorter dates tenors blowing out well beyond their normal range even in major currency pairs.
Discussion and Analysis by Charles Porter
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