Last week was a volatile one for financial markets, beginning with Fed Chair Jerome Powell’s testimony to Congress on Tuesday and concluding with the collapse of Silicon Valley Bank — and another strong jobs report — on Friday.
The S&P 500 index erased almost all its gains for the year as bank stocks slid after SVB was taken into receivership.
Bonds benefitted from a “flight to quality” with two-year yields falling 48 basis points in two days and 10-year bond yields down 29bp over the same period.
The collapse of SVB was partly due to losses on its bond portfolio on the back of aggressive Fed rate rises since last year and raised concerns that other (small) banks may face similar pressures.
There were other factors specific to SVB’s business model that contributed significantly to its liquidation, and the larger banks are well capitalised and unlikely to face similar problems.
Moreover, regulators over the weekend took steps to ensure banks can access liquidity from the Fed if needed, and that all depositors of SVB would have access to their funds, which should go some way towards reassuring markets.
However, the events at the end of last week, and their impact on confidence more broadly, may complicate monetary policy decision making for the Fed.
In his testimony to the Senate banking committee last week, Mr Powell indicated that the Fed may need to raise rates further than previously expected, and opened the door to a 50bp increase in March if the “totality of the data” warranted it.
His comments came after a blowout US jobs report and higher-than-expected inflation data for January, as well as economic survey data that pointed to an acceleration in economic activity at the start of this year, rather than a slowdown.
Consumer sentiment improved in February and activity in the housing market picked up in January.
While the manufacturing surveys remain in contraction territory, activity in the services sector has improved and, importantly for Fed, the surveys pointed to accelerating price pressures in February.
Overall, the US economy appears to be very resilient after 450bp of rate rises and against this backdrop, it was perhaps not wholly surprising that Mr Powell indicated that rates may need to move higher than previously indicated.
The Fed’s December 2022 interest rate projections showed a likely peak of 5.25 per cent in the Fed Funds rate this year, although several policy makers expected rates to rise more than this.
The real hawkish surprise in Mr Powell’s comments was that the Federal Open Market Committee might consider a larger increment than 25bp at coming meetings.
The February employment report released on Friday confirmed the strength of the US labour market. After a gain of 504,000 jobs in January, another 311,000 jobs were added last month, well above the 225,000 the market had been expecting.
While the unemployment rate edged up to 3.6 per cent from 3.4 per cent in January, this was due to more people entering the labour force and looking for work rather than people being let go from their jobs.
Wage growth at 4.6 per cent year on year also remains far above the 3 per cent the Fed believes is consistent with its inflation target.
Without the SVB developments, the February jobs data may have cemented a 50bp rise at this month’s FOMC meeting.
But the collapse of the bank underscores the need to adjust policy at a more measured pace, to allow the full effect of the 450bp in rate rises over the past nine months to feed through to all sectors of the economy.
Markets are now pricing in a lower probability of a 50bp move in March than they were immediately after Mr Powell’s testimony to Congress.
There is one more key release before the FOMC meets on March 21 and 22, and that is the February inflation data, which is due on March 14.
The market expects inflation to fall back to 6 per cent year on year from 6.4 per cent in January, with core inflation easing slightly to 5.5 per cent.
If the inflation reading comes in higher than forecast, there may be some members of the committee who push for a bigger rate increase.
At this stage, however, the consensus view is that the Fed will probably continue with a more moderate 25bp increase but indicate a higher peak in the Fed Funds rate this year in its new interest rate projections, the so-called dot plot.
Khatija Haque is chief economist and head of research at Emirates NBD