Now That The Fed Has Made Some Breaks, Traders Are Held Rate-Hike Bets

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(Bloomberg) — A year after the Federal Reserve began sharply raising interest rates, the collapse of a Silicon Valley bank answered what had become perhaps the hottest question on Wall Street: When is something going to break?

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Its seizure by regulators, which marked the biggest bank failure since the 2008 crisis, is triggering a rapid recalculation on trading desks about how much will be prepared to reduce inflation. Traders are now placing bets on whether the Fed will hike just one more time this year — a staggering face-off from last week’s speculation about how big the next hike would be. What’s more, they are reviving bets that officials will be forced to start cutting rates before the year is out.

Ironically, many on Wall Street were just beginning to consider the possibility that their instincts were wrong and that their initial concerns were unfounded. The economy was holding up remarkably well – companies were still hiring and loan defaults were down – and so perhaps the acute pain from rate hikes limited the bursting of bubbles in things like New Thought, cryptocurrencies and meme stocks. Will be Over the past few weeks, he had raised his expectations for the highest rate, spurred by Fed Chair Jerome Powell’s tough inflation talk.

They just needed, it turns out, to give the rate hikes a little more time to show their effects. And now they are left to figure out the Fed’s path, caught between extremely high inflation and signs of stress in the banking sector, which will carve out.

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“We are finally starting to feel the long and variable lags with which monetary policy operates,” Blerina Urusi, chief US economist at T. Rowe Price Associates, told Bloomberg Television on Friday. “The first indication of that, I think, is what we’re seeing here with Silicon Valley Bank. A lot of businesses and banks — we’re going to find out this year — haven’t been able to operate at these high interest rates.

Although SVB’s crisis no longer seems likely to pose a systemic financial risk, its surprise collapse is a reminder that the banking sector is vulnerable to rapidly rising funding costs after years of operating in a low-rate environment. Its dissolution forced to set up a new emergency facility to allow banks to pledge a series of high-quality assets for cash over a one-year period. And regulators also pledged to fully protect uninsured depositors with the lender.

Given the delay in tight monetary policy translating into the real economy, traders are now looking for further signs that could indicate is finally engineering the recession it wants – albeit a messier, more sudden, one. The way it probably will be. Liked.

Two-year yields at one point fell nearly 60 basis points to 3.99% from Monday, the lowest since October, and remain on par with the steepest three-day decline since October 1987’s Black Monday. All-maturity Treasuries rose in demand as investors continued to flee bank stocks.

“Bank stress can be seen as a sign that monetary policy is working to tighten conditions,” said Mark Dowding, chief investment officer at RBC Bluebay Asset Management.

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History shows that the road to rate hikes can be bumpy and long to make a meaningful impact on the economy.

For example, a Fed hike of more than 400 basis points was expected to put the brakes on the labor market, but it hasn’t happened yet, with data coming in on Friday at best.

“If you had said a year ago that would tighten 450 basis points in 12 months, you would have thought the economy would have rolled over now,” said Vanguard Group Inc. ,

As well as many locked at low levels, there are also issues on the labor market side of things, Madziere said. Labor market participation is tight because many people chose to retire early during the pandemic and immigration remained restricted for a long time.

An important consideration here is whether the US economy is less sensitive to interest rates in the wake of the fall in the cost of borrowing to generational lows during the pandemic. For example, according to data from Black Knight, more than 40% of all US mortgages originated in 2020 or 2021.

Most US Mortgages Are Pandemic Vintage, Locked Beyond Fed Reach

But with the collapse of the SVB starting to take effect on monetary policy, the question now is how will balance its mandate to contain inflation with fractures in the economy.

Goldman Sachs Group Inc has scaled down its call for a rate hike at next week’s Fed meeting. Traders now see the top US benchmark at around 4.7% mid-year, down from 5.7% a few days ago. And while there is certainly a possibility of a rate cut if consumer price data due on Tuesday shows a sharp increase in inflation, investors are starting to consider the extent of the destruction of wealth due to financial stress and How can it reduce inflation?

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“This time is no different – ​​Fed tightening cycles always end with something breaking,” said Jack McIntyre, portfolio manager at Brandywine. “Bad things happen when you drain the liquidity too quickly. It was going to be the economy or inflation, and instead we have the financial system collapsing.

– With assistance from Ben Holland.

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