Evening Brief – 03.28.23

As nerves in the banking sector ease for now, investors are again turning their attention to the economy and the outlook for US monetary policy. Currently, the swaps market is pricing in a more than 50% probability of an interest rate hike at the next meeting in May; however, the market continues to expect sharp easing later this year, with pricing suggesting the fed funds rate will drop to around 4.30% in December, down from around 4.95% in May.

Some economists estimate that the credit tightening among smaller regional banks that are on wobbling is probably the equivalent of a 100bp hike, and therefore questioning the Fed’s decision to raise interest rates a quarter-point last week, which has likely contributed to the increase in odds of rate cuts.

Hiking interest rates in the middle of a financial crisis has been done before. In 2011, Jean Claude Trichet, the President of the European Central Bank at the time, hiked the main refinancing rate, equivalent to the fed funds rate, a quarter-point, only to reverse course and push rates into negative territory, as threats of deflation and a misfiring financial system crippled the Eurozone. We don’t have deflation right now, but Chaiman Jerome Powell may be fighting the wrong foe, inflation, which is falling.

The uncertainty of future policy expectations is evidenced by the continued wild swings in the government bond market. The volatility, which can be seen in the US Treasury futures contracts, is as high as what we had in the 2008 financial crisis, when measured by the ICE Bank of America MOVE Index. One can compare this volatility to the S&P 500 Volatility Index (VIX). The swings in the MOVE are as bad as if the VIX were near 80. Yet, the VIX closed Tuesday below 20.