Financial market tremors continued in the wake of the sudden failure of SVB and Signature Bank last week and concerns around continuing uninsured deposit outflows among a few U.S. regional banks. On Wednesday, investor concerns crossed the pond and grew around Credit Suisse's survival among mounting liquidity issues. Credit Suisse is a large European investment bank and wealth manager with over $500 billion in assets, about 2.5 times the size of SVB, and has been struggling with liquidity issues for some time even before the SVB shock. In 2022 Credit Suisse lost around $133 billion in deposits with $110 billion in deposits walking out the door in the fourth quarter of 2022 alone.
This has prompted further action from U.S. and European financial regulators and the U.S. banking industry itself this week to further stabilize these on-going financial stability challenges. The Swiss National Bank said Wednesday night that it was prepared to back Credit Suisse because it is a "systemically important bank". Before Thursday morning trading began in Europe, the Swiss central bank announced a loan of $54 billion dollars to Credit Suisse to bolster confidence in Switzerland's second-biggest lender.
Here in the U.S. pressure continued to mount on San Francisco based First Republic Bank, forcing them to announce on Wednesday the search for a potential buyer. Then on Thursday a consortium of eleven large U.S. banks agreed to deposit $30 billion with First Republic Bank to help stem the tide of deposit outflows.
Not surprisingly this has played havoc with bank stocks over the past week, but it hasn't all been downhill. Many bank stocks rallied strongly on Tuesday and Thursday as investors were reassured by central bank and regulatory actions to provide much needed liquidity. In total, the Federal Reserve is reporting that banks borrowed a record $152.85 billion from the Fed's Discount Window in the week ended March 15th, up from just $4.58 billion the prior week, and banks borrowed another $11.9 billion in the first three days through the new Bank Term Funding Program (BTFP). The prior weekly record of $111 billion of Fed Discount window borrowing occurred during the 2008 financial crisis.
But as I wrote in our Instant Analysis report on Monday, Federal regulators have two major problems they are trying to solve: 1) Stanch deposit outflows at other vulnerable financial institutions and 2) Stop Treasury fire sales due to banks' large unrealized losses in their investment portfolios. We stand by our assessment then that the actions of the Fed, FDIC, and Treasury Department last Sunday night go a long way in resolving both of these bank financial stability threats. The fact that the banking system was able to tap an additional $153 billion in liquidity in less than a week was a tremendous step in the right direction. Stock and bond markets remain on edge and continued market volatility is likely as we learn of other collateral damage from what has already transpired in markets around the world. However, these lingering financial stability concerns are likely to give way over time to rising concerns about the negative impact on the bank credit channel and the economic outlook. Even before the bank-runs, we were seeing evidence of banks becoming more cautious in lending and tightening credit standards across most of their loan portfolios. Now a shortage of liquidity could force many banks to pay higher interest on their deposits and get pickier about who they lend out their money to. While this might help out on the bank liquidity front, the payback will likely be lower net interest margins for banks, slower loan growth, and weaker economic activity than there would have been if the bank-runs never happened.
Against this deteriorating backdrop, the FOMC meets next week to decide what to do with the Fed funds rate. Jerome Powell and other Fed speakers were sounding quite hawkish about future rate hikes before they entered the mandatory quiet period before next week's meeting. Chair Powell noted in his Congressional testimony that the peak funds rate that the Fed will need to reach this cycle will likely be higher than the median projection of 5.00 to 5.25% in the FOMC's December Summary of Economic Projections, though the pace of hiking will depend on the "totality of the data". Others have said the terminal Fed funds rate for this cycle remain uncertain and will depend on incoming data. A few participants mentioned the 1970's experience and counseled against easing monetary policy prematurely.
Those hawkish arguments feel so two weeks ago now, given the banking shock and market events of the past week. Economist and market projections of the likely path of the Fed funds rate are all over the map and appear to be shifting dramatically on a daily basis. Hard to fathom what is on FOMC members minds today, but for what it's worth here is our call. We expect the FOMC will go ahead with another 25 basis point hike at next week's meeting. Before this market dislocation, some had been leaning toward a larger 50 basis point hike, given the resilience of the U.S. labor market and the glacial decline we are seeing in overall consumer inflation. Just this week, we received more news that housing starts and permits and homebuilder confidence are on the rise. Initial jobless claims have been below 200k in eight of the past nine weeks. Based on the strength of the labor market and the stubbornness on consumer inflation, it's hard to argue it is time for the Fed to take a pause next week.
Moreover, if the Fed were to pause after their hawkish rhetoric in recent weeks, it could do even more damage to the Fed's credibility and deliver a message to the markets that Washington DC regulators are panicked and maybe investors should be too. Not a good look. So in the end, they will likely stay the course and hike one more time at their diminished 25 basis point pace, and repeat the mantra that they will remain data dependent and that nothing in the Summary of Economic Projections or the revised Dot-Plot that will be released at the same time as the FOMC Statement next Wednesday is set in stone. The fact that the ECB went ahead yesterday with another 50 basis point increase in their policy rate despite the liquidity problems of Credit Suisse is a telling action.
Fed Funds Rates – Will They Go Up Or Down?
With that said, the banking world has clearly changed from two weeks ago and the bank credit channel is likely to tighten even more than we expected before, so in a nod to that risk we are removing the June quarter–point rate hike from our baseline forecast. We now expect only two additional quarter-point rate hikes from the Fed in March and May before an extended pause at a level of 5.00 to 5.25%. Our view differs from the markets in that we still don't expect any near-term rate cuts from the Fed this year, even as the risk of at least a mild recession has increased. Though with the banking crisis still on-going, the risks to the Fed rate outlook remain more heavily weighed to the downside.
To learn more, check out this week's U.S. Outlook Report.