Future Fed rate hikes: Damned if they do and damned if they don’t

WELREX® Director John Longo shares his latest views on US markets and the economic outlook.

Pause or no pause. That is the question, at least for the Federal Reserve. The main problem that the Fed, and many other central banks, has been grappling with over the past two years has clearly been inflation. Just when it seemed like taming the inflation beast was within the Fed’s grasp, a regional banking crisis in America emerged. In its aim to quell the latest banking crisis, the Fed pumped even more liquidity into the system and the biggest banks in America got even bigger, exacerbating the “too big to fail” problem that helped fuel The Great Recession.

The Fed is caught between a rock and a hard place. It either raises interest rates and increases the odds of a recession, or pauses and then cuts rates, likely aggravating the inflation problem. In short, The Fed is damned if they do and damned if they don’t raise rates. Let’s flesh out this line of thinking and discuss how it may impact asset prices.

Inflation was trending in the right direction, but …

Inflation in the U.S. peaked at 9.1% in June of 2022 and has continued to trend down, as shown in the graph below. Other measures of inflation, such as the Personal Consumption Expenditure (PCE) Index and Producer Price Index (PPI), have generally fallen at an even greater rate. The base effect component of the inflation calculation is also arguably keeping reported inflation rates higher than their true, underlying levels. In concert, the Fed’s year-plus long campaign of raising interest rates from 0% to now 5% and some improvement in supply chains that were snarled since the onset of COVID-19 had inflation moving from “enemy # 1” to a more tractable problem.

U.S. Consumer Price Index (CPI) prior twelve months

A regional banking crisis emerges

The crash in Technology and other speculative stocks in late 2021 had a slowly but surely negative impact on the entire technology ecosystem. The collapse of FTX, a leading cryptocurrency exchange with a star-studded roster of backers, added to the turmoil. A more recent case in point was the run that occurred on Silicon Valley Bank (SBV) a few weeks ago. The run on SVB was accelerated by a tweet from the noted venture capitalist, Peter Thiel, who recommended his partner companies withdraw cash from beleaguered SVB. Signature Bank, a New York-based bank with a sizeable focus on cryptocurrency firms was the next notable bank to fail. Credit Suisse, a once venerable 167-year-old banking icon, was forced into a shotgun wedding with its larger rival, UBS. The merger price, down more than 90% from the stock’s all-time high, was a bitter pill to swallow for CS shareholders, including the Saudi National Bank, and a specific group of bondholders got completely wiped out. Other banks that rely on large depositors, such as First Republic, are now on the ropes.

The U.S. Treasury and Federal Reserve issued a joint statement designed to alleviate the stress on the entire banking system while fully guaranteeing the deposits of the failed banks. Furthermore, the Fed engaged in coordinated action with other central banks to improve U.S. dollar liquidity and alleviate panic in the global banking system. As we stand today, smaller banks lost $120 billion of deposits while larger ones gained $67 billion. The balance of the pulled deposits likely found their way into money market mutual funds and U.S. Treasuries.

Reading the financial tea leaves

The exodus of assets from the banking system, combined with investor fear and the cumulative effect of central bank tightening, is likely to lead to a credit crunch and increase the odds of a recession. An economy trending toward recession is harmful to the profits of most companies. When combined with heightened stock market valuations of nearly 20x earnings, the short-term outlook for most firms may be rocky and equity performance may be constrained on the upside.

The Fed will eventually come to the rescue, likely within months, with a pause and then cut in interest rates, but by then it may be too late to push the economy out of a stagflationary type environment. The inflation problem is likely to percolate in the background since wages are often negotiated with a lag. For example, given the high levels of inflation over the past couple of years, many unions across the country are seeking substantial wage hikes, some as high as 30% over a four-year period.

The investment implication is that the odds in the near term are skewed toward a risk-off environment, where broad diversification and an emphasis on high-quality investments are warranted until the earnings disappointments to come are fully incorporated into asset prices and the Fed signals that the rate hike regime for the current cycle has ended.

John M. Longo, Ph.D, CFA

Director, WELREX Ltd.