Interest Rates Are (Probably) Cresting
Inflation slows, plus the impact of bank failures
On March 22nd, the Fed hiked interest rates by another quarter point. It was the ninth straight rate hike going back to March 2022 as the Fed continues to try to hammer down inflation. What was most notable about this most recent increase, however, is that in the weeks prior, market participants and other prognosticators had been predicting a rate increase of 0.50%. The comparatively smaller increase instead may have marked a key inflection point in the Fed’s trajectory, which has some major implications for borrowers, banks, and the economy as a whole. Further data released this past week also supports the premise that interest rates may be topping out with more downside than upside at this point. Let’s dig in.
0.25% vs. 0.50%
On March 8th, just two weeks prior to the Fed’s March meeting, the market was pricing in a 78% chance that the Fed would hike rates by 0.50% according to the CME FedWatch Tool. That is a pretty decisive percentage, and more than likely it would have been accurate had the events that took place in the subsequent two weeks not unfolded the way they did.
So what happened? Facing a unique set of poorly timed variables including their own bad decision making, there were two major bank collapses. First it was Silicon Valley Bank on March 12th and then Signature Bank two days later. A short time after that, 166-year-old Credit Suisse, the second largest bank in Switzerland and one of global importance, was forced into being acquired by UBS in a fire sale.
These events sent fear throughout the economy and the global banking sector that the bank failures could snowball upon one another and lead to a real banking crisis. This risk of contagion is itself one reason why the Fed may be slowing up its interest rate hikes. There was for a long period of time a general premise that The Fed would raise interest rates “until something breaks.” Well, things started to break. And although inflation is still a concern and the Fed has been quite hawkish on the need to hammer down inflation, the Fed is also mindful of the need for a stable banking environment even if inflation continues to run a little bit hot. It is a tough balance for sure, but this new risk of the potential for serious peril in the banking sector is likely, I think, contributing to an easing off of interest rate hikes.
Keep in mind, too, that it was the massive losses Silicon Valley Bank and others took on their poor, long-term, low-yielding investments as interest rates rose that contributed to this sudden peril in the banking sector. Safe to say that no one anticipated 500+ basis point hikes in one year (5.00%, for all intents and purposes), but as rates rose, investment values fell, which triggered not-just-paper losses as those investments had to be liquidated to honor customers’ cash withdrawals. I wrote about this in depth a few weeks ago so I’ll leave it at that for now, only just to say that I am curious about whether the upside-down nature of so many banks’ balance sheets played a role in the Fed easing off from hiking more aggressively in March even if the Fed itself would have liked to stay aggressive on rates in its continuing bout with inflation.
So What About Inflation?
The main reason why interest rates keep going up is that the Fed wants rates to be higher in order to slow down the economy and with it, inflation. I’ve written a lot about inflation so I won’t dwell on it here, other than to note that the Fed’s target inflation rate is 2.00%, and inflation has been greater than 7.00% for most of the last year. However, there are now clear signs that inflation is on the way down, or at least decelerating. This past week, the monthly Consumer Price Index (CPI) report showed that prices rose by 5.0% in March. This was good news for two reasons. First, inflation was running at 6.0% in February, so the 5.0% shows trajectory in a good direction. And second, market participants and economists had been projecting a 5.1% increase in inflation, so the report beat expectations to the good side (even if it was only by 0.1%).
If inflation does continue to subside, which I think it will, the Fed will no longer have as much motivation to keep raising rates, which is why I think there is more downside than upside to interest rates at the moment.
What is the Market Predicting?
Economists and investors are currently giving a 78% probability that rates will go up by another 0.25% following the Fed Meeting in May and a 22% chance that rates stay where they are. But the interesting thing is when you look at rate projections for six months out or by the end of the year. According to the CME FedWatch Tool, the market is giving a 78.5% probability that rates will be lower than they are right now by December. The market gives a 17.1% chance that rates will be the same as they are today, and they give just a 4.3% chance that rates will be higher than they are today. In other words, if these market projections hold, we will see a quarter point rate increase in May, a plateau for several months, and then the beginning of rate decreases in the fall.
Is that good news? Well, if you are a borrower with exposure to variable rate debt than undoubtedly yes. And if you are in real estate or your income is somehow tied to real estate activities, lower rates could help the market. But on the other hand, the reason it is likely that rates will decline according to economists it that the economy may by the end of the year be in a recession. So while inflation and high interest rates are a problem on one side of the coin, a recession that results in job losses and a slowing of all sorts of major levers in the economy would also not be good.
The soft landing possibility is that inflation continues to ease, interest rates settle back down to a more moderate level, and the economy holds up to the extent possible without too much pain and suffering. Time will tell. I’ve been saying to a lot of people recently that money was too cheap from 2020 to 2022, and now it is too expensive. The “right” level for interest rates in my opinion is somewhere in between. Possibly one year from today in April 2024 we will be there.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank. © Ben Sprague 2023.