March 24 2023
The central banks of the US and UK continued their battle against inflation this week, both lifting their key interest rate by 0.25%. This took the US Fed Funds Rate to 4.75%-5% and the UK base rate to 4.25%.
The move in the US was in line with expectations although some investors had thought that they may pause to enable them to assess the events within the banking sector. The central bank increased, however, in what was perhaps a signal to the market that they believe they had interest rates to tackle the inflation issue and other liquidity tools to provide financial stability if necessary.
The latter did acknowledge that the recent developments in the sector were likely to result in tighter credit conditions for households and businesses. These have already seen a marked pick up. This could ultimately have a negative impact on economic activity. The peak in US interest rates may therefore be at a lower level than predicted. The market then believes that we will see interest rates cuts in the US because of the events of the last week or so. This is difficult to see given the stubbornness of inflation. This mismatch in expectations between the Federal Reserve and the market could give rise to market volatility further down the line. We have already seen heightened volatility in the bond market, with the ICE Bank of America MOVE index at levels not seen since 2008. We are yet to see it move into the equity market to the same extent.
The Bank of England were perceived as having little option but to hike following the release of inflation data which was higher than expected. CPI had been expected to post a year on year rise of 9.9% but instead came out at 10.4%. Not only was this above the forecast, but it was also above the 10.1% for the year to the end of January. The largest upward pressure came from cost of food and non-alcohol drinks. This is more due to supply rather than demand issues. This is where the Bank of England will need to be careful. Hiking interest rates is unlikely to have as much effect in this area, as it is supply led, but could have a more serious impact on areas such as credit affordability, which is needed to keep the economy ticking along. Still, policy makers still warned that if there were to be more evidence of persistent inflation pressure, further rate hikes may need to be seen.
Despite the best efforts of regulators and authorities to shore up confidence in the banking sector, nervousness still remains, especially in those where there have been perceived issues before. For now the US authorities are refusing to insure all deposits for the regional banks up to an unlimited amount. This could still see further flight in deposits to the majors by deposit holders.
Furthermore, US investors have realised that there were better alternatives to cash deposits, namely in the shape of money market funds holding Treasury Bills or by holding the latter directly. This has seen a flight of monies from banks into said vehicles. Banks could try to bring this to a pause by increasing the rates which they offer themselves, but this will ultimately eat into their margin. We suspect depositors are doing their homework a little more closely than they used.
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