The financial market developments of the last month strengthened the thesis of a potential hard landing that had gained ground during February. However, the expectations of year end policy rates being higher flipped again during March after the collapse of a few regional banks in the US and signs of stress developed in a few international banks. As implied by the Fed Funds Futures, the expectations of the year-end policy rate that stood at ~4.47% on January 31st, rose to as high as ~5.55% on March 8th and fell to ~4.35% on March 31st. The yield on the US 10-year treasury jumped from ~3.50% on January 31st to ~3.99% on March 8th and dropped again to ~3.47% on March 31st, indicating the uncertainty in the fixed-income markets (Source: Bloomberg Finance L.P.). As we see it, the confusion in fixed-income markets stems from the Federal Reserve's persistent hawkishness even as cracks emerge in financial markets.
While keeping inflation under check is one of the primary goals of the central banks, the stability of the financial system is paramount. As the risk of deposit flight from the US regional banks gathered pace, the Federal Reserve announced the availability of additional funding through a new Bank Term Funding Program (BTFP) to shore up depositors’ confidence in the banking system. Historical evidence suggests that such support measures are typical at the end of a policy rate hike cycle as the damage from higher interest rates begins to show. The fixed income markets discounted this probability by pushing down yields across the yield curve during March (See Figure 1). However, on March 22nd, the US Federal Reserve decided to push through the 25-basis point rate hike despite emerging cracks in the financial system.
Figure 1: Yields have dropped across the curve
During a transitional period of high policy rates, falling but still high inflation, and a slowing economy, uncertainty and therefore volatility is inevitable in financial markets. The central banks have a tightrope to walk on as premature signalling of an end to the tight monetary conditions might prove counterproductive and keeping policy tight for too long increases the risk of recession. Leading indicators such as the Institute of Supply Management’s Manufacturing PMI (Purchasing Managers’ Index) and Services PMI are showing signs of a decelerating economy (the central banks’ desired path to bring down inflation). Lagging indicators such as unemployment and job openings, while still strong, are beginning to show the effects of higher interest rates. The ISM Manufacturing PMI declined to 46.3 in March from 47.7 in February. The ISM Services PMI dropped to 51.2 in March from 55.1 in February. The ratio of total job openings to unemployed workers in the workforce also dropped from 1.96 at the beginning of the year to 1.67 as of the end of February (Source: Bloomberg Finance L.P.).
In line with our expectations, the various inflation measures are also improving. US headline inflation fell to 6.0% in February (reported in March) from 6.4% in the previous month, and the Canadian headline inflation fell to 5.2% in February from 5.9% in the previous month (Source: Bloomberg Finance L.P.). Overall, we believe the signs of a slowing economy and stress in the financial system indicate policy rates are close to reaching their peak. We expect the tone of central banks to get incrementally less hawkish in the coming months. This should prove to be a tailwind for risk assets, in our view.