It's all about the Fed policy decision today and their response is going to have some major reaction, one way or another, especially for regional banks sentiment in the US.
The jitters resurfaced again yesterday and it was ugly, like really ugly. So, where does this leave Powell & co. ahead of today's decision? Adam highlighted the risks here nicely and it is most likely to come down to how dovish the Fed wants to communicate a pause to their tightening cycle.
Essentially, it boils down to a couple of key things. Let's try and take a look at them.
Will there be a rate hike?
The return of the regional bank turmoil isn't going to help make it easy but after weeks of having settled with a 25 bps rate hike, it might be too late for the Fed to walk back now. In terms of market pricing, we are closer to when we were left off after the end of the first turmoil period at the start of April than we were during peak inflation jitters last month:
If the Fed decides to raise interest rates by 25 bps, it could send regional banks reeling once again. But at the same time, if they decide not to raise interest rates at all, it could be a situation where markets see it as being a case of "the Fed knows something that we don't". And in that instance, it isn't a good thing as perhaps things are much worse once you uncover the sheets.
In short, it could be a damned if you do, damned if you don't scenario for the Fed. But the lesser of two evils might be to just stick with their conviction to hike by 25 bps at the end of the day.
Regional banks crisis.. is there more to come?
There are plenty of theories flying about on why regional banks are being crushed. And some of those are a bit out there like how the Fed is cornering regional banks and making the big boys even bigger than their already "too big to fail" status.
I would argue that there are some truths in every version but perhaps the simplest way to look at it is to drill down to the operating model of regional banks. Now, a lot of these issues are only coming up now as rates have shot up higher in the US over the past year.
Essentially, it boils down to the portfolio of these banks and the staggering rate hikes by the Fed has essentially crashed the bonds of these banks and at the same time, also seeing their loans get impaired.
If you add that to the nature of the banks and their clientele, it's not any better - especially for Silvergate and SVB in particular.
Now, there are major banks with similar situations but let's face it, they are called the big boys for a reason. And when depositors are having to take out their money from these regional banks, where are they going to go to? Well, we all know the answer.
Going back to the discussion, it is as much a duration issue because of the bond holdings of these regional banks that is the main problem now. But in the wake of fears being widespread among the public, bank runs are not going to help with their ability to stay afloat.
That's one of the simpler way to put things into context I would say. So, don't be surprised if we start seeing more trouble brewing in this space. Pac West and Western Alliance are the two names that seem to be next on the list.
How dovish will the Fed message be?
I think any hawkish communication is surely to be ruled out after what transpired in markets yesterday. At this point, the Fed has a few ways to play this out.
The most direct path is to be explicit about pausing the tightening cycle after the rate hike today. But that would mean giving up on the inflation fight and that would blow a massive hole in their credibility over the past year or so. As such, I wouldn't expect them to do that.
Instead, there should be tweaks to the statement and plenty of massaging in the forward guidance to suggest that they will be data dependent moving forward - even more so than they already are.
That means if inflation does become more of a problem again, they will have no qualms - or so they say now - with raising rates again. But otherwise, they will let the higher rates cook for the time being. I mean, they can easily point to a slowing economy and the banking turmoil for any reason to pause; although more indirectly for the latter.
The other way that the Fed can communicate a more dovish message is by choosing to not push back hard about the current market pricing. If the Fed hikes by 25 bps today, markets are then seeing three rate cuts to follow by year-end with the first coming as soon as September.
If Powell doesn't say anything to invalidate that sentiment, that could very well be a positive note for broader markets. While the absence of a push back does not mean a confirmation in this case, it's about as good as markets could hope for I would say.
