Interest Rates Could Rise Again If The Fed Stays The Course

Despite expectations, the Federal Reserve could still quickly change policy if the financial system becomes stressed, resulting in a quarter point rate increase next week.

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The Fed funds futures are forecasting an increase of 25 basis points next Wednesday after a wild ride on Thursday. Percentage points are expressed as basis points.

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Despite the Fed's expectations of another quarter point hike, Bank of America's global economic research head Ethan Harris predicted a change in course.

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The Fed is expected to hike three 25 basis point rates next week, he stated. According to him, this assumption is made on the assumption that the regulatory efforts to support the banking system are effective and that further negative news will not be too frequent so that the Fed can refocus its attention on inflation next week. Basically, the Fed is going to meet next week, and it's a very close call, as it all depends on what the markets do when they meet."

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Investors expected a $30 billion deposit into First Republic Bank by a consortium of 11 banks, including JPMorgan, Citigroup, PNC, and Truist. Shares of regional banks closed higher on Thursday. Tax yields also rose as investors learned the consortium of 11 banks would deposit $30 billion into the bank.

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After the Swiss National Bank said Wednesday that Credit Suisse is well capitalized and that it would provide liquidity if needed, concerns about the bank's health were also calmed. The European Central Bank raised interest rates by a half-point.

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Situations in flux

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Stocks and oil prices plummeted in response to fears about bank contagion following Silicon Valley Bank's failure.

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Since then, the 2-year Treasury yield has fluctuated widely. It rose from a low of below 3.9% in morning trading to 4.17% in late trading Thursday. The yield moves in the opposite direction of the price.

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Federal Reserve rates are expected to rise by 50% on Thursday, up from 50% on Wednesday. There has been a wildly fluctuating swing in expectations. Traders had also expected a half-point hike prior to Silicon Valley Bank's failure after big swings Wednesday. As First Republic news was released Thursday afternoon, the odds shot up to over 85% and fell back to closer to 80%.

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As a result of recent failures of U.S. banks and concerns about Credit Suisse, economists have differing opinions about how the central bank will react. In May, the Fed will raise interest rates again, according to JPMorgan economists. Economists at Goldman Sachs anticipate that policymakers will hold off on raising interest rates. It is expected that the Fed will stop raising rates soon, according to Moody's Analytics.

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Bank of America’s Harris stressed the importance of being flexible in this situation if you are the Fed. “If you are in a position where the market is under stress, you probably should not hike,” he said. Alternatively, if everything is calm and you feel confident about containing the crisis, you probably proceed with the hike. It sends a positive message to the markets that the Fed is not panicking.”

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Reversal of course is possible if necessary

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In the event that things go bad, the Fed can temporarily reverse course if it hikes.

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“It might be worth considering that the Fed can cut rates in order to deal with financial problems at some point, he said. "Let's assume regulatory measures and the targeted approach aren't working," he said.

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Harris observed that after the 1987 stock market crash, the central bank cut interest rates and then raised them again. Moreover, the Fed cut interest rates in 1998 due to Long-Term Capital Management's demise, but then raised them again.

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The Fed can handle both problems at once, he explained. “One deal with the immediate crisis, and the other deal with the regular program once things quiet down and things are less fragile.”

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There could be some impact on the economy, Harris said.

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In the event that the crisis is resolved quickly, it is unlikely that the growth picture won't change, he predicted. “This is another warning sign to people that the economy is likely to remain weak.”

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It would be a bad message for the Fed to not raise rates if the economy is strong enough. “It makes it look like there is a skeleton in the closet if they don't hike when the economy is strong,” Harris said.

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According to him, the financial system is not vulnerable like it was during the great financial crisis of 2008.

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According to Harris, "The current period is not characterized by a collapse in credit standards like the housing market." Hiking interest rates stresses the economy and markets... In Warren Buffet's words: When the tide goes out, you discover who is swimming naked."

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The Fed moved so quickly and massively in the last year, starting with the first rate hike from zero, that it was not surprising that some fallout occurred. There is a 4.50% to 4.75% range in the fed funds rate now.

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“The Fed went from being remarkably dovish to extremely hawkish. Some institutions are going to get into trouble when there’s that dramatic a shift in the interest rate environment,” he said.