Tomorrow (Wednesday, March 22) is a big day for the Federal Reserve. They control the economic wheel and will dictate where we go from here.
The decision they must make? Raise interest rates or hold steady. This decision will profoundly impact the global economy as the banking sector is showing signs of weakness.
On the one hand, the Fed faces an inflation rate that remains stubbornly high. Raising rates will help temper this and (hopefully) bring inflation to its 2% long-term target rate.
On the other hand, banks are starting to fail under the weight of rising interest rates. Further rate hikes will put even more pressure on these institutions.
The Fed Meeting
The FOMC (Federal Open market Committee) holds eight scheduled meetings throughout the year to discuss whether there should be any changes to near-term monetary policy.
Tomorrow’s meeting announcement is arguably the most important since the Fed decided to begin its rate hike campaign last year.
There is an 18% implied probability that the Fed will hold steady at tomorrow’s meeting (4.75%). Whereas a month ago, there was a 0% probability implied in market prices that they would hold steady.
Most investors are effectively betting that they will increase rates by 0.25% to 5.00%. However, with the recent banking turmoil over the past few weeks, Fed officials are recalibrating their interest rate plans.
What has happened over the past few weeks is eerily similar to the 2008 financial crisis. The last thing the Fed wants to do is to create a banking panic.
Now we have to ask ourselves: has the Fed tightened economic conditions to the point where something has broken? Do they raise 0.50%, 0.25%, or 0.00%?
Recent Banking Recap
A lot has happened recently. To bring you up to speed, here is a fun little recap:
- March 8: Silvergate Capital, a cryptocurrency-focused bank here in San Diego, ceased all operations after a bank run forced it to sell a chunk of its securities. As Ron Burgundy would say, “Great Knights of Columbus, that hurt!”
- March 10: Silicon Valley Bank (SVB) failed after a run on deposits, the second-largest bank failure ever. This is an excellent write-up if you want a breakdown of how this happened.
- March 10: Signature Bank is seized by regulators to prevent the spread of banking contagion.
- March 12: The Federal Reserve, Treasury Department, and FDIC jointly announced that all depositors would have access to all of their money. This is significant for SVB customers as 90% of deposits at this bank were NOT FDIC insured. Lesson here? Make sure your bank deposits are insured!
- March 12: The Fed also announced an emergency lending program, allowing U.S. banks to borrow money from the bank to “meet the needs of all their depositors.”
- March 13: First Republic Bank stock price plunges 60% as investors worry they might be the next regional bank to fail.
- March 15: Shares of Swiss giant Credit Suisse tumbled by 24%. Credit Suisse has long been troubled as it has made poor investments and faces ongoing litigation.
- March 16: First Republic received a $30B cash infusion from Wall Street banks, including JPMorgan, Morgan Stanley, and Wells Fargo.
- March 16: Credit Suisse borrows $54B from Switzerland’s central bank.
- March 16: The Fed announced that banks have already borrowed $11.9B from the emergency loan program.
- March 19: UBS, Switzerland’s largest bank, agrees to acquire Credit Suisse for $3B (a pretty small amount, given the global presence of this firm), a deal brokered by the Swiss National Bank. The deal includes a 100B Swiss franc loan to UBS and wipes out $17B worth of Credit Suisse’s bonds.
The Bigger They Are
One of the moral hazards that many are not talking about is whether or not UBS is now too big.
If Credit Suisse was too big to fail, then what about UBS now that they have absorbed Credit Suisse? What happens if/when they begin to show weakness?
No doubt, these bankers know they will be bailed out if something were to go wrong. Every central banker’s nightmare includes fear contagion. If one institution begins to fail, then so might another. This is why almost every financial crisis in history includes a bank run – nobody wants to be the last one holding the bag.
Wouldn’t it make sense, then, for these bankers to take on excess risk if they know the government will act as a backstop? Is this really in the best interests of taxpayers (whether here in the U.S. or in Switzerland)?
The Fed’s Decision
Nonetheless, the Federal Reserve faces a tough decision tomorrow: should it proceed with its plan to raise interest rates or hold off in light of the potential risks? The Fed has been on a path to normalize monetary policy, which involves gradually raising interest rates to keep inflation in check. However, the recent banking developments may give the Fed pause, as raising rates too aggressively could put additional pressure on the already fragile financial sector.
On the other hand, delaying rate hikes may lead to unintended consequences, such as fueling inflation and/or creating another asset bubble (wouldn’t that be fun).
What Does This Mean for You as an Investor?
We cannot predict with any certainty what the Fed might or might not do. Perhaps the prudent move for the Fed would be to hold off on any rate hikes this month. Or, perhaps, the Fed may believe they have done enough to reassure depositors that their money is safe at their banking institution. We cannot know for sure.
Either way, there will likely be market volatility tomorrow as (short-term) investors digest the Fed’s decision. If you are a long-term investor (as you should be), then this shouldn’t really affect you either way. As Warren Buffett would say, “Our favorite holding period is forever.” What a gem.