Even though the European Central Bank appeared to choose fighting inflation over defusing banking instability, its struggle to tighten interest rates any further from here will likely show that the two issues are joined at the hip.
After a dramatic week of U.S. bank failures, a near-death experience for Switzerland’s second-biggest lender Credit Suisse and wild swings in bank stocks and bond markets, the ECB stuck to its plan for a half-point interest rate rise to 3.0 percent - its highest level in 14 years.
But even though it’s own above-target forecasts for inflation through 2025 demanded further tightening, there was a distinct sense that it may be tightening for the sake of it rather than assessing what’s coming down the pike.
And with ECB chief Christine Lagarde admitting that it was impossible to say what happens from here due to the “completely elevated” uncertainty, money markets appear convinced the ECB is almost done and dusted - and have stopped short of pricing another full rate rise over the cycle.
Even though reading anything with certainty from such volatile prices is difficult right now, the runes of the bond market suggest unfolding banking stress will suppress inflation anyway - regardless of further central bank action.
Despite an additional turn of the screw from the ECB this week, the financial blowups on both sides of the Atlantic have collapsed the horizon for further interest hikes everywhere - but with no commensurate change to long-term inflation expectations.
If the lower rates outlook wasn’t warranted, then presumably those expectations should be creeping steadily higher.
The fact they haven’t reflects a well-learned lesson among investors that bank stress and failures historically lead to tighter credit and credit standards, stricter regulation and reduced lending - all of which do central banks’ job for them, potentially obviating the need for higher policy rates.
“The tensions of the past few days could make banks more cautious in their lending and keen to cut back on risky commitments,” asset manager DWS told clients. “That would be very much in line with what the central banks want.”
Since the run on Silicon Valley Bank first emerged in the middle of last week, so-called implied “terminal” or peak rates for the ECB, U.S. Federal Reserve and Bank of England have been crushed.
Not only is the ECB considered to be done tightening at 3 percent rather than 4 percent, but the Fed is now expected to peak at under 5 percent compared to 5.75 percent just last week - with about 75bps of easing priced between May and yearend. The Bank of England has barely a quarter-point hike to 4.25 percent left, if you believe money markets, whereas a 4.75 percent peak rate was in the price just eight days ago.
If more policy rate rises than that were deemed warranted by market views of growth and inflation dynamics alone, then investors should be scrambling for more inflation protection.
But 5-10 year inflation expectations derived from the inflation-protected securities and swaps market show otherwise.
While all remain above 2 percent inflation targets, the euro zone, five-year, five-year forward inflation-linked swap actually fell 10bps over the week to just 2.3 percent even as peak ECB rates were revised down sharply. U.S. equivalents were steadier about 2.5 percent, but five-year “breakeven” inflation rates from the index-linked market fell to 2.3 percent.
In essence, financial stress tightens credit of its own accord - and if that snowballs to a full-blown credit crunch then central banks may even be forced to add liquidity to prevent an economic shock.
Aiming to quantify the risk, JPMorgan’s economists reckon heightened regulatory scrutiny of smaller U.S. banks and a run on deposits to larger institutions could hit loan growth hard. With no offset from larger banks, U.S. gross domestic product would be cut by up to 1 percent over the next year or two.
How distressed the credit markets get from here then is everything, with little overall visibility likely for several weeks at least.
U.S. high-yield “junk” bond borrowing premia over U.S. Treasuries have already jumped by more than a percentage point over the past week to their widest in almost six months. Euro zone equivalents hit their highest since November.
To be fair to central bank policymakers, their own early warning systems - such as the ECB’s Composite Indicator of Systemic Stress - don’t yet show any more pressure on the system than they did during last year’s tightening.
But as Lagarde intimated on Thursday, these are early days.
Barclays strategist Ajay Rajadhyaksha and team raise the puzzle as to why the main stock market indices have not reacted quite as badly to the sort of risks that seem to warrant 75bps of Fed rate cuts by yearend, suggesting the rates market may have overreacted as a result of whiplashed positioning.
After all, banking stocks aside, the wider S&P500 is down only 1 percent over the past week and the Stoxx index of euro zone equities is off only 4 percent.
“U.S. stocks are still slightly up for the year, not what one would expect if the Fed is about to respond to a widespread financial and economic crisis,” the Barclays team wrote.
For the stock market to be a better gauge of upcoming economic strength than the bond market would be unusual indeed.
Armed with Thursday’s trial run from the ECB, the Fed and BoE will now have to make that judgment next week.