What’s Next for The Fed?

Steve Wyett, Chief Investment Strategist of BOK Financial, shares what the Federal Reserve may be watching ahead of its next meeting in May, and what to know about the banking industry.

How do you think the Fed is evaluating the current market environment? 

From our perspective, the Fed is trying to separate two issues at hand. First is the liquidity issue in the banking industry. The FDIC insured limit, currently $250,000, covers a lot of bank deposits but not nearly all of them. The Fed has already implemented an emergency lending program, the Bank Term Lending Program (BTLP), which allows banks to pledge government securities as collateral for loans at par, regardless of depreciated market value. There are also funding options to provide liquidity to banks and provide a cushion for banks and lessen the risk of a systemic crisis.

The second issue is inflation, which is still far higher than the Fed’s 2% target. Slower loan growth and higher rates should result in slower economic growth and a chance for the labor market to cool. If this happens, it might be the Fed can stop raising rates at this point. But how the data on the job market and inflation unfolds from here will be very important.

What can we expect from the Fed after their next meeting?

The next scheduled meeting is in May, which gives us and the Fed some time to watch economic data and see if the recent bout of financial system unrest has an effect on the economy and inflation. If we get data which shows the labor market slowing, wage pressures declining, other inflation measures like CPI and PPI falling, the Fed might be done raising rates. 

But we know this Fed is acutely aware of the risks of stopping or easing policy too soon. Hence it will take clear evidence of a weakening job market, economy and inflation for the Fed to pause interest rate increases. And once paused, they would need even more evidence before they would consider cutting rates as the bond market is nor forecasting. 

How’s the recent unrest in the banking sector different than prior times?  

Past periods of stress in the financial system were primarily caused by credit issues. As economic growth would slow, banks would see loan losses begin to increase, which would overwhelm their loan loss reserves and begin to materially reduce capital. In the case of Silicon Valley National Bank, losses in their bond portfolio were large enough to raise concern amongst depositors and trigger a classic run on liquidity, which led to the FDIC stepping in to close the bank and act as receiver. From the perspective of the FDIC, they acted as they normally do, but the reason they had to step in was different than past periods.

What kind of regulatory responses do you expect to come out of this? 

We never have a period of financial system instability without some sort of regulatory response. The nature of this period will, hopefully, not warrant the type of response we saw after the Financial Crisis, but we certainly can expect additional levels of oversight and potential rule changes as it pertains to bank bond portfolios and their use of “Held-to-maturity” designations. The lack of credit risk obviously does not mean holding treasuries is riskless.

What should investors keep in mind during this time?

Our sense is it is prudent to be more heavily weighted towards managing risk than pursuing returns in the current environment. There are pockets of opportunity in the bond market and for all the pain investors went through last year as rates increased rapidly, the opportunity to actually generate reasonable cash flows from bond investments is a welcome development.

Remember, the economy has always been cyclical, and longer term, these periods where excesses are revealed end up positioning the economy for more growth going forward. The list of concerns today can be scary: inflation, banking system unrest, debt ceiling discussions, war in Ukraine, “de-dollarization” among others, but companies and the U.S. economy have  a history of being resilient and overcoming problems to move ahead.

What other factors/news should investors keep an eye on? 

In addition to the domestic economy, we always need to be cognizant of international markets and events. Global risks seem elevated at present too with the war in Ukraine grabbing headlines, but higher inflation is a global issue as well. The valuation of international stocks appears more reasonable than domestic stocks but headwinds to growth abound. 

In the U.S., we think the discussions around the debt ceiling could get very interesting. We have a split government with Democrats in the White House and controlling the Senate but Republicans controlling the House of Representatives. Ordinarily these check and balances can be a good thing, but we will need strong leadership in Washington to work through our budget issues. 

Spending has come down a lot since the peak of the pandemic but is still running much higher than was normal on a pre-pandemic basis. And mandatory spending on Social Security is going higher based on inflation cost of living adjustments. About 60% of the government’s spending is mandatory or non-discretionary, meaning it does not go through the annual appropriations process.

The two largest discretionary parts of the Federal budget are defense spending (probably going higher) and interest expense on our debt (definitely going higher). When taken in total, the ability of the government to cut spending is focused on a small part of the budget.

Of course, the other option is to raise revenue which, in the face of a slowing economy, might be just as difficult as reducing spending. Longer term, we expect an agreement and would view any short-term market declines from this issue as a potential opportunity, but the short-term rhetoric and action could be difficult to watch.

This interview originally appeared in our TradeTalks newsletter. Sign up here to access exclusive market analysis by a new industry expert each week. We also spotlight must-see TradeTalks videos from the past week.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Economy Markets