USD Swaps: Not satisfied with $30bn? A dovish hike and more options for the Fed

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Not satisfied with $30bn; A dovish hike and more options for the Fed

As one of the worst weeks on record for the global banking system comes to a close, markets don’t appear too satisfied with the Band of White Knights and their massive $30bn purse to stave off First Republic Bank’s demise - notably, the bank's stock is currently down 26% today.

Indeed, risk markets today are now looking at yesterday’s late afternoon rescue plan/capital infusion as a mere band-aid that won’t necessarily stem any further bleeding down the line, with the rising default risk concerns and the potential business/economy-crippling tightening in lending standards across ALL banks adding to investor concerns today.  And these concerns have only added to another bank's (i.e. Credit Suisse) tangled net of problems that were already causing some angst today (see Total Derivatives).  Accordingly, the major domestic equity indices are all in the red in the mid-afternoon trade today (Dow -1.41%, S&P -1.17%, Nasdaq -0.92%).

Against this risk-off backdrop, Treasury yields have careened roughly 10-23bps lower in another front-end-led move today.  The benchmark 10y note yield is last 18bps lower at 3.397% while the 2s10s spread is 10.8bps wider at -48bps.  SOFR futures are now up to 32 ticks firmer in the outperforming reds while fed fund OIS futures are now pricing in a terminal rate south of 5%.  Meanwhile, swap spreads are tighter across the board with the wings outperforming amidst better receiving flows best seen at the 5y, 10y and 30y tenors. 

And looking back on this topsy-turvy week in the rates market, while many will have opinions and try to wrap their conclusions into pretty concise bows, one source simply grumbled that “trading conditions stand in the way of nuanced analysis” as illiquidity, volatility and uncertainty were his key takeaways this week as the dust settled into the weekend.

Looking ahead, next week has grown exponentially more important as markets are unsure if the Fed will continue to tighten at its breakneck pace or decide to stand down given this week’s banking turmoil.  Prior to the emergence of financial market turbulence, strategists at BofA felt that “altogether, it seemed that the committee was willing to shift back to a larger 50bp rate hike, but the data had to push them over the edge.” 

However, BofA now thinks that “recent events, including the revelation of financial stress in a few regional banking institutions, has changed the debate”.  It expounds below:

”…The emergence of financial stress is likely to indicate to the committee that monetary policy is closer to ‘sufficiently restrictive’ than some may have thought previously. At a minimum, stress in financial markets suggests the Fed should proceed with caution. We suspect the debate is now between a 25bp rate hike in March, or none at all. More financial instability between now and next Wednesday could tip the balance in the direction of a pause in the rate hike cycle – and perhaps a pause in balance sheet runoff – but our expectation is that the Fed will lift the target range for the federal funds rate by 25bp to 4.75-5.0% and maintain its current balance sheet policy.”

However, if things get worse and the train goes off the rails, BofA reckons that the Fed has more tools in its tool box:

”…Our outlook on the Fed makes several assumptions. First, the Fed has strong tools to respond to challenges that originate in the banking sector, as opposed, for example, to the bursting of asset price bubbles. Second, central banks can walk and chew gum at the same time. It is reasonable for the Fed to use its lender of last resort capabilities while also fine tuning its monetary policy stance in an effort to restore price stability. Yes, conflicts between these two goals may emerge, but the Fed has different tools for different reasons and an “all or nothing approach”, in our view, is too simplistic. Third, should the tension be too great and financial stability concerns become too large, there is nothing untoward about using precautionary rate cuts and halting balance sheet runoff in the short run if needed. If successful, the Fed could then tighten policy later to pursue its dual mandate.  

 

“…Examples of this behavior can be found in the Fed’s response to two financial events of prior decades—the 1987 stock market crash and the 1998 collapse in Long Term Capital Management (LTCM). These were much bigger events than what we are experiencing in markets today, or at least so far. They also were events where the Fed could not apply the targeted tools it has developed to manage banking sector stress. In both instances, the Fed pivoted from fighting inflation to stabilizing the financial system. They responded by cutting rates by about 60 bp in 1987-88 and 75 bp in 1998. However, that was not the end of the story. In both instances, with persistent inflation concerns and financial markets stabilizing, the Fed resumed its regularly scheduled program, hiking 325bp and 175bp, respectively. Given the inherent nonlinearity of financial events, sometimes stabilizing the markets means delaying the inflation fight. We do not expect that to happen next week, but we cannot rule it out entirely.”

Currently, SOFR swaps – 2s -3bps (-2.25bps), 3s -14.375bps (-2.5bps), 5s -18bps (-0.25bps), 7s -27.5bps (-0.25bps), 10s -25bps (-0.875bps), 20s -66bps (-2.75bps), 30s -71.625bps (-1bps).