How Credit Suisse just unleashed a nightmare decision for the Fed and the ECB

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Thursday March 16, 2023

Today’s newsletter is by Jared Blikre, a reporter focused on the markets on Yahoo Finance. Follow him on Twitter @SPYJared. Read this and more market news on the go with the Yahoo Finance App.

Credit Suisse (CS) just suffered its worst day on record — sending the stock plummeting 22%. The bank’s bonds are also crashing, and investors are paying for insurance on its bonds at rates not seen since the Global Financial Crisis.

As investors call into question the solvency of one of Europe’s biggest banks, the safety and soundness of the entire global banking system is once again a big question mark for Wall Street. Meanwhile in the U.S., investors are still coming to grips with the fallout from the failures of Silicon Valley Bank and Signature Bank, sending regional bank stocks down for the seventh time in eight sessions.

The once-difficult job now facing Federal Reserve chair Jay Powell and his central banker colleagues just became a seemingly impossible dilemma — continue its fight against inflation by raising rates and tightening credit markets even further, or battle a new banking crisis that poses systemic risk.

It’s worth remembering that only last week, Fed chair Jay Powell sat in front of Congress and said the Federal Reserve was “prepared to increase the pace of rate hikes.” He hedged the statement (as a conservative central banker should), citing the need to consider the “totality of incoming data.”

But the bond market took notice that day, and so did bank stocks. Suddenly, markets were pricing in a 50 basis points (0.5 ppt) March rate hike instead of 25 bps. The U.S. 13-week Treasury-bill yield (^IRX) jumped the most in two months — topping 4.8% for the first time since 2007. Meanwhile, the S&P 500 Select Financial SPDR ETF (XLF) had its worst day in nearly six months, settling at a six-week low.

From there, banks have been caught in a week-long slide that’s erased billions in market cap value.

Whether or not Powell’s visit to the Capitol last week was the proverbial straw that broke the camel’s back, he and his central banker colleagues are facing a monster decision next week with tough choices, and no ideal solution.

Raghuram Rajan, Chicago Booth professor of finance and former Reserve Bank of India governor, joined Yahoo Finance Live to explain the difficult choices the Federal Reserve now has with its twin problems of stubborn inflation and banking instability.

Rajan says the Fed is likely deciding between a 25 basis point hike and standing pat, leaving rates where they are. (Bond futures are ascribing equal probabilities to both, as of Wednesday afternoon.)

“I doubt they will cut,” says Rajan, who also says a more aggressive hike of 50 bps is probably off the table. “That would be a pretty hard hike at this point when you have so much fragility,” adding, “the question is 25 or zero [basis points].”

If the Fed holds short-term rates steady, Rajan expects Powell to downplay investors’ perceptions that the Fed is on “pause” for several meetings.

Historically, the Fed doesn’t change direction on interest rate policy too frequently, and market participants might get the impression that future hikes are off the table. That could threaten the Fed’s inflation-fighting credibility and its perceived resolve to start hiking rates again if inflation fails to subside.

Rajan says if the Fed doesn’t hike, it will protect against this with “very strong language,” saying, “We’re not pausing. We’re just taking a break, looking at how the markets settled down,” adding that the Fed would leave the window open to resume tightening.

Conversely, if the Fed raises by 25 bps, that indicates the Fed is still concerned about inflation and the need to slow down the economy. However, this option risks freezing credit markets further and deepening the cracks in the financial system. (Remember what happened when Powell simply talked a hawkish game last week.)

It might seem non-intuitive, but the Fed can still theoretically achieve its goal of tamping down inflation by not moving short-term rates next week. First, picture a business owner or C-suite executive observing the current troubles in the banking sector. Many will see a recession on the horizon and decide to lay off workers, which slows the economy.

“The financial sector turmoil will do part of the Fed’s work. Now, that’s not the ideal way to get the Fed’s work done. But it can be part of [it],” says Rajan. If the Fed believes the crisis is bad enough to do its dirty work, that would lean the Fed towards zero, he explains.

“This is all up in the air [and] very confusing,” says Rajan.

Bottom line, it’s a big dilemma.

If the Fed doesn’t move, it risks damaging its hard-won inflation-fighting credibility in the middle of the battle.

If the Fed hikes, it could exacerbate the worsening credit market conditions, contaminating the “productive” areas of the economy.

At least Powell has another week to digest the developing situations both domestically and abroad. His European counterparts have to act this morning. Decisions, decisions.

What to Watch Today

Economy

Building permits, February (1.238 million annualized rate vs. 1.339 million in January)
Housing starts, February (1.31 million annualized rate vs. 1.309 million in January)
Initial jobless claims (205,000 expected vs. 211,000 last week)
Philly Fed manufacturing survey

Earnings