Risk Control vs. Fundamentals
17 March 2023
Read Time 2 MIN
Fed Policy Rate
The market is still trying to evaluate the effectiveness of the U.S. Federal Reserve’s (Fed’s) liquidity reprieve for banks. A Bloomberg chart making rounds this morning shows a huge spike in banks’ discount window borrowing at the Fed (see below), but some bank credit default swaps (CDS) widened again. A big question is whether the Fed will reaffirm the “new normal” of lower interest rates at next week’s meeting, or follow the European Central Bank (ECB) hawks and prioritize inflation. The expectations are mixed. The implied probability of the full 25bps hike is still around 70%, and the implied peak rate remains below 5%. Today’s softer than expected University of Michigan survey – including short- and long-term inflation expectations – points to even more uncertainty in the next few days.
Most emerging markets (EM) are watching the current situation from the sidelines (policy-wise), but China decided to respond with a broad-based 25bps cut in its reserve requirement ratios1 (RRR) – in addition to liquidity injections through other facilities. The RRR cut was not entirely unexpected – short rates have been grinding higher for some time now, which is not an ideal backdrop for the nascent recovery – and the move does not contradict the State Council’s “supportive yet restrained” policy objectives. The timing, however, suggests that risk prevention played a big part.
EM Reaction to the Banking Crisis
China’s reaction is important because a number of EMs – especially in in Asia – are arguably more correlated with the reopening/rebound narrative than with the Fed. This reflects not only the “growth” links, but also the fact that inflation had peaked at lower levels than in EM peers, putting less tightening pressure on central banks. The EMFX price action in the past week illustrates the “anti-Fed correlation” point quite well – Asian currencies pretty much ignored the banking mini-crisis in developed markets (DM), rising against the U.S. dollar. Other important policy litmus tests in EM include rate-setting meetings in Brazil, Mexico, Colombia, Thailand and South Africa – all these will take place after the Fed reveals its policy objectives. Stay tuned!
Chart at a Glance: U.S. Fed’s Big Response to Banking Mayhem
Source: Federal Reserve
1The “reserve requirement ratio” (RRR) or cash reserve ratio (CRR) is the percentage of customer deposits and other liquid assets that commercial banks must store, within its own institution or with the central bank.
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