Everyone was watching the US Federal Reserve as it met in the middle of a financial crisis that could lead to the collapse of the whole economy.After the previous Fed meeting, expectations had shifted dramatically. After Powell’s hawkish comments last time around, certain segments of the market expected a 50-bps raise, which swiftly shifted to mainstream estimates of a 25-bps hike. Due to recent bank problems, some elements of the market have already begun to advocate for a halt. Once the US government began to take immediate action to assure deposit safety and liquidity assistance to banks via emergency lending, the chances shifted back towards a 25-bps raise.
The US Fed lifted rates by 25 basis points, as expected, bringing the Federal Funds rate to between 4.75 and 5 percent. Although the boost and its magnitude were expected, the Fed’s perspective on delaying future rises was unexpected. That would put an end to the fastest rate of increase in decades. Yields declined across the board as a result.
Decoding the Fed’s outlook
The US Fed was already in an untenable situation since it had to walk a tightrope in order to curb excessive inflation without stifling the economy. Its situation became even more insecure as the economy sent contradicting signals: on the one hand, the labour market remained robust, while three relatively minor American banks failed. While rising core inflation and persistent wage inflation made the case for more rate hikes, the addition of bank-struggles complicates matters.This might explain the Fed’s decision to pause further rate rises.
The Fed, on the other hand, said that the financial system is stable. Given that US inflation is still far above the Fed’s objective of 2% and the labour market shows no symptoms of a recession, if the banking sector was really out of the woods, the scenario would not have called for the Fed to announce a halt in rate rises. In other words, the Fed is not worried about systemic credit risk at the moment, preferring to wait and see. The situation’s evolution is unpredictable; it might either be brought under control by the Fed’s and governments’ actions, or it could deteriorate into a systemic catastrophe. “It could easily have a significant macroeconomic effect,” Powell said.
What can investors do?
If the Fed had signalled its intention to keep raising rates, it would have been terrible news for those banks that have been treading water in terms of asset-liability matching and/or have experienced deposit runs as a result of continued banking sector worries. As a result, the Fed’s forecast for a rate pause offers much-needed breathing space for banks.
Furthermore, the US Fed’s pause in hikes allows the RBI to take it easy on future hikes without worrying about the negative impact of falling yield-spreads on foreign inflows and, thus, on the Indian currency. This could benefit the domestic economy, which has recently shown signs of slowing. Stabilisation or improvement in yield spreads would have a more direct impact by attracting foreign inflows into emerging assets such as Indian equities.
Nonetheless, investors are encouraged to follow the Fed’s lead and take a wait-and-see strategy, keeping a careful eye on how the situation develops. Any signs that a risk of contagion is affecting banks that are otherwise strong should be seen as a sign to take less risk, and portfolios should be shifted towards safer assets and good large-cap firms among equities.
Of course, the second order effect on Indian banks is expected to be minimal for the time being.Indian banks benefit from stronger capital adequacy laws, bond classification as held-to-maturity, and mark-to-market norms. As a result, if Indian bank stocks decline dramatically, particularly those of bigger banks with the ability to fight through these difficult times, it will create an excellent opportunity for investors to scoop up such stocks at favourable prices.
Several hazards persist in addition to the most recent concern on the block, systemic credit risk. Internationally, we confront threats of prolonged inflation on the one hand and serious recession on the other. At the same time, geopolitical crises such as the war in Ukraine are far from over. Domestically, rural development was already sluggish and is now threatened by unseasonal rain. Urban demand, which had previously underpinned expansion, has begun to show indications of weariness. Private capital expenditure has also slowed. Because of global macroeconomic and geopolitical worries, exports have been slow. Yet the Indian government’s infrastructure effort can only help development to a certain degree. As a result, investors should take smaller and more measured risks until the situation on the ground shows obvious indications of recovery.