Bank Turmoil: What Does It Mean for Fed Policy?

Markets have been rattled by recent turmoil in the banking sector. Bank stocks have fallen sharply and overall market volatility has spiked. However, the U.S. Treasury and the Federal Reserve have moved swiftly to address potential risks to the financial system. While it's too soon to tell how long volatility will last, we view the steps taken so far as positive. We also believe the turmoil will relieve some pressure on the Federal Reserve, possibly leading to a pause or slowing in its current rate-hike cycle.

Below we'll discuss the potential impact on Fed policy, followed by an overview of the "backstops" the central bank, the Treasury and the Federal Deposit Insurance Corporation (FDIC) have put in place to shield depositors.

There's an old saying that "when the Fed tightens policy, something breaks." In other words, the tightening in credit and liquidity often uncovers weaknesses in the economy or financial system. Low-credit-quality lending and high levels of borrowing are frequently where the cracks emerge.

Since March 2022, the Fed has been hiking short-term interest rates at the fastest pace in modern history, so it is not too surprising that the markets are starting to account for the underlying risks. After a long period of very low interest rates, the steep pace of federal funds rate increases, along with the Fed's quantitative tightening program, have heightened the potential for a sudden shock as investors begin to rethink riskier investments.

While it appears that the turmoil in the banking sector is not a sign of widespread "systemic" risk to the financial system and steps are being taken to address risks to depositors, it has created ripple effects throughout the markets. In our view, these developments suggest that the Federal Reserve's rate-hiking cycle may pause, or even be near its end.

In addition to its dual mandate to keep inflation in check and to promote full employment, the Fed has a third unwritten mandate: to maintain financial stability. In times of stress, financial stability concerns often trump the other two mandates. Consequently, we believe the Fed may pause its rate-hiking cycle, or make smaller rate increases, until the outlook is clear.

Financial conditions had already begun to tighten in recent months and the recent volatility will only make that worse. Banks already have been tightening lending standards and raising interest rates on loans, making credit for businesses and households less available and more costly. As you can see in the chart below, both investment-grade and high-yield corporate bonds' yield difference, or "spread," versus a comparable Treasury security has widened sharply as investors demand a higher premium to compensate for perceived higher risks in the credit market.

Moreover, there are signs that inflation pressures are easing and wage pressures are slowing. These indicators suggest that the effects of Fed rate hikes of the past year are beginning to work by causing growth and inflation to slow.

The fixed income markets have shifted dramatically. After discounting the potential for a federal funds target rate rising to as high as 5.5% or more in the next few months, expectations are now for a peak rate of 4.75% to 5%, suggesting just one more rate hike of 25 basis points and then rate cuts in the second half of the year. Long-term Treasury bond yields have also fallen sharply.

The Fed is still concerned about inflation, but the recent financial market turmoil will likely lead to a slowdown or a pause in the pace of tightening, in our view. It's even possible that the peak in the cycle has already been reached, but that will depend on the path of inflation. In the near term, however, the Fed is likely to follow a more cautious approach to its policy until the dust settles.

The failure of a large bank with significant ties to the tech industry set off concerns about the safety of deposits and led to customers attempting to pull their money out quickly. As is often the case, when one bank appears to be in trouble, fear spreads quickly, leading to customers pulling money out of other banks. This "contagion" effect brought the S&P 500^® Financials sector's five-day decline to nearly 12% as of midday Monday, the worst since March 2020.

As mentioned earlier, however, it doesn't appear that this is likely to become a systemic problem for the financial system. The banks that have seen the most problems are considered relatively small, and therefore were not subject to the tightest regulations. In general, large banks are far better capitalized and more highly regulated since the 2007-2008 financial crisis.

Moreover, the FDIC, the Treasury and the Fed have responded quickly, taking significant steps to stabilize the situation. Customers with up to $250,000 on deposit were already covered by the FDIC. The FDIC went beyond that using its "systemic risk exception" to backstop uninsured deposits for the banks that have failed (this backstop does not apply to all banks, just those specifically named by the FDIC). It's worth noting that bank failures are not uncommon, and the FDIC has programs in place to deal with them. The size of these banks was larger than usual, leading to a stronger response.

In addition, the Federal Reserve has tapped its Exchange Stabilization Fund (ESF), a program used during the financial crisis. It announced a newly created Bank Term Funding Program (BTFP), which provides liquidity to other banks that might be facing heavy withdrawals. The program allows these banks to access funds from the Fed, pledging their government bonds as collateral. Significantly, the bonds used for collateral are marked at par value even if the market value has fallen. The purpose is to prevent banks from having to sell their bonds, driving up interest rates and causing a further ripple effect. The ESF is making $25 billion available for this program.

None of these measures will directly support the banks' shareholders or bond holders, just the depositors.

The recent volatility confirms the importance of building and maintaining a diversified portfolio of stocks, bonds and other assets, based on your risk tolerance. We know it's hard to ignore volatility when headlines and TV news are focused on the market drop. However, markets historically have fluctuated and recovered. It's important to stay focused on your plan and track progress toward your goal, not short-term performance.

For fixed income investors, the downturn underscores the importance of staying up in quality, which we've been suggesting for a while now. Lower-rated, lower-quality bonds are likely to be the most volatile if conditions remain unsteady. Treasury securities can provide a buffer when volatility rises. We continue to suggest that fixed income investors keep the bulk of their fixed income holdings in "core" bonds, such as Treasuries or investment-grade corporate bonds.