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A whirlwind of events recently swept through the financial world, temporarily pushing aside the usual Fed/CPI/Employment headline-market movement. In addition, the fallout from bank failures has begun, and its effects on the markets will likely be long-lasting, drawing our attention back to the Federal Reserve.
Here's a brief history refresher to provide some context.
The Ghost of 2008: Are We Better Prepared?
The 2010 Dodd-Frank Act aimed to tighten federal financial regulations in response to the 2008 financial crisis. A crucial aspect was addressing institutions considered "too big to fail" and subjecting them to higher standards. Banks with over $50 billion in assets were classified as "systemically important" and faced increased scrutiny.
In 2018, bipartisan legislation raised the asset threshold for enhanced standards to $250 billion. However, the Federal Reserve retained the authority to apply stricter Dodd-Frank regulations to banks with at least $100 billion in assets.
The Triumvirate: FDIC, Treasury, and the Fed
The Treasury, the Federal Reserve, and the FDIC (which insures deposits up to $250,000) are working together to backstop the assets of regional banks, ensuring the availability of deposits. In addition, the Fed is boosting liquidity by offering one-year loans to other banks through the new Bank Term Funding Program (BTFP).
Unlike in 2008, funds are now directed to depositors instead of the institutions themselves. The money won't come from taxpayers; the funds will be drawn from the Deposit Insurance Fund (DIF).
Economic Impact: What Lies Ahead?
The Federal Reserve has adopted a "higher for longer" stance on rates, as inflation remains persistent and significant rate hikes haven't significantly slowed the labor market. While the government has managed to contain the situation with two regional banks, the entire regional banking sector is now under a microscope.
Increased stress on the financial sector could lead to a faster credit constriction than the Fed has achieved through rate hikes. Banks may begin to shrink their loan portfolios for various reasons. Smaller banks will face lending limitations due to deposit outflows, and even larger banks may exercise more caution due to heightened volatility and a potential recession. In addition, the prospect of new regulations could prompt banks to offload riskier loans or revise their lending policies.
Before these recent events, economic data suggested a healthy, albeit slightly cooling, labor market and lower inflation reading in the Consumer Price Index. Moreover, confidence in the economy, as measured by the Business Roundtable CEO Economic Outlook Survey for Q1, had risen by six points over the last quarter. Nevertheless, the market impact is still unfolding, with the bond market reacting wildly to the news – a typical indicator of a pessimistic economic outlook.
The Fed convened in their March meeting to decide on potential interest rate hikes. They increased interest rates by 25 basis points (0.25%). Given the current market turmoil and economic uncertainty, the Fed did not pause or decrease rates. The next Fed meeting will be in early May.
Volatility has been the keyword for 2023, with the Fed juggling inflation, a robust labor market, and an economy that isn't slowing down enough to reduce inflation. Remember that Chairman Powell has consistently emphasized the need to prevent high inflation from becoming entrenched, as in the 1970s and early 1980s.
Your Takeaways
Recent bank failures and the still-unknown impact on the banking sector, overall market, and broader economy contribute to short-term volatility. However, remember that investing is a long-term endeavor, and attempting to time markets may result in missing out on the best days of the eventual recovery.
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