We know from history that major Fed tightening cycles tend to reverse when something "breaks" in the financial system. In 2007 it was subprime mortgages, in 1998 it was Long-Term Capital Management, and so on. But we never quite know, beforehand, what is going to break or at what rate level it will happen.
In this case, we're seeing a massive asset-liability mismatch facing the banking system—including both commercial banks and central banks—due to bond portfolios that have lost value as interest rates have risen. That mismatch has quickly become problematic in recent weeks as depositors have been withdrawing money—reversing the huge tide of deposits that had flowed into the system since the start of COVID.
Now, the big question is whether the Silicon Valley Bank closure (and subsequent closures and takeovers), will turn out to be the catalyst that ends and reverses this tightening cycle.
The markets, at least, appear to be saying "yes" to that question. As of late last week, the market was pricing in one more 0.25 percentage point rate hike this week, followed by a significant rate-cutting cycle.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
An exercise in needle-threading
We will find out soon enough if the Fed will pause its rate hikes. While the developments in the banking sector could undoubtedly be seen as reason to pause, it's important to remember that the Fed faces a truly difficult dilemma—choosing between defending its inflation mandate and financial stability.
One possible scenario would be that the Fed tries to thread the needle. For example, the Fed could try keeping rates where they are and continuing quantitative tightening (the process of shrinking its balance sheet, such as by not reinvesting the proceeds of bond holdings as they mature), while at the same time providing liquidity to the banking sector as needed (via its new Bank Term Funding Program, and now also central bank swap lines).
In that sense, it's worth looking back to last fall, when the Bank of England (BoE) conducted temporary asset purchases to solve for a similar asset-liability mismatch. The BoE was adamant that these temporary purchases of sovereign bonds were not quantitative easing, and it was right. The purchases were temporary. Once the crisis had passed, the quantitative tightening continued, and so did the rate hikes.
Reading the yield curve's tea leaves
One thing seems clear from the turbulence of the past few weeks, which is that we seem to have reached "peak inversion" in the yield curve—and the gap between short-term and long-term yields is unlikely to increase further from here. (In normal times the yield curve is upward sloping, with long-term rates higher than short-term rates. When short-term rates are higher than long-term rates it is called an "inversion," and is often seen as a harbinger of recession.)
While yield-curve inversions have a perfect track record in predicting a recession, the signals are frustratingly disparate in terms of the lead time and magnitude of the outcome.
But now that the curve has reached peak inversion, we may have a bit more clarity on what could happen next. I looked at S&P® 500 performance following historical peak inversions, going back to 1968. In most cases, the market holds up for a bit, but stocks have experienced losses of 11% to 51% in the months that follow (with the exception of the 1998 cycle, which followed a barely visible inversion).
To be sure, past performance is never a guarantee of future results. But it's a good reminder to be careful what you wish for when it comes to Fed pivots.