Markets may cheer if Federal Reserve delivers its last 25 bps hike before a pause

• The US Fed-led Federal Open Market Committee (FOMC) is expected to deliver a final 25 basis point rate hike on Wednesday, taking the total quantum of rate hikes to 500 bps since March last year.
  
• Economists state that after this hike, the FOMC might take a pause and ease up on its monetary policies keeping in mind the banking sector crisis.
  
• This could trigger a stock market rally, according to JP Morgan which scooped up First Republic Bank’s assets on Monday this week.
  

A stock market rally is on the horizon as the US Fed’s Federal Open Market Committee (FOMC) is expected to take a pause after a final 25 basis point rate hike on Wednesday. While equity markets have been jittery this week due to the US banking sector crisis, a pause in rate hikes is not baked into equity markets, according to the analysts at JP Morgan.

It will be the tenth rate hike by the FOMC since March 2022, taking the interest rate to 5.25%.

Elevated inflation has made the FOMC’s job difficult amidst growing calls by US lawmakers to pause rate hikes, including the likes of Elizabeth Warren and Pramila Jayapaul, who called on the US Fed to “avoid engineering a recession that destroys jobs and crushes small businesses”.

Despite this, the broader consensus is that the FOMC may still deliver a 25 bps rate hike before taking a pause.

“Even as regional banking sector stress remains in place that is visible in the credit markets, we expect the FOMC to move forward and deliver its final rate hike of 25 bps in the current cycle,” said a report by ICICI Bank.

This will take the interest rate to 5.25%, and the total quantum of hikes to 500 basis points since March last year.

“We expect the forward guidance to change to indicate that the central bank is moving to a prolonged pause as it waits to assess the lagged effect of monetary tightening,” the ICICI Bank report added.

FOMC caught between a rock and a hard place

Recent macroeconomic developments in the US have made the FOMC’s job difficult as far as the monetary policy direction is concerned. While retail inflation in the US fell for the ninth consecutive month to 5% in March, it is still above the Fed’s target of 2%.

Multinational bank ING said in a note that “inflation remains unacceptably high, but banking stresses are leading to a tightening of lending conditions.”

Wage inflation, too, has remained robust, which is feeding demand-side inflation – the average hourly earnings increased from 4.4% in January to 4.6% in February. Core inflation, on the other hand, remained elevated at 5.54% in February.

On the other hand, the US' gross domestic product (GDP) grew at just 1.1% in the March quarter, as against expectations of 2% growth.

Data from the US Fed also underlined the elevated stress amongst regional banks, with emergency borrowings rising for the second consecutive week at the end of April by $11.3 billion.

Rate cuts could start this year

The analysts at ING added that while a 25 bps hike is a given, the rationale for further rate hikes is “highly questionable” given the stress in the US banking sector. Earlier this week on Monday, First Republic Bank collapsed, making it the second-largest failure in US banking history. The lender reported that its customers withdrew $100 billion in deposits in the March quarter, effectively sealing its fate. ING expects rate cuts to begin as soon as November this year.

Analysts at Nomura also note that a 25 bps hike is likely on Wednesday, but going forward, the monetary policy tightening could come to an end.

“There appears to have been uptake in emergency borrowings at the San Francisco Fed region, even after adjusting for the impact of quantitative tightening, which might be related to continued news of stress at the First Republic Bank,” the brokerage said, adding that it expects rate cuts to start in March 2024.

All in all, the consensus is that the FOMC is highly likely to deliver one last 25 bps rate hike today while keeping a close watch on inflation. Rate cuts could begin later this year, but until then, economists expect gradual easing up of monetary policies.

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