Brace for more banking shocks with the Fed in a 'twilight zone' where it can't tame inflation without threatening financial stability, Fidelity warns
- The banking turmoil might not be over just yet, according to Fidelity.
- The Fed is in a "twilight zone" where it can't tame inflation without hurting financial stability, Fidelity said.
There may be further turmoil ahead for the US's embattled banking sector, as the Federal Reserve is forced to pick between curbing inflation and ensuring financial stability, according to Fidelity International.
The asset-management titan said earlier this month that the Fed is trapped in a "twilight zone" where it is unable to tame soaring prices without increasing the risk of further banking shocks.
"We believe we have now entered the 'twilight zone' of central banking where financial stability concerns start to impinge on policymakers' primary price stability objectives," a team led by Salman Ah said in Fidelity's global macro insights report for April 2023.
Silicon Valley Bank sparked fears of a full-blown financial crisis last month when it collapsed after disclosing massive losses on its bond portfolio, with the value of its fixed-income holdings cratering over the course of the Fed's 13-month tightening campaign. When depositors learned of the losses, they feared the bank could fail and pulled their money out in droves, spurring the FDIC to take control of the lender and guarantee all of its deposits.
The Fed launched the Bank Term Funding Program to prop up other struggling lenders in response to the turmoil – but still raised interest rates by 25 basis points to upwards of 4.75% on March 22, as it forged ahead with its efforts to bring inflation down to its 2% target.
The European Central Bank also raised rates by 50 basis points on March 16 – even though fears about contagion had sent Credit Suisse's share price tumbling. The 167-year-old Swiss lender was rescued by its longtime rival UBS just three days later.
Those rate hikes increase the risk of further banking shocks even though the Fed and the ECB have tried to emphasize to markets that they have a separate monetary policy toolkit for dealing with the potential crisis, according to Fidelity.
"While we expect the Fed and the ECB to continue the policy of tool separation in order to juggle both of these objectives – trying to convince markets there is no trade-off between them – given the role of markets and sentiment in policy transmission, this trade-off is alive and well and getting sharper," Stainton's team said.
Money-market funds are a further threat to the banking sector, they added.
These funds – which invest in short-term, low-risk debt securities – have experienced massive inflows in recent weeks with bank deposit interest rates lagging the Fed's benchmark by a record amount.
"As long as money market yields remain substantially higher than banking system deposit rates, deposit flight from smaller banks to larger banks or out of the banking system entirely might continue fuelling further tightening or stress in the credit channel," the Fidelity strategists said.
"The risk of further stresses emerging in the banking system, not just in the US but also in Europe, remains high in our view," they added.