Investors expect smaller rate rise amid cooling wages and market fears

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Investors have lowered interest rate expectations in response to a jump in unemployment, cooling wages and anxiety over the collapse of Silicon Valley Bank, with most now predicting a 0.25 percentage point increase from the Federal Reserve this month.

Just this week, investors were betting that the Fed would crank up the pace of its interest rate rises after a number of strong economic data throughout February.

Following testimony from Fed chair Jay Powell to Congress on Wednesday, in which he said the bank was prepared to return to bigger interest rate rises to fight inflation, the chances of a 0.5 percentage point increase in March rose to nearly 80 per cent, using calculations based on fed fund futures cited on Eikon. But by Friday evening, they were at 28 per cent, meaning a 0.25 per cent increase was heavily favoured.

The shift followed a mixed monthly employment report from the world’s largest economy. While US employers added 311,000 jobs in February — lower than January, but more than the expected 225,000 — the unemployment rate ticked up for the first time since October. The report also showed that average hourly earnings increased 0.2 per cent versus the 0.3 per cent expected, hinting at less pressure from wages on inflation.

“The jobs report is weaker than it appears on the surface. Although the headline number was strong, if you look at the details — the wage growth, average hourly earnings — those figures give the Fed the ability to continue on the 0.25 percentage point path, versus what markets had been expecting a few days ago,” said Greg Davis, chief investment officer at Vanguard.

“There has been a significant repricing today — in part because of the jobs number and in part because of Silicon Valley Bank.”

The jobs data will be a crucial piece of the Fed’s calculus when it meets on March 21-22. After a series of 0.5 and 0.75 percentage point increases last year, the Fed in February raised interest rates by 0.25 percentage points. Accelerating the pace would represent a big deviation in Fed policy and would suggest that the peak in interest rates may be far higher than the 5.3 per cent currently being priced in by markets.

The shift has not just been in expectations for March, noted Davis. Earlier this week, investors had been pricing a peak in interest rates at nearly 5.7 per cent in September. A peak of 5.3 per cent is now expected in June and between one and two rate cuts priced in by year-end.

“The labour market is moderating more slowly than expected,” said Michael Gapen, chief US economist at Bank of America. But he said: “This report does not suggest re-acceleration in the economy. It suggests resilience. That’s a world in which 0.25 percentage point increases in interest rates are appropriate.” 

Adding to the volatility on Friday was news that Silicon Valley Bank, a California-based bank serving venture capital and tech start-ups, would be shut down by regulators. The crisis at the bank had led to a flight to safety in markets with investors selling bank stocks, and buying up Treasury bonds.

The two year Treasury yield, which moves with interest rate expectations, has fallen by 0.49 percentage points since Wednesday evening. Its move on Friday — roughly 0.3 percentage points — was the biggest one-day fall since 2008.

While the problems at Silicon Valley Bank are not thought to be evidence of widespread systemic issues in the bank sector, it has still affected market expectations for the Fed.

“SVB is adding some angst to markets,” David Kelly, chief global strategist at JPMorgan. “Does the Fed really want to add on when inflation is clearly subdued? There is not a thing in this data today suggesting the Fed should raise by 0.5 percentage points.”

Matt Freund, co-chief investment officer at Calamos Investments, added: “When you are draining liquidity from the market — and clearly the Fed is doing that — it affects the shallower, more fragile markets first.”

That was evident in the crypto market collapse, said Freund, which took down crypto-focused bank Silvergate this week and is now appearing in places like Silicon Valley Bank, which is more exposed to venture capital.

“This may be another indication that the Fed has gone far enough,” said Freund.

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