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Investment bank Nomura is one of the first major investment banks to come out and say the Federal Reserve will cut interest rates next week in light of recent stresses in the U.S. banking system.
In a note to clients, Nomura says ahead of the failure of Silicon Valley Bank they were expecting a 50 basis point hike, but now a 25bp cut is to be expected.
"We now expect the Fed to cut rates in 25bp increments in the March FOMC meeting in comparison to where we had previously expected a 50bp rate hike since 24 February," says Aichi Amemiya, North America Economist at Nomura.
Furthermore, the Fed is expected to announce it is halting its balance sheet reduction - known as quantitative tightening - to ensure it complies with its mandate of promoting financial stability.
The Dollar and stocks came under pressure last week after Silicon Valley Bank (SVB) failed with selling pressures extending into Monday on news another smaller lender, Signature Bank, said it would fold.
Above: Image courtesy of Goldman Sachs.
The failures come amidst an environment of rapidly rising interest rates that have exposed the idiosyncratic risks unique to some lenders.
But the Fed recognised the dangers of contagion and announced measures, alongside the U.S. Treasury and Federal Deposit Insurance Corporation (FDIC), that would shore up the system.
The question facing investors now is whether the targetted measures are strong and credible enough to allow the Fed to continue its fight against inflation.
The selloff in bank stocks and equity markets suggests investors remain nervous.
"Judging by the market’s reaction, financial markets seem to view these policy actions as insufficient," says Amemiya.
Nomura says authorities will not have allayed concerns amongst corporate depositors of a loss of access to deposits, even if temporary.
Furthermore, the sensitivity of individual depositors to deposit rates might have increased due to the FDIC’s announcement of making all Silicon Valley Banks' depositors whole," says Amemiya.
"If the Fed keeps the policy rate “higher for longer”, banks would be averse to liquidating securities holdings for which selling would realize losses in securities any time soon," says Amemiya.
Nomura says although a 25bp rate cut seems unlikely to be a panacea for financial institutions, if the Fed shows expected continued rate cuts in the Summary of Economic Projections (“dots”), markets could quickly price in further rate cuts.
"This could somewhat reduce the risk of further bank runs, as well as reduce unrealized capital losses," says Amemiya.
Money markets show investors are no longer fully priced for a 25bp rate hike on March 23, suggesting a 'hold' won't come as a surprise.
However, cuts are only fully priced by the market for later in the year meaning the market will be taken by surprise if Nomura is correct.
Stocks would likely rally and Dollar exchange rates would come under pressure under such a scenario.