The Fed needs to cut rates soon

Since the failure of Silicon Valley Bank almost a month ago, interest rates have fallen dramatically. 2-yr Treasury yields are down 130 bps, 5-yr Treasury yields are down 100 bps, and 10-yr Treasury yields are down 70 bps. This amounts to a pronounced steepening of the yield curve, and that in turn is the market’s way of telling the Fed that they are going to have to cut short rates soon, and by a lot. In effect, the bond market has priced in a strong likelihood of significant monetary ease. The only question seems to be the timing: will it come at the May 3rd FOMC meeting, or will it be at the June 14th meeting? I wouldn’t be at all surprised if it happened before May 3rd. If I were Fed Chair, I would announce a cut in the funds rate of at least 50 bps way before May 3rd. 

While it’s very encouraging to note that swap and credit spreads are largely unchanged in the wake of the SVB failure (i.e., there are still no signs of an imminent recession, and liquidity in general remains abundant), there has been some significant capital flight out of smaller banks and into larger banks, and out of deposits and into money market funds and government securities. Since the end of February through March 22nd, commercial bank deposits have plunged by about $400 billion, according to the Fed. At this rate, it’s reasonable to think that by now, deposits have plunged by at least another $200-300 billion, or almost $1 trillion since the end of last year. Depositors are voting with their feet, and they are almost running for the exits. Bank stocks have been hit hard, especially the regional banks. There’s a strong whiff of crisis in the air.

As Chart #1 shows, the last time the bond market experienced something similar was in late 2007, just before the Great Recession. That’s an uncomfortable parallel to say the least.

Chart #2 shows that the percentage of service sector businesses that report paying higher prices has plunged to its lowest level in almost three years. This is powerful evidence that inflation pressures in the all-important service sector peaked long ago (in December ’21) and continue to decline. The inflation problem that the Fed is determined to fix is definitely on the mend; lowering rates today wouldn’t stop this. Not cutting rates would only increase the downside risks to the economy. The time to ease is before the economy shows obvious signs of weakness, not after.
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