Banking Stresses Change Game

The recent stresses in the banking system have been a game changer for central banks, says RBC’s Harbour Group. After last week’s Federal Open Market Committee meeting, the U.S. Fed raised interest rates 0.25 per cent, down from the 0.5 per cent expected before U.S. regional banks came under pressure. The Fed also used language in its statement that suggested it is set to pause rate increases, at least in the short term, as tighter financial conditions in the banking system have done some of their work for them. The upshot is that bond yields have fallen sharply, led by two-year Treasuries, the benchmark bond with the closest link to future Federal Reserve policy. The 1.37 per cent drop in under a month now puts the two-year yield under the Fed funds rate of five per cent, suggesting that the market expects rate cuts to commence shortly. Steep drops in bond yields have the impact of an interest rate cut on many parts of the economy, as these yields are the benchmarks for setting interest rates for consumer loans and mortgages. As well, since interest rates started their climb in 2022, “we have seen an unwelcome phenomenon which has upended the logic behind holding a balanced portfolio of stocks and bonds. As interest rates rose (and bond prices fell), stock prices fell too, making 2022 the year of ‘nowhere to hide.’ The one positive that has emerged from the recent uptick in volatility is that bonds are acting like bonds again, providing the portfolio ballast which was sorely missed in 2022.