Strains in the system

Question: Will banking sector turmoil impact rate hikes and recession risks?

R.J. Gallo: Stresses in the banking system tend to cause the Fed to pull back. As a result, we expect the Fed to hike probably one more time, taking the Fed Funds Rate to around 5%, 5.25%, but we think they'll hold it there for some time. The markets are pricing and easing at this point by the end of 2023. I'm not so sure we're going to get there. I think the Fed might end up being stubborn, holding rates high, letting the economy slow and inflation decelerating. As a result, the bond market might be a little disappointed about the fact that easing by the end of the year seems unlikely, knowing what we know now.

At the last FOMC press conference, Chairman Powell made a comment that the literature is clear about the impact of banking stresses, banking system problems. And what he was referring to, and this goes back to the Great Depression in many other periods in history, when the banking sector starts to crack, it becomes a major headwind to the economy. So, now that we're seeing banking sector stresses in the form of weaker balance sheets as well as most importantly, deposit flight and deposit instability in the form of a couple bank runs, it's pretty safe to say that recession odds have in fact increased. We came into this year thinking we'd probably have recession by the end of the year. I think it's much more likely now that the banking sector is starting to show some strains. In terms of probability, it's always hard to cuff it, but I would say at least 60%, 70% chance that we have a recession by the end of 2023.