The Fed vs. the ECB: Which central bank is likely to pause rate increases first?

Executive summary:

The Fed signalled a potential pause in its rate-hiking campaign
U.S. regional bank worries have resurfaced after the failure of First Republic Bank
Equity markets have slipped amid the uptick in U.S. regional banking concerns

On the latest edition of Market Week in Review, Senior Director and Chief Investment Strategist for North America, Paul Eitelman, and ESG and Active Ownership Analyst Zoe Warganz discussed the recent rate hikes from key central banks. They also chatted about the decline in U.S. regional bank stocks and reviewed recent global market performance.

Powell signals potential rate pause, while Lagarde hints at more hikes to come

Warganz and Eitelman began their conversation by discussing the latest rate hikes from the U.S. Federal Reserve (Fed), the European Central Bank (ECB) and the Reserve Bank of Australia (RBA). Eitelman noted that the Fed, as expected, opted for a 25 basis point (bps) rate increase at the conclusion of its 2-3 May meeting, but also signalled that it might pause its rate-tightening campaign soon.

"Chair Powell made it clear in his follow-up remarks that the Fed believes monetary policy in a range of 5%-5.25% is restrictive enough to slow the U.S. economy down and lower inflation to around 2% over time," he stated. Eitelman added that this represents a notable change in tone from the U.S. central bank, which has raised rates by a cumulative 500 bps since March 2022.

ECB leaders also lifted borrowing costs by 25 bps the week of 1 May, he said, with President Christine Lagarde indicating that the bank may raise rates a few more times this year. This is because inflation is still running stubbornly high across Europe, with the region's labour market also remaining hot, Eitelman noted. He added that at 3.25%, the ECB's key rate still lags the Fed's by around 200 bps, meaning that the ECB has more ground to cover to reach a similarly restrictive level.

Australia's central bank also increased its cash rate by 25 bps recently, Eitelman said, noting that the decision by the RBA took markets by surprise. "Hardly any economists in Australia were anticipating a rate increase, and this led to some volatility in fixed income markets," he stated, adding that concerns over inflation were what led the central bank to opt for a rate hike.

First Republic Bank fails. Could other U.S. regional banks be next?

Shifting from central banks to regional banks, Warganz noted that the takeover of First Republic Bank by JPMorgan Chase on 1 May has put some regional banks back in the market's crosshairs. Eitelman said that First Republic had similar characteristics to Silicon Valley Bank and Signature Bank, both of which collapsed during March's banking crisis.

"First Republic had a concentrated base of depositors with uninsured deposits, deposits above the FDIC coverage limit of $250,000," he explained, adding that the bank saw a large outflow of deposits in March during the teeth of the banking-sector turmoil. This left First Republic in a weak position where its profitability was challenged, Eitelman explained.

Going forward, the big question for investors is whether more U.S. regional banks could fail, he said. While First Republic was somewhat unique among regional banks, for instance, it leaned heavily on the Fed's emergency lending programs, banks in general rely a lot on the confidence of their clients, Eitelman stated. "Because of this, whenever a bank fails, it's natural for some concern to creep into the market. And ever since March, we've seen investors looking for the next weakest link in the banking system," he noted.

This helps explain the increasing pressure on U.S. regional banks in recent days, Eitelman said, noting that many have seen their share prices plummet since the failure of First Republic. Overall, the situation bears close watching moving forward, he remarked.

Market performance recap

Warganz and Eitelman concluded the segment by recapping recent market performance, which Eitelman said shifted to a more risk-off tone the week of 1 May. Through market close on 4 May, global equities were off about 2% on the week, he said, with U.S. equities down by even more.

Eitelman said that U.S. Treasury yields also slipped, with bond prices rising, on the risk-off tone. "As banking stresses came more into focus, investor expectations around what the Fed might do through year-end shifted a bit, with markets anticipating that the central bank might start cutting rates later on," he explained.

Watch the video Listen to the podcast

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.