A big question on the minds of investors this year is the trajectory of interest rates. As inflation soared last year, the Federal Reserve rapidly raised its benchmark overnight lending rate, the federal funds rate, from practically zero at the beginning of the year to a range of 4.25% to 4.5%.
Now there are signs that inflation is cooling, but many investors are still unsure about how much more the Fed will raise rates. Some believe the Fed is almost done with its rate-hiking campaign. Some believe inflation will be more persistent than initially thought and the Fed will keep having to raise rates higher than expected.
And others believe the Fed's intense interest rate hikes will dramatically slow growth once they fully kick in and lead the Fed to cut rates. Interestingly, two of the largest banks in the world are now in this camp. Here's why.
Preparing for a "mild" recession
JPMorgan Chase (JPM 0.49%), the largest bank by assets in the U.S., and Wells Fargo (WFC -0.56%), the fourth-largest, both recently reported their fourth-quarter earnings results.
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During this time the two banks also provided their initial outlook for 2023, which includes key revenue drivers such as net interest income (NII), the money a bank makes on loans and securities after funding those assets. NII is heavily driven by the direction of interest rates because those rates will impact what happens to loan yields and deposit rates, which are big drivers of NII. That's why banks will often provide their assumptions on interest rates so investors and analysts understand their guidance.
In its NII guidance, JPMorgan Chase said that it's assuming the Fed will raise the federal funds rate by a quarter point two more times this year before then cutting the federal funds rate twice later this year, which would result in the federal funds rate ending up inside the same range it's in now.
Wells Fargo expects the Fed to get a little more aggressive and raise its federal funds rate over 5% by the second quarter of the year before then doing one rate cut toward the end of the year.
Now, keep in mind that JPMorgan and Wells Fargo could certainly be wrong or update their assumptions as the year progresses and they gain more visibility into inflation and the economy. But these are the current assumptions they are using for their own modeling, so it does paint a pretty good picture of how they are thinking about the trajectory of interest rates.
In 2022, the Fed raised rates rapidly to slow down a sizzling-hot economy that led to some of the highest levels of inflation seen in about four decades. But those rate hikes could end up going too far and slowing down the economy to the point where it tips into a recession.
This seems to be what JPMorgan Chase is expecting, as management recently said its central case this year now assumes a "mild" recession. A recession could force the Fed to cut rates to try to stimulate growth again.
More clarity is needed
Although it's quite interesting to see JPMorgan and Wells Fargo both penciling in a rate cut this year, which could be good for stocks, I still think it is too early to know what will happen.
All of the Fed's rate hikes still need time to work their way through the economy and it's quite possible the economy stays healthy enough to where the Fed doesn't need to cut rates. Interest rates have never risen this fast and therefore we are in uncharted waters. So investors will need to be patient, let this all play out, and be prepared for a wide range of outcomes.
But keeping an eye on these large banks, which have tons of economists and other resources at their disposal, and how they are thinking about the direction of interest rates is a good way to monitor the situation.
