The Fed Will Slow Rate Hikes As Risks for a Financial Accident Grow

• The Fed will be forced to slow its pace of rate hikes as volatility ramps up, Charles Schwab said.
• Analysts pointed to strains in bond and currency markets, which stem from the Fed’s aggressive hikes this year.
• That means risks are not only rising for a recession, but for a financial accident as well, Schwab warned.

The Fed will be forced to slow its pace of rate hikes as it risks not only sending the economy into a recession but causing a financial accident as well, according to analysts from Charles Schwab.

The central bank issued three consecutive 75-basis-point rate hikes this summer in response to growing inflation, which hit a 41-year high in June, with expectations now for the Fed to keep tightening until the policy rate hits 4.5% to 4.75%.

Markets are expecting another 75-basis-point increase in November, but the central bank could soon be forced to slow its pace of tightening, Charles Schwab analysts said in a note on Friday, pointing to growing volatility stemming from the hikes issued so far.

“In recent weeks the possibility of a more serious accident has emerged – the risk that the Fed’s aggressive tightening will not just tip the US into recession, but potentially de-stabilize the financial system in the process,” analysts said.

The bank pointed to choppy waters in government bonds, in which volatility is currently measured at 153, according to Merrill Option Volatility Estimate. That’s nearing levels seen in March 2020, when the Fed began injecting liquidity into the financial system to quell markets during the pandemic.

The US dollar’s rally this year is also ramping up volatility in markets outside the US. The Fed’s rate hikes have an outsized impact on the global economy since most trade and debt are denominated in dollars.

Because a strong dollar makes imports less expensive, rate hikes are effectively exporting inflation to other countries, analysts said.

In addition, a rapidly rising dollar increases borrowing costs, especially in emerging markets, so servicing loans or debt with a depreciating currency raises the risk of defaults, Schwab warned.

“Volatility has spiked up in a range of markets from currencies to bonds, raising concerns about the ability of the global economy to cope with sharply higher US interest rates,” the bank added. “While we don’t expect the Fed to stop hiking rates, we believe a good case can be made that market pressures may force it to slow the pace.”