Bullish investors had a rough day on Wednesday, as markets tanked after comments from Fed Chair Jerome Powell and Treasury Secretary Janet Yellen. The pair dropped three explosive statements late in Wednesday's session.
As expected, the Fed raised its key interest rate, the Fed funds rate, by 25 basis points. This was widely anticipated, so it had little effect on the markets.
Then Powell said two things that disappointed investors:
"Participants don't see rate cuts this year. They just don't."
Powell was referring to voting members of the Federal Open Market Committee (FOMC), the body within the Fed that determines interest-rate policy.
The FOMC expects slowing growth, a return to balance in the labor markets, and a gradual reduction in inflation. But even if that scenario unfolds, don't expect interest-rate cuts 2023.
Powell has been signaling 'higher for longer' for months, but previously, markets reacted with skepticism. On Wednesday, the reality behind that phrase finally hit home.
Another statement from Powell that agitated investors dealt with the issues facing U.S. banks.
First, Powell signaled that the Fed might need just one more rate hike before reaching its so-called terminal rate. That seemed dovish on the surface, and potentially positive for markets.
Then, in response to a question from the Wall Street Journal, Powell explained the FOMC's reasoning:
"Tightening of credit conditions would really have the same effects as our policies do. If that turned out not to be the case, then you'd need more rate hikes."
Translation: There's no easy way out.
Powell and the FOMC are expecting the current turmoil in the banking sector to result in tougher lending standards. This would slow the economy, similar to an interest-rate hike.
If banks fail to tighten their lending policies, or if those policies fail to slow the economy, then the Fed will continue to raise rates.
Bottom line: One way or the other, expect Powell and the FOMC to reach their goal of 2% inflation.
The third blow was delivered by the Treasury Secretary:
"We are not considering insuring all uninsured bank deposits."
Recently, Yellen has made similar remarks in response to questions about turmoil in the banking sector. If that's the case, then why were her comments so disappointing to investors on Wednesday?
Just one day earlier, in a speech before the American Bankers Association, Yellen indicated that small investors would be protected in the event of a bank run. "Our intervention was necessary...and similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion," said Yellen.
The two statements are not contradictory, although some investors are taking it that way. Yellen is signaling additional protection, but only if it's absolutely needed.
That's the right call, because guaranteeing all deposits could encourage risky behavior. Yellen is trying to alleviate fear, while simultaneously signaling to financial institutions that excessive risk has consequences.