Rates on Hold: The Fed Talks Inflation and Repo

The Fed leaves rates unchanged as expected. More importantly and a theme we’ve been discussing, is the Fed’s concern of missing their 2% inflation target. Although the bar for future cuts has been set high it’s even higher for future hikes.  

Let’s take a look

THE MARKETS

There was nothing in the Fed meeting short-term to move the broader markets in a meaningful way. The Fed was expected to keep rates on hold and they did. In the end, a very long year of transition, and one in which Powell reflected on when asked if he would have done anything differently.

It was hard not to be somewhat critical along the way. But when pressed about the Fed’s posture late last year (2018) Powell’s response was straightforward: 

Powell: “The facts on the ground had changed” 

Indeed they did. And with the Fed whipsawed by the intensifying trade war and the uncertainty of how to respond in the face of US data which continued to project signs of strength. This was certainly an evolving saga (trade) throughout 2019, and no doubt continues to be so. 

Looking back, Powell indicated this week that back in the Fall of last year the Fed truly believed 3% was the neutral Fed Funds rate, and if anything were still being accommodating. 

We think in reality, Vice Chair Clarida joined in October of 2018 and brought a very real and different mindset, with the new global norm on rates, growth and inflation. And RC was very much a part of the Pivot heading into 2019.  

When we listened to the Chairman this week and look back in time, it actually presents even worse.

Not only was the Fed whipsawed by the intensifying trade war, the move and latest hike in 2018 created an extremely violent move in risk assets which impacted financial conditions and inflation expectations. Financial conditions have recovered with the Pivot and rate cuts, but inflation expectations remain well below levels when the Fed was raising rates. Basically late 2018 into 2019 acted as a double whammy (global economic and swift financial markets because of the Fed being blindsided). 

Perspective Year over Year: S&P versus CDX 5-year Corporate Bonds

Perspective Year over Year: S&P versus CDX 5-year Corporate Bonds

It’s important: the context. And it’s not so easy. From Powell’s stance: “this is what we thought”. This is what the models were telling us”.

There were consequences within the Fed’s actions, and although I credit the Chairman for turning the boat around, far more damage was done in the Fall of 2018 than overshooting on the upside of tightening. This much we are certain of as equity valuations in the 2019 calendar year look fantastic but not nearly as much Fall over Fall. The Fed’s choice was to restore valuations or ensure recession with the global dynamic already pressuring US dynamics. 

THE FED

Our views on the Fed have been known. We’ve been in the easing camp since early 2019. In reality, the pocket of time from 2016-2018 with real yields moving higher and equities in tow is clearly our preference: Fed normalizing.

It wasn’t meant to be. Bottom line, the Fed began tightening too late.

Let’s take a look

Inflation

We’ve been beating the drum (very loudly) about the inflation side of the Fed’s mandate: Since late 2018. They have leaned on this now for the entire year and it will carry us into 2020. 

The Fed mainly looks at core Personal Consumption Price Index when evaluating their 2% symmetric objective. It’s been running at 1.6% and missing for quite some time. Powell referred to it directly this week. In conjunction with this, the Fed is evaluating the trade off between employment and inflation (Phillip’s Curve). 

Reality: the Fed has been extremely vocal about this all year. Jobs are great but wage pressure remains muted and so too does inflation. And when asked about other periods of mid-cycle adjustments (1995/1998), the Chairman clearly said the one big differential is the Fed’s inability to meet its inflation target. Happening Globally. Time’s have changed. 

We’ve been discussing the bar for future cuts. And won’t bore you with the “material reassessment” to the outlook for that to happen. The biggest takeaway from the Fed of late, aside from Powell’s time spent yesterday which we expected, is the Fed’s bar for future hikes being very high. We’ve been discussing since the October meeting.  

To Hike: In Powell’s words before, and including yesterday: “it will take a significant and sustained move in inflation higher”. And in fact, Powell said directly yesterday that several members wrote down their preference for inflation to run above their 2% target. 

The conclusions from the “Fed Listen’s” program of the Fed traveling the country to understand better how to implement their Congressional mandate of maximum employment and price stability will not be concluded until mid-2020, yet we think it’s becoming increasingly clear the Fed has been operating under an unofficial policy change. 

The Fed Listens

No alt text provided for this image

When questioned explicitly about inflation, and potential new policy framework, Powell’s response was: 

Powell: “Nothing official has been announced”- enough said. 

The implications for “lower for longer” are significant for markets. The Fed’s released forecast through 2022 for Core PCE is 2%. And the notion of potential “makeup strategies” the Fed is considering focusing on NOT letting bygones be bygones. In other words, if you missed your inflation target for years, perhaps you look to run it above your target going forward to achieve a longer term objective. Thus some members of the committee comfortable penciling in inflation running above target yesterday. 

The Fed wants to fight global deflationary forces. It’s clear at every level of communication this year. This is not the same new norm. It’s not the Fed going on hold at a 3% Funds rate. The Fed is closer to the ZLB, and with global forces and negative rates they have little control of. Pointing to the risks of lower and declining inflation expectations and the implications for rates, the Fed is providing very powerful forward guidance for global markets. The Fed is telling you what to watch.  

Chart below 5-year forward, 5-year break-evens. We will need to see a revisit of the range from 2017-2018 and for a sustained period for tightening to become a reality again (SEE BELOW). 

No alt text provided for this image

US Funding

This past Tuesday morning, and prior to the Fed announcement we released to our social media thread:

Tuesday, 12/10

Quick Fed preview: Our baseline call from early 2019 was/is 50 to 100-basis points lower through 2020. We still believe the skew into 2020 is lower, not higher. On hold at a minimal through the election.

Things for the Fed to address:

1) Elevated term funding levels. Still an uneven playing field for levels. More, not less (Fed) into year end likely the theme.

2) Further awareness and willingness to address the “funding markets of 2019” (market structure/regulatory/supply). The balance sheet move should be tactical and is a very lazy solution if not in conjunction with broader actions. The playbook has changed.

 3) Rate forecast (2020). Priced for another cut. Push back?

Fed is likely to mention: Economy/policy in good place. Material reassessment for a change in stance. No preset course. Risks remain. Inflation shortfalls. Good luck.

https://youtu.be/AZKlrbCIxLs

The Fed took a wait and see approach on Bank reserves this year. But in listening to Powell this week he pushed back. His answer, although perhaps too simplistic was straightforward:

“We survey the Primary dealers, ask them the level of reserves they need and took the responses tallied them up and felt we had more than enough”. 

It’s an honest answer.

In fairness, we looked at ALL the survey numbers. And what Powell said this week was factually correct. If you tallied it all up the banks had plenty of reserve for the Fed’s “ample reserve” new framework. One in which all Fed members have reiterated they are committed to. The challenge is, and we believe Powell and the Fed are NOW aware, is that it’s not that simple. 

On October 29th, we spent time with CNBC and were covered in an article back then about the Fed needing to do more not less for the funding markets. Over the past week, an investment bank came out with a call for QE 4 prior to year end. Not likely based on Powell’s testimony (“not there yet”). 

https://www.cnbc.com/2019/10/29/the-fed-may-have-to-do-more-to-calm-the-repo-lending-market.html

Since September, we have been out in front of the need for short and longer term solutions from the Fed. Tactically, the Fed needs to use tools they have NOW, and Powell reinforced the Fed’s commitment to doing just that Wednesday and followed up with an announcement from the New York Fed yesterday.

https://www.newyorkfed.org/markets/opolicy/operating_policy_191212

No alt text provided for this image

It may not be perfect, and ridden with criticism around the balance sheet expansion, but it’s logical at this point all things considered. The Fed’s simply not going to sit back and do nothing. 

When you’re dealt with unexpected event, generally you react and think more deeply later. The most constructive outcome this week was the Chairman’s gesture that they (the Fed) are open to ideas around market structure and regulatory relief without comprising bank safety to avoid more hiccups around the financing of the most liquid sovereign market in the world.

This is not a one size fits all solution. Plenty have opinions, yet in the end what seems most prudent is to listen to ALL the participants that have capital and skin in the game to arrive at a comprehensive framework for the funding market of today. The playbook has changed, along with the participants, regulations and supply dynamics. 

For now, Powell was clear: we are focused on what we control and that’s around year end, short term operations and the continued buying of T-bills. We have expressed our view that the Fed would potentially extend out to short coupons. The reality is some of that buying has already occurred. 

Short term, the Fed’s balance sheet will likely grow larger than expected into 2020, but if the Fed irons out the workflow between liquidity providers (broad-based), regulatory inefficiency and market/supply structure changes, this too shall pass just like negative rates coming to the US in August of this year.  

The bigger issues take more time and thought. In Powell’s words, “notice of rule changes etc”. So long as the Fed doesn’t lean on simply increasing aggregate Bank reserves as the sole solution things will evolve stronger and even more efficient. 

Although we disagree with the Chairman on potential macro economic implications of the funding distortions, it’s clear from this week’s press conference: Washington is now in touch with New York and the Fed is prepared to do more not less in the coming weeks.

Changes at the New York Fed below:  

https://www.newyorkfed.org/newsevents/news/aboutthefed/2019/20191212

RIP Paul Volker

No alt text provided for this image