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The Fed’s Not Letting Go

July comes to an end:

  • Big tech crushes it. Clear market winners and losers during the coronavirus
  • The coronavirus continues to thwart the global reopening
  • U.S. Treasury yields flirt with the lower end of their range in 10-years
  • Congress is monetarily and philosophically apart on a pathway forward
  • August will bring the 2020 election front and center
  • The Fed will do “whatever it takes, for as long as it takes”

As was witnessed coming out of the Great Recession, extreme shocks to the economy often result in clear winners and losers. The shock from the pandemic has been like no other. And forced a complete rethink given the health component as to how consumers behave with the need for urgency in many cases. The price action in the tech high fliers in more akin to the behavior of the consumer than its strength.

In the end for us, the bigger concern right now is Covid and the underlying real economy. And in particular the job market. This is not to suggest these big tech names haven’t and won’t continue to impact equity indices. They will. We simply don’t feel the performance of these indices is a good reflection of the economic reality right now. This has largely been a liquidity driven move in risk assets for the better part of the past five months.

Money Supply: Money Zero Maturity (par cash) in green. NASDAQ in white

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In general heading into August, there is a renewed sense of nervousness. Not that we wanted to, but we’ve lived in the uneven camp from the start. Anytime you have different solutions to the same problem, different outcomes are likely. And our feeling from the beginning was federal, state and local disparities. Not a question we will always root for the US economy. Yet, the behavior of the US consumer that we loved for years has been hindering us amidst the reopening. The US consumer enjoys being out and about, and no wonder such a big part of the global economy over time. But very much at odds with social distancing and staying at home.  

August will bring a heightened sense of attention to the 2020 election. The President kicked it off yesterday with warnings on mail-in balloting and Joe Biden will follow with his much anticipated pick for a running mate. There is little to no chance of a delay in the election this November. But we do expect the conversation around the election to become more granular in the days ahead. Markets to date have been unfettered. In the end, although specific policy differences are very clear, broader measures of both monetary and fiscal contribution likely remain unchanged regardless of who wins in November. The spending and Fed buying is not over unfortunately.

Macro Themes

This morning, as markets digest earnings from big tech, the macro themes we’ve discussed remain in focus. We’ve been highlighting the move in real interest rates with nominal levels at the lower end of their range. And today showing signs of breaking out lower. On the short end, yields continue to make new lows with negative cash rates well within reach.

Increases in virus cases, questions about jobs and reopening with uncertainty around fiscal policy have been luring yields lower. “Global yield” continues to dwindle. And this all in conjunction and confirmed by the Fed: More uncertainty likely means more contribution on the monetary front. In the end, this in no way a win, win. We all want people healthy and the economy thriving again and can certainly do without more involvement from the Fed.  

Gold (white), Real U.S. 10-year yields (yellow) and the USD (green) going back to 1970

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We’ve been highlighting the chart above. You can’t teach an old dog, new tricks. The Fed is operating largely from the 2008 playbook. And they’ve been clear about their comfort zone with unconventional policies (Large Scale Asset Purchases and Forward Guidance). They used both in the 2008 crisis, are familiar with and have recently indicated both now acting as “standard” tools for the Fed. The Fed has certainly given us strong informal guidance on the inflation and employment side, yet formal changes will likely be coming in the Fall.

As the Fed exerts pressure on nominal yields through asset purchases (Powell came forward that clearly purchases for “market stabilization” (Brainard) fall into accommodation as well), indicates a desire to let inflation “soar” (Evans) above its target, the result is driving real yields to all-time lows debasing the dollar and driving investors to find inflation hedges as the money supply explodes. Challenge for investors: finding good inflation hedges; see Gold and U.S. housing right now for more info.

In the end, Powell weighed in on inflation Wednesday: More concerned about disinflation than short-term price increases right now. Yet at the same time, the amount of both monetary and fiscal liquidity is unlike anything this global economy has seen. Coupled with the notion that real stimulus has not even begun, in our view. 

The market has reached a very interesting juncture heading into August. Our weekly from last week: ‘Don’t Get Lulled by Summer Months.” Chart below highlights 5-year Treasury yields (new lows) and the Treasury’s General Account (all-time highs). Yesterday’s balance sheet numbers from the Fed show a continued leveling off in the aggregate numbers, small growth in asset purchases and a continued decline in the international swap lines. The Fed’s lending programs remain marginal and the liability side continuing to show offsets in bank reserves and the TGA.

5-Year U.S. Treasury Yields

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Treasury General Account versus Bank Reserve Levels

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Negative Rates without NIRP

We’ve been asked extensively over the past few months about negative interest rates and a NIRP from the Fed. And our answer has been steadfast and validated by the Fed: very low probability as a formal policy move. Having said that, we’ve been pressed about the cash and funding markets. Essentially, what would be the catalyst for these markets to turn negative regardless of formal policy from the Fed? Early in the crisis we did have Treasury Bills in negative territory.

Our answer has been along the lines of where the Fed and Powell went this week in words and their formal statement: COVID, jobs and the global economy.

With the pool of negative yielding assets once again on the move higher, cases of COVID increasing across the globe with the employment picture still very fragile, any positive yield becomes paramount. Sure, currency adjusted yields do matter for foreign buyers, but as we began to see in mid-2019, buyers can become very indiscriminate as conditions worsen and positive, high quality nominal yield dwindles. 

Negative Yielding Asset Pool (Rates lower than 2019, spreads have adjusted but moving back closer to pre-pandemic levels with central bank influence)

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In conjunction with economic uncertainty, increases in the Treasury’s cash pile (over $1.8 trillion) has been draining reserves from the banking system. Historically, there has clearly been volatility in this account (TGA) which at times can create issues for the Fed in an ample reserve framework. In this window, however, with the extreme purchases from the Fed, bank reserve balances are abundant and just under $3 trillion. But with expectations of the TGA declining in the second half of 2020, a sharp increase in bank reserves and cash if money flows from fiscal liquidity, could very well exacerbate the downward pressure on the short end with cash looking for yield and a home. 

Fed Recap

Our takeaways from this week’s Fed meeting. We expected a continued strong message from the Fed with no demonstrative changes to policy 

 1. The Fed remains very concerned about the virus. They’ve been vocal about the importance of the health side over the past month. For us largely expected, but strong enough for the Fed to include in their statement. Seems intuitive but the Fed went out of their way to stress. In many ways, we have all moved out of our comfort zone in exploring and trying to better understand better public health protocols. And the Fed is no exception. We all have major skin in the game personally and economically. 

 2. The Fed pledges to do “whatever it takes, for as long as it takes”. We’ve discussed the emotion behind the pandemic for the Fed. This involves people’s lives and health. Like it or not, it’s a different type of crisis in the Fed’s mind. And Powell has been explicit about the Fed crossing Red lines in the process.  

 3. The Fed has extended most of their lending facilities, along with the international swap lines and the foreign reverse repo facility. An extreme USD crunch globally in March triggered a dramatic liquidation in US Treasuries to raise cash. The Fed did a solid job of quelling the dollar strain, and now if anything we are seeing the USD reprice lower. The balance sheet for the international swap lines peaked around $450 billion, now sitting at $125 billion. Precautionary as Powell indicated, but should keep a lid on short term funding rates. 

 4. Powell pushed back on the fiscal side“lending powers, not spending”. We’ve been vocal about this. Much of the Fed’s cash production (asset purchases) lands in the banks. It continues to be “critical” for the fiscal side to support the economy short term.

The Fed acted quickly to ease financial conditions and markets responded, yet cash flow and solvency issues are not within monetary reach. We expected this to be a theme of Powell’s this week, especially in light of the ongoing negotiations in Washington.

There is little doubt the Fed’s influence and sensitivity to financial conditions: investment grade credit spreads are close to pre-pandemic levels and functioning well, the USD is lower, equities are near or above their highs and short and long end rates at or near all-time lows. This was evident in late 2018 as well and leading to the Pivot early 2019. In many cases right now, however, what’s needed is pure cash to keep businesses and individuals afloat as we move toward broader reopening, employees coming back to work and better medical solutions for the virus. The Fed simply cannot provide that support and relief.  

 5. Powell: “Even if the reopening were to go well (including a vaccine), tail risk remains in the job market. Essentially, it will take a very long time to get back to normal and job displacement is a legitimate concern. The Fed remains committed to not only seeing this through the pandemic, but will be supportive for years to come. We still had issues with job displacement from the 2008 crisis even before the pandemic hit.

6. On raising rates, Powell reiterated a prior phrase: Fed not thinking about thinking about raising rates. Whatever that means. Calendar indications to date have been through at least 2022. “Economic based” forward guidance is likely coming as the economic dust settles. Either way, the Fed’s on hold for a very long time.  

7. Policy review” reinvigorated at this meeting. This will highlight the Fed minutes to be released in August (Wednesday’s meeting). Irregardless, any changes to guidance will likely come after the policy review is complete (Powell’s words when questioned). Powell said the policy review will be completed in the “near term”. 


More importantly, Powell explicitly said the Fed has already been implementing the policy review in actions to date. We agree!

The Fed has discussed inflation averaging since the Pivot in early 2019. In this window on employment, Powell has indicated he wants the “January 2020” job market back. The Fed can issue formal guidance (or not) in the future, but Powell has already told you: years not months ahead of accommodation. The Fed (NY Fed Williams recently) is aware informal guidance is working well right now. The Fed has also made it been clear lately, they now view formal guidance and large scale asset purchases to be standard tools. 

8) Stabilization versus accommodation (Brainard). Powell admitted, stabilization of markets also lends to accommodation. Let’s face it, hard to argue that buying $100 billion in Treasuries “a day!” (March) will not impact the level of rates. Takeaway here, purchases to date have been across the yield curve, and if anything skewed toward duration five years and under. The Fed views Large Scale Asset Purchases as targeting the long end, and certainly this is on the table moving into the Fall and with the economic rebound in question. Powell was reluctant to commit on timing but was clear: prepared to adjust purchases as needed. 

9. Fed is more focused on income disparity between white and minority communities. Powell has indicated in the past that African-American unemployment was at its lowest point in early 2020 since disparate data recording began. Acknowledging too, unfortunately, still two times that of white unemployment. The Fed has one benchmark rate, tough. So in Powell’s words, “a tight labor market is not to be underestimated”. We’ve discussed in our notes recently, and Powell acknowledged this week, the pathway to early 2020 employment levels in the US took 8-10 years since the great recession. And Powell was clear this week: we simply don’t have that much time. Lends to the Fed being more aggressive, not less, in our view. Essentially, more focused on getting jobs back sooner than later. Fiscal support & policy will be needed.

10. We’ve written about the four phases of monetary policy to date as we see it: the fourth leg being temporary regulatory relief. Powell discussed this week, and the exclusion of US Treasuries from certain capital ratios. In general, if Treasuries don’t function global markets have serious issues. And locally, each time the Fed pushes back to the fiscal side, it equals more and more Treasury debt. There is little question, and especially with increased supply, regulatory restrictions have impeded Treasury and funding liquidity. We had this in September of 2019 with the Repo hiccup. To be critical, the Fed has acknowledged in the course of 2019 but slow to react. Certainly, the pandemic has accelerated thinking around plumbing, inhibiting regulations and increasing funding needs from the Department of Treasury.