Monetary Policy & Inflation | US
If this were any other period (or more like any other dimension), Fed Chair Powell should express some concerns over the growing speculation that has now spread to all of the corners in the market. But given the economic outlook’s fragility, we highly doubt he will do so. That said, there is a risk that a market hooked on easy money can still get disappointed if there are no promises of new liquidity ahead. Powell will aim for a neutral message, highlight the launch of various Fed facilities and stick to administrative aspects, like walking markets through their new economic projections.
Balance-sheet Growth Has Slowed Due to the Tapering of POMOs
The balance sheet has increased by over $500bn since the last regularly scheduled FOMC meeting in April. That is still a massive amount versus the prior QEs, which would have taken months to see the Fed’s balance sheet grow that much. However, that seems slow in comparison to the six weeks prior to the April FOMC where the balance sheet grew roughly $2tn!
As seen in Chart 1, most of the balance-sheet growth was in the liquid product space (i.e. USTs and MBS) but the Fed has clearly pivoted away from buying at all costs and in huge sizes to stabilize markets (for a while it really did feel like ‘ludicrous speed’ from the movie Spaceballs) to a more normal-sized pace of POMOs (permanent open market operations).
With the Treasury having to term out its debt more on a go-forward basis couched against no signs of an immediate emergency, that would require the Fed to all of a sudden start buying USTs and MBS at a much fast pace again, along with only a gradual usage in the new liquidity facilities, lower amounts of Fed easing is consistent with our view that net new liquidity is behind us – as per our US Policy Net Liquidity Challenges report.
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If this were any other period (or more like any other dimension), Fed Chair Powell should express some concerns over the growing speculation that has now spread to all of the corners in the market. But given the economic outlook’s fragility, we highly doubt he will do so. That said, there is a risk that a market hooked on easy money can still get disappointed if there are no promises of new liquidity ahead. Powell will aim for a neutral message, highlight the launch of various Fed facilities and stick to administrative aspects, like walking markets through their new economic projections.
Balance-sheet Growth Has Slowed Due to the Tapering of POMOs
The balance sheet has increased by over $500bn since the last regularly scheduled FOMC meeting in April. That is still a massive amount versus the prior QEs, which would have taken months to see the Fed’s balance sheet grow that much. However, that seems slow in comparison to the six weeks prior to the April FOMC where the balance sheet grew roughly $2tn!
As seen in Chart 1, most of the balance-sheet growth was in the liquid product space (i.e. USTs and MBS) but the Fed has clearly pivoted away from buying at all costs and in huge sizes to stabilize markets (for a while it really did feel like ‘ludicrous speed’ from the movie Spaceballs) to a more normal-sized pace of POMOs (permanent open market operations).
With the Treasury having to term out its debt more on a go-forward basis couched against no signs of an immediate emergency, that would require the Fed to all of a sudden start buying USTs and MBS at a much fast pace again, along with only a gradual usage in the new liquidity facilities, lower amounts of Fed easing is consistent with our view that net new liquidity is behind us – as per our US Policy Net Liquidity Challenges report.
The Fed is Focusing on New Facilities Designed to Keep Credit Flowing
Meanwhile, the Fed in the inter-meeting period has focused its efforts on all of the new credit and liquidity facility that it had yet to launch by the April FOMC meeting. The corporate credit facility is up and running and has been buying credit-based ETFs. The municipal liquidity facility has also come online as has the main street lending facility (which most recently saw some of its terms tweaked to be even more favourable to borrowers).
At this point, we believe the Fed has enough programs to combat any sort of uncertainties that may arise if the economy does not rebound as priced in by risk markets. Therefore, we doubt that at this meeting the Fed is looking to make a big splash and announce any new programs. Instead expect Chair Powell to give a good rundown of how these programs are performing while stating they could also do more if the case were to arise.
QE vs YCC Uncertainty Means They Probably Do Nothing About it Now
In terms of QE vs yield curve control (YCC), it’s too soon, and we doubt that the Fed has ironed out all of the kinks in how to launch YCC nor what to do with the POMOs and/or to officially convert it to official QE policy as designed in the past. For now, it’s best to do nothing. And it’s also possible that the Fed is now secretly getting worried about how rampant market speculation has returned and so quickly even though the economic outlook remains uncertain. Now, we doubt that Chair Powell will outright try to lean against the bull market, but at this point he doesn’t need to egg it on either.
Is the Market Set Up and Starting to Price in a YCC Happening Soon?
In Chart 2 we compare the JGB curve versus the UST curve to see if there is any similar pattern forming in the lead up to the BoJ YCC announcement. Well, there is – sort of. The observant reader will notice that we compared the US 2s10s curve versus 10s30s JGBs (as the BoJ targets the 10yr), this is because, if the Fed does YCC, as per all of the recent Fed speeches, its likely they would pin the very front-end and not go as far out as the BoJ. As seen in the chart, the US curve has out-steepened the JGB curve move.
Now in all fairness global rates in 2016 had by September been selling off and that dragged up long-end JGB rates too. The follow-through to even steeper levels was likely due to YCC after, but not before it. So, we are not hinting that the US curve now is only discounting YCC too. There are many factors that could be driving the curve, like a ton of UST debt to underwrite and a bond market that is re-pricing to the potential of a V-shape recovery.
Furthermore, the US curve already looks pretty steep and so doesn’t really require the Fed to steepen it further now. For example, the current curve (as seen in Chart 3) looks like a modified version of the WW2 YCC that the Fed used. Note, with US rates much lower than they were in the 1940s, I thought of designing a WW2-lite version of YCC, where I made the spread between the 3m rate and 10-year rate about 100 bps (which is roughly half of the original WW2 yield curve spread). I also show a Japan-like YCC curve (modelled after its current shape but keeping US rates above zero) which takes rates to extreme levels so it’s something they can hold off on.
Conclusion
These last few months have felt like years, and I am pretty sure Fed policymakers harbour the same sentiment. That doesn’t mean they are looking to rest on their laurels. Instead, now is the time to take a wait and see approach. In addition, the Fed really needs Congress to step up at this point if there is need for more stimulus (and if that happens then at that point launch something like YCC). Meanwhile, the Fed should allow current easing programs to get fully utilized before starting something new.
Therefore, it’s in the best interest of Chair Powell to deliver as neutral of a message possible during the Q&A. If there is any risk today, it’s more to the hawkish side (because no new easing feels ironically like tightening). The thing to watch is how TIPS real rates react to the FOMC as that drives the price action in all the financial-repression trades (like gold and equities).
In general, we view this event as a return to normal with the Fed poised to re-introduce its economic projections (in a scenario format). The time alone needed to explain its new forecasts may take up the majority of the airtime at the press conference. The key thing to watch is the shape of the dot plot. But if that, too, is presented in a scenario format, we should not read too much into it (because it would not be a pure form of forward guidance).
George is a twenty years fixed income veteran. Over that time he has been an active participant on the research and investment side covering rates, structured products and credit. He worked both on the buy-side and sell-side. He can be reached here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)