FOMC Preview: Does The Lame Duck Session Also Apply To The Fed?

The last FOMC meeting of 2020 is upon us. Given the year we’ve just had we doubt the Fed wants to create any additional liquidity waves at this point. In my humble opinion, the Fed will also take a page out of the lame duck session concept and avoid introducing any major policy changes at this meeting. At most there could be a further clarification of its guidance on what will drive their QE policy and easing options discussed in the presser. Otherwise the Fed likely wants to close its 2020 chapter like everyone else.

We thought of recapping all the support mechanisms launched by the Fed. But upon review of the many press releases in 1H20 (with the introduction of new facilities day after day and week after week) this would turn into a much longer note. Instead, a brief recap is that the Fed slashed rates back to zero with one of the largest rate cut in history, purchased the largest amounts of USTs and MBS ever at the start of the crisis, re-introduced liquidity facilities and new programs for corporate credit and muni debt. They suspended many regulatory requirements and now target the average inflation level. Let’s just say this was the most active Fed easing, and by comparison 2008-09 looked like a dry run for what was executed in 2020.

Does the Fed Really Need to Easy Further Now, At Year-End No Less?

There is a clear tension between the financial economy and the real economy. On the one hand, broader risk markets have more than recovered from the COVID-19 market vol shock experienced earlier in the year. But small businesses and industries directly impacted by COVID-19 continue to struggle and face further lockdown pressure as we head into winter for the northern hemisphere.

This has led many folks, including myself early on in the year, to call this a K-shaped recovery. Those with financial assets and employment have benefitted from the Fed’s largesse, yet not enough of this easy money trickled down to those who really need the support during this tough time. So, what exactly would additional Fed easing accomplish at this point? This is why chair Powell and other key Fed speakers have been pounding the table that fiscal policy needs to take over. The good news is that recent developments in DC suggest a stimulus bill is hopefully coming soon.

What to Expect at the Meeting: Dovish, Neutral, and Odd Hawkish Risks

On the Dovish side, the Fed could tweak its bond purchases towards the backend of the curve (otherwise known as extending the weighted-average maturity) which would take out more 10-year equivalents of duration risk. However, why do that at a time when we do not know how large the various fiscal stimulus bills will be (both the current lame duck version and once President elect Biden is in office expect to see even more fiscal support). They might even need to buy more USTs next year if fiscal stimulus is so large that markets start commanding a real premium on long-term rates. In a way, adding to long duration now sends a mixed signal on their yield curve control (YCC) intentions. They can always change policy post fiscal stimulus but it would be rash and disjointed if they keep tweaking things.

On the more neutral side, which is my base case, the FOMC meeting concludes that the current pace of asset purchases is working fine, repeating the stance they’ve had for months. They could specify guidance and turn what initially started out as ‘market functioning’ QE support for the bond market into clear macro-driven monetary policy version of QE.

In many ways once the Fed settled in on the current $80bn UST and $40bn MBS per month run rate, they ostensibly made that transformation. What has been lacking is what would guide the Fed to do more (or less, which is the key part here in my view) buying of bonds ahead. The chair can also emphasize that the outlook, although highly uncertain and likely will see a rough patch during the winter months, looks brighter because of the warp speed launch of the global vaccine roll out. That would suggest that the Fed is willing to take a wait and see approach versus over doing it now.

There really is no room for a hawkish scenario. The FOMC statement and chair Powell will either try to sound neutral, or lean dovish, at this last meeting of the year. However the risk is how markets read between the lines. If the recent rise in risk markets has been a combination of fading election uncertainty and hopes of more Fed easy money, the mere fact that the Fed does not give the market further liquidity could be construed as hawkish (trust me, I think its ridiculous that markets have gotten to this point of even contemplating this notion). Also, the guidance on QE could be symmetrical and once the markets read that one day QE will go away, that too would run the risk of generating some taper 2.0 fear concerns as well.

Conclusion:

At the end of the day timing matters. The Fed usually adds to easing either in reaction to something bad just happened, or because there is a clear and present danger on the horizon. Given that the Fed’s toolbox has dwindled after the salvo of easing launched this past year, it’s best to save some ammunition for next year. The economy may not perform as well as what’s priced into the forwards of nearly every market indicator.

Although risk markets have gotten better at understanding Fed policy signalling, increasing duration withdrawal probably doesn’t have as much efficacy this time in a world that is obsessed with big numbers. In other words, unless the Fed actually up the quantum of its QE buying sizes (by like 50% to $120bn USTs), the overall market might not take much notice.

For example, let’s look at this last chart, if we put aside the massive spike in buying during March thru May, overall, the term premia embedded in the 10-year rate has moved up and down with the 3-month change in the Fed’s balance-sheet (B/S). With 10-year rates still under 1%, unless they are worried about a major move up in real rates from this point (which would also push the 10-year clearly above 1%) its best to hold off on more easing.