FOMC Preview: Easing for Markets Helps a Levered Economy

Since the July Fed rate cut of 25bps and the conclusion of its balance sheet roll-off (known as quantitative tightening, or QT for short), there have been many major markets moves. These include a massive duration rally and then a retracement, factor-model rebalancing of growth and value, along with a spike in oil prices. On the US economic front, some key data has looked better: retail sales, jobs, and even the latest industrial production.

The data in particular has some arguing that the Fed should feel vindicated with calling their recent policy actions as ‘mid-cycle adjustments’ and that after easing one more time, Fed should take a ‘wait and see’ approach.

It’s a logical call – for those grounded in old fashioned economics, that is. But the past couple of decades have witnessed the inextricable connection of the economy and the markets, and the Fed is hostage to this feedback loop. And if they don’t get it right, they run the risk of another policy error.

Stocks are near the highs; therefore one could argue that there is no need for further liquidity to improve risk markets at this time. Furthermore some feel the Fed might miscalculate and create a repeat of 1998-00. Then, the Fed eased due to non-economic reasons and that led to an even bigger inflating of the bubble at the turn of the century. I do not subscribe to this view exactly. The present-day world needs liquidity just to maintain current valuations, meanwhile the real crux of the liquidity concerns lies in money markets. This won’t be the first or last time the Fed ease for an FCI benefit.

And for the record, what I’m conveying about the Fed’s reaction function is not what I believe they should do based on economic factors, just what they will probably do in the pursuit of market functioning. For any of the purists out there that still believe the Fed should let markets correct and not attempt a soft-landing, that ship sailed this year after the Jan-Powell pivot.

FOMC Expectations and Implications: 50bp Cut and New Tools?

Base-case: First and foremost, the Fed is going to ease. The uncertainties are over how much and the exact nature of the package delivered. Given the market volatility and a jump in geopolitical risks, at a minimum the Fed will cut rates by 25bps at the September meeting. Markets will be looking at the SEP forecasts to make sure they are reasonable (i.e. the dots come down with growth forecasts), but in my view, that is becoming less of a driver. What is important is the press conference and what is said about recent repo dynamics. Chair Powell will refrain from stating the easing cycle is over. Instead he will keep the door open, since ‘uncertainty’ has not fully abated.

Lastly, repo markets have been under severe stress and, as seen in chart 1, that has finally led to the Effective Fed Funds Rate (EFFR) hitting the upper band of the Fed Funds target range (2.25%). As a result the NY Fed is conducting overnight repos, ahead of the FOMC, in an attempt to ratchet down short term interest rates. Since this is fresh on everyone’s minds, Powell will be asked about it in the press conference. Short of launching a new tool (like a Standing Repo Facility – SRF), Powell will emphasise that market function is also paramount and that they have tools and are working on solutions.

Chart 1: Fed Policy Rates – Target and Actual

Dovish-case: Let’s just ‘cut’ to the chase. The Fed needs to ease by at least 50 bps to re-steepen the curve and they are just having a hard time getting everyone on board. If the goal is to sustain the expansion, nothing matters more to this economy than buoyant FCI.

There has been a lot of discussion around the SRF. Even if it’s not perfect (or fully vetted for that matter), having it announced and in place by quarter-end would help tame the fears that the Q4 dollar funding squeeze will not be addressed piecemeal via strictly overnight repo operations. If SRF is discussed/launched in the context of changing the floor system and other Fed administered rates get tweaked (such as those paid to central banks reverse repos), that would make such an announcement an even more dovish event. A lot of the issues plaguing money markets are down to the exhaustion of reserves. It is possible Powell mentions a non-term premia focused QE as a tool to offset currency in circulation growth.

Conclusion

We let our imagination run a bit wild for the dovish case, but that’s largely because we are at a time when the Fed needs to be creative. The ECB is back in easing (via rate cuts and QE, no less) and the dollar has been bid and runs the risk of strengthening if they don’t ease more than the forwards. Meanwhile, there are signs of market disfunction in repo-land. And let’s not forget that the world is a dangerous place, and what seems stable now can easily turn worse. Sometimes taking on more insurance makes sense.

As per chart 2, USD 3M LIBOR has been range-trading post the July Fed rate cut, but Fed cut expectations have been elevated resulting in FRA-OIS spread blowing out. Until USTs are attractive for foreign buyers (requiring a steeper curve to overcome FX hedging costs), the Fed should stay in an easing mode.

Really, what the Fed should do is to over deliver. But the only reason why this isn’t my main case is that there could be enough internal pushback between those that put the economy versus those who put the markets first. We therefore anticipate some combination of the base and dovish case. The key thing to watch is anything meant to address money market/USD funding as the fourth quarter (rebuilding of Treasury cash balances and year-end pressures) can exacerbate recent repo issues.

Chart 2: Short-Term US Money Market Rates and Spreads

George is a twenty years fixed income markets veteran. Over that time he has covered 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.)