July FOMC Preview: The Setup For Dovish September Policy Moves?

This past year feels like a blur for all the obvious reasons. But before the all-out blitzkrieg easing campaign that the Fed launched post March 2020 to help combat the fallout from the COVID-induced disruptions, it is worth mentioning that this time last year, at the July FOMC meeting, the Fed actually embarked on its first of the many so-called “insurance rate cuts”.

Those following my work for the past twelve months will recall that I was sceptical that once the Fed starts easing it would only tweak rates a few times like it did in the 1990s mid-cycle adjustment. For starters, the US economy was late cycle to begin with, and in 2019 we were still dealing with the QT aftershocks which led up to the repo crisis. The COVID shock was just the catalyst that exposed many of the fragilities (bond market functioning liquidity flaws, over-levered corporates, CREs, etc.) in the financial system. This is not completely shocking; but when faced with all these market challenges and now economic hardships post COVID, the Fed has become even more hypersensitive to the evolution of financial conditions and has performed easing operations that once took years in a matter of weeks. They have also resorted to sounding uber dovish, too.

Meanwhile, although the economy has managed to bounce back, there is a high degree of uncertainty on how truly sustainable the recovery is after the lockdown shock of late Q1/early Q2. Furthermore, since the last FOMC meeting, COVID cases and now deaths, especially in the sunbelt states, have seen a dramatic increase. This extension of the COVID first wave in the US and a rise in permanent unemployment figures is likely what is weighing on overall consumer confidence, as seen with the recent weaker-than-expected results. Lastly, the expiration of certain measures like unemployment benefits and the ongoing debate in DC on a new fiscal stimulus package are likely to keep the Fed super cautious and dovish.

At this point, there are a number of items still up in the air. What else could the Fed do if the economic outlook were to worsen more than it already has? Or when will they finally release their new policy framework approach? I do not believe the Fed is ready to release new measures, but it will also try not to disappoint markets at the upcoming July FOMC meeting. Let’s explore what may be discussed and the market implications thereof.

Still Too Early to Shift From Market Functioning QE to Macro-based QE

In the period between the June FOMC and now, the Fed’s balance sheet (B/S) has actually seen periods of shrinkage as FX swap lines roll-off. Were it not for the constant buying of UST/MBS, the B/S would have been down the most since the post-2009 unwind of liquidity programs. And speaking of UST/MBS, the Fed continues to hold the view the $120bn in purchases are about maintaining market function and are not a macro policy tool. Now, granted, when they are buying that many HQLA assets, it is also to introduce easing into the economy; but to them that is a secondary benefit.

Given that it’s the middle of the summer, we expect no alterations to the ongoing open market operation process. It’s possible that Chair Powell mentions that during the meeting there was discussion on how to change the current buying to become more targeted. We could also learn more about the debate between potential QE tweaks (for example, shifting the concentration for each UST target bucket) and if that will come with a version of yield curve control or not. And then there is Jackson Hole at the end of August, which could further clarify the changes that lie ahead.

The Barely Used Fed Lending Facilities Get a New Expiration Date

During the first day of the two-day FOMC meeting, we got word that the lending facilities that were going to expire in September will be extended until the end of the year (31 December). In my humble opinion, that expiration date will also be extended by another three months, given that we will be in the dead of winter and at peak risk for a COVID second wave.

I believe there are a number of reasons why the Fed decided to release this information before the official statement release. One, they have other, bigger issues to deal with, and it’s a minor detail that needs addressing. Two, they need to get this done anyway before September so that it’s before the expiration date and well ahead of the election period. Three, they are barely used, so why not? Especially after all the time they put into creating these facilities, they should have a longer shelf life. And four, these facilities are really targeted at credit easing and main-street lending, which the real economy (and not just the financial markets) could see another relapse in activity into the end of the year if the second wave is rough.

Conclusion

The Fed is clearing the decks to set up for major changes in September; that requires getting consensus established in the coming weeks, starting with the July FOMC meeting. There is risk of a relapse in the data and further weakness as the COVID first wave makes its way across the country. Meanwhile, it’s looking like the second round of fiscal stimulus will be less impactful than the first tranche. This will likely result in Chair Powell sounding dovish and emphasizing they are prepared to do more easing. With the lending facilities barely used, they have scope on that front; but the next major round of easing will likely come in the form of a more targeted QE program and linkages back to real rates and the curve.

Recall in the last recession the Fed lowered rates to the zero bound and then, through QE, dropped the shadow Fed funds rate even further. With curves much flatter now vs 2009, hoping for a rate sell-off to the steepen the curve to incentivize the struggling banking system to lend is not recommended given that the government will need super-low rates to help ease COVID pain. They will need to get creative on the real curve soon.