- Fed's actions and projections remain disconnected from each other
- Powell needs to make bonds attractive in order to keep the US economy going ahead
- Meanwhile, a bearish steepening has made it even harder for the Fed to pull off the ultimate balancing act
A few weeks ago, in light of Powell’s Jackson Hole speech , I noted that the Fed was focusing its monetary policy on preventing the bond vigilantes from taking control of the rates market, thus spoiling the soft-landing party many (the Fed included) have been betting on.
But to do that while controlling inflation, I noted, the Fed needed to keep stock market expectations put, maintaining speculative capital as far from the labor market as possible.
“The Fed finds itself uncertain about its future course of action. However, as it has found out, it wants things to stay that way.
That’s because two intertwined opposing forces are pulling markets: the expectation of the end of the rate hike cycle and the probability of a recession in the near term. Against this backdrop, Powell has realized he can manage forces spanning from either of the aforementioned factors by keeping the equity and debt markets at a consistently high risk.
This indicates that regardless of whether the Fed decides to raise rates once more, conditions will continue to be highly constricted along the entire spectrum of interest rates and within the broader economy.”
That’s why Powell, more than ever, needs to buy time. And how to do that? Well, by selling bonds for once.
The debt-reliant US economy cannot run without more issuances. However, persistently high rates have kept treasury risks high, leading to the selloff we’re seeing now.
Calculations are that if the current pace of debt growth persists, the federal burden is projected to escalate from $32 trillion to approximately $140 trillion by the year 2050. Under the assumption that the Federal Reserve maintains its practice of monetizing 30% of debt issuance, this implies that its balance sheet will expand to over $40 trillion during the same period.
That’s why I believe that Powell’s angle is to make bonds attractive for investors again.
Conditions Have Changed Globally
If one were to look at the results from the Central Banks super week strictly from the rates decision perspective, the conclusion would be that we are closer than ever to the shift in global monetary policy investors have been anxiously waiting for.
In fact, the least predictable moves came in the dovish form, with the Bank of Japan (BoJ) maintaining rates negative and the Bank of England (BoE) leaving policy rates unchanged due to the positive surprise on the inflation front in the previous week.
But none of that seems to have counted in light of Powell’s hawkish remarks and the takeaways from the DotPlot :
- 12 Fed officials anticipate one more rate increase against seven who project no further rate hikes. Interestingly, one fed member foresees a year-end 2024 rate of 6.125%.
- DotPlot projections reveal policymakers’ continued expectation of an additional rate hike this year. The projections for 2024 and 2025 both show a half-percentage point increase, indicating the Fed’s belief in sustained higher interest rates for longer.
- The Fed’s outlook predicts inflation to reach 2.6% in 2024. Furthermore, the median projection for economic growth in 2023 has risen from 1% in June to a solid 2.1%. Officials have significantly lowered their unemployment forecasts, now expecting a peak jobless rate of 4.1%, down from the previous estimate of 4.5%.
- These changes have led to shifts in fed futures. Now, Fed futures no longer imply rate cuts until September 2024.
- To provide perspective, just three months ago, futures were pricing in four rate cuts in 2023. Presently, interest rates will remain steady for at least one year.
Now, either the landing ahead will prove considerably rougher than anticipated, or the Fed might find itself compelled to start going against its rhetoric.
In fact, mentions of inflation in the latest Fed Beige Book were the fewest since January 2022. In stark contrast, mentions of recession have surged to their highest levels since at least 2018.
This noteworthy shift, with the term’ recession’ now appearing frequently in a context where it was virtually absent just a year or two ago, provides a significant insight into the prevailing concerns at the Fed today.
Given that 2024 is an election year, the Fed can sound as hawkish as it wants to. However, once the economy starts slowing down, the pressure to ease financial conditions could become unbearable.
During Powell’s conference, rates on US government bonds experienced a widespread increase, with the 2-year rate reaching its peak level since 2006, while the 30-year rate reached a level unseen since 2011.
In fact, in the days that followed the Fed’s meeting, the entire yield curve underwent an upward shift, characterized by a significant bear steepening in both the 2/10 and 5/30 yield curves. Over the past month, the 10-2 year Treasury yield spread has seen an increase of approximately 10 basis points, while the 5-30 curve has surged nearly 20 basis points.
This shift in the yield curve has led to a considerable tightening of US financial conditions. Notably, the long end of the curve is rising at a faster rate, resulting in the repricing of long-term assets such as mortgages, which have seen rates rise to as high as 7.6%. Corporate debt markets are also experiencing similar repricing effects.
The tightening of financial conditions comes at a time of unprecedented uncertainty regarding the future trajectory of US GDP growth. Forecasts for economic growth in the near term vary significantly, with the Atlanta Fed projecting a robust 4.9% GDP growth for 3Q’23, while the New York Fed is more conservative with a forecast of 2.1%. The average of private forecasters falls even lower at just 1.4%. Such substantial disparities in economic outlook are rare outside of major crises or exceptional circumstances.
There is a growing disconnect between the expected growth rates of the US economy and the projected policy rates set by the Federal Reserve. Even if the Fed’s projections prove accurate, US nominal GDP growth rates are quickly converging toward 4%, significantly lower than the expected policy rates, which are nearing 5.5%.
The mantra says don’t fight the Fed. Well, this time, the Fed is saying loud and clear: buy bonds.
It isn’t doing so for any reason other than to support its ongoing long-term policy mistake. However, looking at the current perspectives for stocks, I am certainly protecting some of my returns with a few juicy yields.
Disclosure: The author holds US 10-Year bonds in its portfolio.
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