Happy Friday, friends! Wednesday brought us minutes from the November FOMC meeting, and the market reacted rather positively to it. This was somewhat surprising given that the minutes themselves had very little, if any, new and positive information within.
The financial media initially focused intently on the Fed's discussion about reducing the size of rate hikes. A change that Chair Powell alluded to during his press conference, that numerous Fed speakers have discussed prior, and which Fed Funds Futures have been pricing in for many months.
The next Fed rate decision on December 14th is currently expected to be 50 bps with 75.8% probability, a level of certainty that did not change whatsoever after Fed minutes were released, meaning the market already expected this outcome.
The Fed's staff signaled increasing concerns about the economy, stating that, "sluggish growth in real private domestic spending, a deteriorating global outlook, and tightening financial conditions were all seen as salient downside risk."
The Fed's aggressive tightening path was cited as a negative economic catalyst by the Fed's staff, who later went on to say, "the staff, therefore, continued to judge that the risks to the baseline projection for real activity were skewed to the downside and viewed the possibility that the economy would enter a recession sometime over the next year as almost as likely as the baseline."
In sum, the Fed's economists are joining the ranks of many institutions who believe that it is all but certain we will see a recessionary economic environment in 2023, thanks in no small part to the Fed's own policy framework. One they feel they have no choice but to pursue with their limited, demand-destroying and centric tools as they focus intently on subduing historic inflation.
Fed Funds Futures once again bumped up their projection of the terminal rate from as high as 5% to as high as 5.25%, and the market barely blinked. This 25 bps move higher is likely in reaction to both Chair Powell's press conference as well as the FOMC minutes themselves, both speaking to some degree of uncertainty as to just how high the terminal rate must go. If Fed Funds are raised above 5% in 2023 it would be the highest rate since 2007.
What's clear is that the Fed Funds Rate is likely to go higher than previously estimated by the FOMC. Inflation remains the prevailing concern, with a Fed that is worried more about doing too little (tightening) than too much.
Recently Bullard spoke about a terminal rate as high as 7%, which may seem excessive on the surface, but if inflation isn't tamed by Fed-induced demand destruction, then it is likely that the Fed will feel it necessary to continue raising rates.
Kashkari also spoke not long ago about the idea that if there was more effort put toward alleviating supply-side inelasticity that perhaps the Fed could ease up on their tightening approach. A clue being sent to policymakers that if they could focus on expanding supply instead of driving demand, that there could be a less destructive monetary policy regime.
The great experiment of quantitative easing is once again being wound down, with the Fed's balance sheet having rolled off over $300 billion in assets. But there remain over $8.6 trillion of assets on the same balance sheet, which as the chart below demonstrates was expanded aggressively during both the Great Financial Crisis and the COVID crash.
In September the Fed increased the run rate of quantitative tightening from up to $47.5 billion per month to as much as $95 billion per month, composed of $60 billion of US Treasury bonds and $35 billion of mortgage-backed securities. Annualized this would be a runoff rate of approximately $1.1 trillion per year, meaning it would take many years for the Fed to normalize the balance sheet back to pre-GFC levels.
Since QT's velocity was increased we've seen the US Treasury market, which was already becoming progressively more illiquid, show greater signs of strain. So much so that US Treasury Secretary Janet Yellen even expressed concern, saying on October 13th that she worried about ‘loss of adequate liquidity’ in US government bond market.
Since then the US government has increased its debt issuance even further, to a brisk $700 billion in the fourth quarter. This increase is attributed to the combination of rising interest costs and larger borrowing for the recent demand-driving spending bills passed by the US Congress.
This, in effect, exacerbates the impact of QT, as the Fed is not only stepping away as the once largest bidder for Treasuries, but the Treasury is also expanding supply significantly, creating a rather imbalanced market.
As a result we may eventually see instability in Treasury and other markets cause greater concern among Fed policymakers, but for now they appear to be sanguine with market conditions such that they are willing to continue to run-off the balance sheet.
In 2021 the UK House of Lords commissioned an interesting study on QE, titled Quantitative easing: a dangerous addiction?
A highlight I found most interesting reads as follows, "no central bank has managed successfully to reverse quantitative easing over the medium to long term. In practice, central banks have engaged in quantitative easing in response to adverse events but have not reversed the policy subsequently.This has had a ratchet effect and it has only served to exacerbate the challenges involved in unwinding the policy. The key issue facing central banks as they look to halt or reverse quantitative easing is whether it will trigger panic in financial markets, with effects that might spill over into the real economy."
We'll have to see just how far the Fed and other central banks can reduce their balance sheets before something significant breaks, which in the longer run I expect will mark the eventual turning point for monetary policy.
It is important to note that there remains a strong positive correlation between the S&P 500 and the aggregate size of major central bank balance sheets. The path of least resistance for risk assets, such as equities, is likely to be lower until the Fed stops their tightening cycle.
The last six out of seven bear markets only stopped when the Fed began to cut aggressively, and these occasions often happened during a recession when we also saw US households raising cash by selling stocks. Of yet we have not seen any of these historic bottom indicators.
Wednesday's trading action was light holiday volume, and largely made possible by junior desks and high frequency trading algorithms. The initial positive reaction may or may not hold.
Part of the positive reaction was likely made possible by event volatility hedges being removed as there wasn't a fire and brimstone level of hawkishness, a departure from Powell's press conference.
It often takes a couple of days for the markets to parse this data, particularly when decision makers are taking time off.
I think we'll need to see how markets perform on Monday and whether a deeper parsing of the minutes, which spoke repeatedly of upside risks to inflation and downside risks to the economy, may lead to a slightly different interpretation of the Fed's apparent steadfast resolve to hike rights higher for longer, even into and through a recession.