On Friday, the Wall Street Journal reported that Donald Trump is displeased with Treasury Secretary Steve Mnuchin.
That displeasure allegedly stems from Steve’s reservations about the trade war and also from Mnuchin’s support of Jerome Powell, who Trump has lambasted on any number of occasions over the past four months, with the latest broadside coming Tuesday evening in comments delivered during a rambling interview with the Washington Post.
According to the Journal’s Friday reporting on the Mnuchin situation, Trump said this of Powell during a conversation about recent market turmoil: “If he’s so good, why is this happening?”
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‘Phony Sources And Jealous People’ Say Donald Trump Is Furious With Steve Mnuchin
Well, according to Bloomberg, Mnuchin was running around to bond dealers last month essentially polling them on which they’d prefer: rate hikes or a faster balance sheet run off.
It sounds like Mnuchin was (or is) hoping that Trump understands so little about post-crisis monetary policy that he won’t mind if the Fed accelerates the pace of balance sheet normalization if it means slowing down on rate hikes. The President, one assumes, will not view tightening via accelerated balance sheet runoff as something that could imperil the economy and the stock market.
“In an October 30 meeting with a Treasury advisory committee that makes recommendations to the government quarterly on its debt sales, Mnuchin asked which they favored — an accelerated balance sheet run-down or further rate hikes — if they had to choose one or the other”, Bloomberg reports, citing six people familiar with the situation, and adding that “Mnuchin raised the question during a regularly scheduled quarterly meeting with the Treasury Borrowing Advisory Committee.”
So basically, Mnuchin is now asking Goldman, JPMorgan and (hilariously) Citadel the following: “Ok, guys, show of hands. Who wants rate hikes and who wants accelerated balance sheet rundown?”
Of course this is extremely precarious and it’s surely not lost on Mnuchin that if the Fed were to placate Trump by eschewing rate hikes in favor of a faster pace of balance sheet runoff, it would make his job all the more difficult because it would mean even less support for the bond market at a time when the Treasury is flooding the market with supply to finance the deficit and direct bidders are drying up.
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Remember, Steve now holds the refunding record, having snatched the dubious title from Tim Geithner this quarter and the less support there is from the Fed when it comes to the U.S. debt market, the harder it’s going to be for Mnuchin to finance Trump’s fiscal insanity.
But wait, there’s more!
Recall what the RBI’s Urjit Patel wrote in an Op-Ed for FT earlier this year about the extent to which the Fed should calibrate the pace of the balance sheet rundown to take account of increased Treasury supply:
Dollar funding of emerging market economies has been in turmoil for months now. Unlike previous turbulence, this episode cannot be attributed to the US Federal Reserve’s moves on interest rates, which have been rising steadily since December 2016 in a calibrated manner.
The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts. Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.
That dynamic would worsen if the Fed were to accelerate the pace in the face of record debt issuance.
Further, most believe the Fed will be forced to halt balance sheet normalization altogether sooner rather than later and the market is on pins and needles waiting for details on the technicalities. EFFR continues to drift and eventually, the Fed is going to have to address it.
(Bloomberg)
In the final analysis, this is just another example of Donald Trump backing everybody into a corner by either not understanding what’s going on or else insisting on pushing competing policy goals.
Finally, do note that even if Mnuchin and Powell could fool Trump, they can’t fool the market, which would invariably see accelerated balance sheet rundown for exactly what it is: more tightening at a time when the total degree of tightening is at or above levels where a recession normally ensues (see left pane below).
(SocGen)
With a Fed funds rate of an eye watering 2.25% and a Federal Reserve Credit at only $4 trillion, I honestly don’t know how the markets can cope…
The question of faster balance sheet run-off or more rate hikes is a legitimate one because the choices will create a different outcome than the path currently being taken. And the reason this is the case is the $1.7T in Excess Reserves that still remain in the US Federal Reserve Banking system. Since the Fed began drawing down the balance sheet, these reserves have been converting at a better than 1:1 pace into the new Treasury supply being created. Accelerating the balance sheet draw down will probably be no problem as supply of Treasuries seems to still underwhelm latent demand for risk-free assets in the system. The concocted interest rate level (concocted because it is not market determined due to the level of excess reserves in the system, but rater just set and maintained by the FMOC thru the repo market), on the other hand, is a real cost to the economy which is slowing down demand in this credit feed economic monstrosity that was created over the last 10 years (worldwide).
The Treasury market is already pricing in an interest rate hike pause or cessation in 2019. However,as you note, market supply of Treasuries will continue to increase. A faster Fed balance sheet draw down at this point in time, rather than higher rates, should result in curve steepening as the market will demand a higher price to hold duration as rate hikes pause but supply becomes even greater. There is plenty of room on the long end for rates to push upward and normalize. And, since the Trump Treasury is doing the majority of its current funding of the economic plan on the short end of the curve (even added a 2 Month T-Bill), the market has a much better chance of returning to historic norm levels without an immediate economic recession. On the current path, however, higher short-term rates in the near-term as the long end stays anchored is a recipe for economic disaster triggered by an ill advised Fed rate over-hike path once again – 2000 and 2007,
A higher long end of the curve will of course have to be digested by the stock market. This will not be without valuation pain. However, the market is currently priced far too high relative to US GDP when compared to historical averages; and the reason for this is that long-term rates are held artificially low by FED, ECB and BOJ policies since 2014. These policies are in the process of reversing, so stocks are going to re-price along with the long end of the curve regardless of the Fed path. Fair value of the S&P500 today is 1800 at a 4% 10 Year and 20T GDP, not 2641 which is the implied bottom being defended today. There is bandwidth in the Federal Reserve system to make a better choice for the US economy at this point in time while meaning the system off the extreme policies of the past 10 years; the Fed rate hike plus balance sheet tightening at the current projected pace is likely to be one that keeps long-term Treasury rates low, but also kills the economy (and blows out corporate credit spreads) over the next year resulting in a 1200 or even lower print on the S&P within the next 2 years. Choose your poison when it comes to equities, but the path is currently lower, not higher based purely on the changes which will be implemented in the world banking system over the next 2 years..
Can you explain the problem you see with the first chart in more detail? Given that IOER is supposed to be a floor for EFFR, I don’t see why the chart is alarming.