On Thursday, Jerome Powell set out to prove that his market-approved, “new” communications strategy which made its debut two Fridays ago in Atlanta, wasn’t a fluke.
In remarks delivered at The Economic Club of Washington, Powell seemed relaxed and confident, cracking jokes and deftly navigating questions about the December meeting minutes and the Fed’s approach to the rate path amid signs of a slowing economy and on the heels of Q4’s equity drawdown and credit turmoil.
The only “glitch” came when he was asked about the balance sheet, and the market’s knee-jerk response to his answers underscored the extent to which the QT conversation has now become more important in the market’s mind than rate hikes.
As a reminder, Powell emphasized that the Fed wants to return the balance sheet “to [a] more normal level”, a statement that to the casual observer, might sound like a man simply stating the obvious, but to the market, came across as a bit tone deaf, in the sense that it wasn’t 100% clear that “normal” is the best descriptor. After all, if you go by historical precedent, we’re “a long way from normal” (to paraphrase the worst communications fumble of Powell’s short tenure).
But (far) worse than that was Powell’s ill-advised decision to describe the eventual size of the balance sheet as “substantially” smaller. That, we noted on Thursday, was an unforced error. There was no reason to use “substantially” and the market immediately seized on it.
All in all, he came away unscathed and stocks would ultimately rebound after briefly dipping into the red, but what I think it’s important to emphasize here is that with the market having priced out the dots (and now increasingly prone to pricing in a Fed cut in 2020), and with analysts seemingly predisposed to throwing in the towel on previous forecasts for more hikes in 2019, the risk is that going forward, any “incremental” dovishness (if you will) will have to come in the form of tweaks to balance sheet rundown. Here’s how we put it on Thursday:
The market has already priced out rate hikes (for the most part) and the Fed’s dovish relent on that front has been unequivocal over the past couple of weeks. That, it would appear, is already in the price – figuratively and literally.
As Powell well knows – just ask the transcript of the October 23-24, 2012 FOMC meeting – “it will never be enough for the market”, and right now, the market wants a clear sign that balance sheet runoff will be reconsidered.
Powell gave the market an inch, and now it wants a mile.
This is not trivial. It suggests that dovish rhetoric around the rate path (e.g., “patient”, “listening to the market”, etc.) will no longer cut it, and while significant changes to the statement might be good for another 5% (give or take) on the S&P, last week’s wholesale dovish relent as communicated by a veritable parade of Fed speakers means they might as well have just preannounced that hikes are out of the question in the first half of the year.
You might see the odds (i.e., market pricing) move a bit as stocks rally and HY spreads come in, but if you ask me, the following chart is all you need to consult when it comes to discerning whether anyone expects a hike in March or June.
“Oversold” or no, “short squeeze” or not, “force-in” or otherwise, you are not going to convince me that the S&P would be up ~11% from the December 26 overnight lows, the Russell up ~15% over the same period and junk spreads tighter by ~90bps since Powell’s Atlanta remarks if there was any question about whether more hikes were in the cards in H1.
Now sure, a continuation of that kind of action could ironically put March and/or June back in play (as it would loosen financial conditions materially, especially if paired with further dollar weakness), and that leads directly to the crux of the problem. Let’s say we run too far, too fast leading the rates market to start pricing in hikes again while trade talks falter and the drama inside the Beltway continues. If the selloff were to resume and credit were to start widening out again, it’s hard to imagine how the Fed could engineer another rally just by repeating what they said last week. Rather, they would likely have to start talking about the balance sheet, only in more concrete terms. And that gets to the heart of what we were trying to communicate on Thursday in the excerpted passages above about “giving the market an inch” only to see everyone “take a mile”.
This risk is especially acute given that there’s already something highly contradictory about describing policy as “not on a preset course” and proceeding apace with a preset plan for balance sheet runoff. Right up until Q4 of 2018, the market was willing to largely overlook that contradiction, but now, not so much. And while Fed officials have gone out of their way over the past two weeks to make it clear that balance sheet runoff is subject to reconsideration, there’s still a sense that they would only do that in an extremely adverse scenario.
“Dovish Fed near-term capitulation [with] STIRs implying no further hikes / partial 2019 cut, while most importantly, Powell stated a willingness to alter the balance sheet run-off, although I’d note that this remains only a ‘break glass’ option for the Fed,” Nomura’s Charlie McElligott wrote on Monday.
Credit Suisse, meanwhile, says that while they “expect balance sheet reduction to remain on autopilot, announcing an end to balance sheet decline would be an attractive dovish option for the FOMC in a moment of deep market distress.”
Again, this is starting to sound like a slippery slope. Powell (and myriad other officials) gave the market what it wanted on rates (by basically announcing a pause ahead of time) and the market, being the greedy, forward-looking beast it is, immediately surged, setting the stage for a scenario where the next dovish escape valve will have to be a balance sheet rundown tweak lest everyone should become even more focused than they already are on the inherent absurdity of pausing rate hikes while tightening via runoff.
Here’s where this gets really interesting. In a note dated Friday, BofAML ponders what it means if the rates market is “right” and the implications are, well, interesting.
“If the US rates market is right, this would suggest that potential growth is much, much lower than generally accepted”, the bank notes, before expounding as follows:
If Fed Funds target rates of 2.00-2.50% are enough to cause the economy to go into recession, with inflation having normalised at around 2%, then potential growth would seem to be less than 50bp. Alternatively, when looking at where the USD OIS curve regains positive shape and flattens out (in the 7-10 year forwards) the market price for neutral rates again seems to be as low as 2.00-2.50%, leading to the same conclusion. If the above were true, every asset bar rates is massively mispriced.
If we accept market pricing, then there is no shortage of inconsistencies to take advantage of. If the world is going into a severe slowdown, then the Fed is unlikely to wait until next year to cut rates
That’s disconcerting, and while the bank takes some measure of comfort in the fact that inflation doesn’t seem to be telling the same story, the rest of their analysis takes it as a given that the rates market is in fact correct (basically, they play devil’s advocate to their own more benign view).
In the course of that exercise, the bank’s rates team notes that the idea of the Fed cutting rates while persisting with balance sheet rundown is patently absurd. “We do not believe that the scenario of the Fed continuing with the reserve drain while cutting rates is credible”, they dryly note, before musing that “it is generally inadvisable to drive an automatic car with one foot on the brake and one on the accelerator.”
The mechanical effect of balance sheet runoff on equities is obviously the subject of vociferous debate and this post is already running pretty long, but a simple read is that, as Barclays writes, “the evidence of a connection between the level of bank reserves and the stock market is weak, as the timing and scale of the reduction in balances at the Fed does not match the movement in the S&P500.” Here’s a chart.
This ultimately comes back to the “flow” versus “stock” debate. Here’s Barclays again (this is from a note dated Thursday):
Bank reserves have been falling since QE ended in 2014, while the S&P500 continued to rise until last fall. Moreover, when bank reserves were last at $1.6trn, in early 2013, the S&P500 was at 1500, or about 1000 points lower than its current level. Of course, it may be that the flow of reserves matters more for stock prices than their absolute level. But the first $1trn reduction in reserve balances was not large enough to derail the equity market rally; instead, the more recent $200bn decline in balances may have helped tip the equity market into a correction.
Right. And none of that accounts for the psychological impact when suddenly, the President is tweeting about QT and high profile investors and officials are penning WSJ Op-Eds during the middle of a brutal selloff.
Another concern is buried some 16 pages deep in the BofAML note mentioned above after the bank revisits the familiar topic of balance sheet rundown colliding with increased Treasury supply. This is a source of ongoing consternation for the very simple reason that when the price insensitive bid from the folks with the printing press goes into retreat just as Steve Mnuchin is breaking refunding records thanks to Trump’s lunatic fiscal policies, you get a decidedly unfavorable supply/demand distortion. That’s made immeasurably worse by the perception that America’s plunge into fiscal largesse makes Treasurys less of a “sure” bet (obviously the US isn’t a real “credit risk”, so it’s all about confidence erosion at the margins, but you get the point). Needless to say, the longest running government shutdown in history doesn’t help this dynamic as it raises questions about future debt limit negotiations.
“Problematic for the balance sheet issue this year will be heavy Treasury issuance and longer duration issuance as coupon sizes have now ramped up to their maximum sizes”, BofAML goes on to write, on the way to warning that “while increased Treasury supply is not news – the backdrop for this supply has worsened over the past couple of months with the dealer community potentially less capable of absorbing supply.”
Earlier this week, a $38 billion sale of three-year notes met with tepid demand – the bid-to-cover was the lowest in a decade.
But wait, there’s more. It’s actually possible that a trade deal with China makes this worse. Consider this, from the same BofAML note:
If we are right that a US-China deal is likely within the next month or two, we think it could worsen both the supply outlook and funding pressures. This is because a trade deal might allow continued Fed balance sheet runoff, adding the full amount of Treasury runoff to overall supply. Meanwhile, lower overall demand for Treasuries in a risk-on environment could further stress dealer Treasury inventories, already at all-time highs. While the consensus view is that CNY would strengthen initially on a deal, there is risk that it weakens afterwards due to increased easing measures over time, and this in turn raises a tail risk for a potential currency-defense phase entailing the sale of Treasuries.
Add to that the PBoC reportedly expressing consternation at last week’s mammoth yuan rally (the best week for the currency since 2005) and the fact that China’s Treasury holdings have fallen for five consecutive months through October, and you’ve got a lot to ponder.