General Powell

Liftoff is finally here, and it’d be difficult to conjure a more challenging set of circumstances for Jerome Powell and his merry band of compatriots.

For the better part of two years, Fed officials were implicitly (and, in many cases, explicitly) asked to deliver authoritative opinions on matters of virology and epidemiology, a ridiculous ask that Powell nevertheless obliged more often than he probably should’ve. Now, he’ll need to ditch the lab coat and microscope prop for combat fatigues and a rifle. Maybe he’ll bring a map of Europe, some push pins and a pointer to Wednesday’s press conference: “Let’s say balance sheet rundown starts in July, concurrent with a large pincer movement.”

This week’s rate hike will be 25bps. We know that. But that’s pretty much all we know. And that’s pretty much all the Fed knows too. But this is an SEP meeting, which means officials are compelled to pretend they know more. Those pretensions to foresight will manifest in a new dot plot. The dots need to be marked to market, where that means closer to the half-dozen quarter point hikes priced for this year. The problem is that the economy is set to lose momentum. The war materially increased the odds of stagflation. The Fed is now virtually guaranteed to find itself tightening into a fairly pronounced slowdown.

The curve is a problem. Policymakers really need to shift the entire curve higher lest it should invert imminently. There are good arguments for the notion that rates are a false optic. The idea that the cycle is “over before it begins” is a consequence of a “fracture across the horizons,” as Deutsche Bank’s Aleksandar Kocic put it. But most investors (and certainly the financial media) will cite pedestrian cash curve indicators and their “track record” for predicting recessions. The 2s10s has flattened nearly 70bps in 2022 and is now very close to inversion (figure on the left, below).

Meanwhile, breakevens long ago ceased to be a referendum on the Fed’s success vis-à-vis averting a deflationary spiral. In the immediate aftermath of the pandemic, the Fed wanted to get breakevens higher, putting downward pressure on reals, on the way to bolstering risk assets and easing financial conditions. Now, though, breakevens are being driven to record highs by surging commodity prices (figure on the right, above), and the read-through for reals (i.e., lower) is arguably unwelcome to the extent it effectively works at cross purposes with the Fed’s efforts to tighten.

I suppose the Fed can take some solace in the notion that longer-term expectations are more subdued, but as Goldman noted earlier this month, “an extremely inverted inflation curve makes inversions of the nominal yield curve that are either earlier in the cycle or deeper” as a “matter of arithmetic.”

“The TIPS market offers a nuanced view into how the US rates market is pricing in the effects of Russia’s invasion of Ukraine,” TD’s Priya Misra said. “The entire TIPS BE curve has shifted higher since before the invasion, but two-year TIPS BEs have risen more quickly by 85bps compared with 44bps for 10-year TIPS BEs,” she added, on the way to noting that “TIPS BEs in the two-year and five-year sector are both near all-time highs [and] the TIPS BE curve has reached record levels of inversion.”

Misra went on to say that while two-year TIPS BEs “should continue to benefit from higher food and energy prices in the near-term,” the move in long-end breakevens is probably overdone if you think the Fed “is likely to bring inflation under control in the longer run or the energy price spike will create a sufficient disruption to slow the US economy.”

Whatever the case, the bottom line is this: Russia’s decision to invade Ukraine is a migraine headache for a Fed that was already destined for a policy “mistake,” where the scare quotes are there to suggest that although policymakers are all but certain to find themselves tightening into, and thereby exacerbating, a slowdown, it’s hard to call that a mistake considering the inflation backdrop.

It’s possible the Committee will feel pressured to take policy into restrictive territory eventually in an effort to tamp down price pressures, but that could be extremely contentious if a recession does develop, especially considering the political ramifications.

“As with all ‘well laid plans’ there is a lot that can change with the real economy between now and the FOMC’s arrival at the terminal policy rate,” BMO’s Ian Lyngen and Ben Jeffery wrote. “The war in eastern Europe has added another layer of monetary policymaking complexity that will limit each hike to 25bps, but we’re also cognizant that there is a compelling case to be made for the Fed to act more aggressively, hence we expect Wednesday’s Fed announcement will unquestionably be a tradable event,” they added, noting that “Powell is well aware that this is the moment to communicate to the market how the Fed envisions the path toward higher rates unfolding.”

The balance sheet discussion is equally convoluted and I’d reiterate that any decision to aggressively wind down MBS holdings is fraught with peril, even as it’s generally seen as desirable and necessary. Part and parcel of the “controlled demolition” narrative is the notion that the Fed can lean into MBS runoff in order to help cool the housing market and take the wind out of risk assets as a kind of backdoor effort to lean against services sector inflation. But controlled demolitions only work in theory. MBS are spread product. When a price insensitive buyer begins to step away, there’s a clear contagion channel to risk assets, and managing that contagion (i.e., ensuring it doesn’t lead to disorderly price action or, say, a drop in home prices that’s too large to be described as constructive) will likely prove impossible.

Complicating all of this is a significant deterioration in Treasury market liquidity (figure on the right, below).

Suffice to say if there’s anything the Fed won’t countenance under any circumstances it’s an illiquid UST market. Inflation or no inflation, they’ll act if conditions deteriorate rapidly. Extreme volatility in Treasurys is a total non-starter at the Fed.

Powell will doubtlessly emphasize how “nimble” policy can be when he speaks to reporters on Wednesday. “The market is well priced for the start of the hiking cycle, pricing in consecutive rate hikes in the coming meetings,” TD’s US rates team said, in a separate note from the piece cited above. “However, the Fed’s tone about the pace of hikes, the endpoint of the hiking cycle and details regarding QT is likely to prove the bigger focus for markets,” they added.

The standard line is that the Committee is taking things “meeting by meeting.” Really, though, the Fed is in the same boat as everyone else at this juncture, including and especially the beleaguered citizens of Ukraine: They’re taking things day by day.