“Powell’s hawkish comments ripple through markets,” one headline read, on Monday afternoon.
This week was destined to be all about Fedspeak and war headlines — “tape bombs and technocrats,” as I put on Sunday evening.
Powell’s remarks, delivered at the NABE’s 38th annual economic policy conference, were hawkish. And why wouldn’t they be? Those who steadfastly refused to accept the reality of a positioning-driven rally convinced themselves that stocks’ best week since 2020 was somehow down to a “dovish” Fed hike or else Powell’s upbeat assessment of the domestic economy, when in truth it was the clearing of the event risk itself combined with a rolling, four-session squeeze into OpEx.
The point is, nobody should expect anything dovish out of this week’s bevy of Fed speakers, especially not Powell who, while not the Committee’s most committed hawk, isn’t its staunchest dove either.
The title of Powell’s Monday speech was “Restoring Price Stability,” which tells you pretty much everything you need to know about the substance. Powell was unequivocal and upfront, where you can take “upfront” figuratively and also literally, because immediately upon thanking the NABE for the “opportunity” to speak, and after taking a one-sentence pause to “recognize the millions who are suffering the tragic consequences of Russia’s invasion of Ukraine,” Powell said this:
The current picture is plain to see: The labor market is very strong, and inflation is much too high. My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability.
After talking about the labor market, he reiterated how perilous the inflation situation is and, importantly, already was, prior to the conflict in eastern Europe.
“The inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine,” he said, adding that although the transitory narrative seemed “plausible for a time,” it ceased to be viable “in the fall.”
Weighing in on why everyone (including and especially the Fed) got things so wrong, Powell mused that “an important part of the explanation is that forecasters widely underestimated the severity and persistence of supply-side frictions, which, when combined with strong demand… produced surprisingly high inflation.”
So, in other words, forecasters got both the supply and the demand side wrong, which makes it really tough to be right considering those are the only two variables in this equation.
Powell’s nod to the possibility of 50bps hikes and contention that the Fed would be willing to “tighten beyond common measures of neutral and into a more restrictive stance,” contributed to what ended up being a very rough session for bonds. The 2s10s hit a cycle low (figure below).
“We came into this week expecting a moment of calm from a macro prospective, but Monday offered another Powell-inspired repricing that brought two-year yields above 2.10% for the first time since May 2019,” BMO’s Ian Lyngen and Ben Jeffery wrote, calling that “a relevant milestone, especially from the perspective that in May 2019 the target fed funds range was 2.25-2.50%.”
If you assume the Fed can actually reach the forecasted 2023 target range, there’s considerable scope for the front-end to sell off further. Three-year yields rose as much as 20bps on Monday, five-year yields by 19bps (figure below), flattening the 5s30s to the narrowest since 2007.
As Bloomberg’s Edward Bolingbroke noted, “by 3pm, around 43bps (or 73% of a 50bps hike) was priced into the Fed’s May meeting, while 188bps of additional hikes was priced in for the year versus 168bps at Friday’s close.”
Powell also addressed the impact of the war on inflation. “There is no recent experience with significant market disruption across such a broad range of commodities,” Powell said, noting that on top of the “direct effects” from the sharp run up in oil and raw materials prices, “the invasion and related events are likely to restrain economic activity abroad and further disrupt supply chains,” all of which may “create spillovers to the US economy.”
He continued, drawing a parallel with the oil price shock in the 70s, which Powell described as “not a happy story.” Thankfully, he ventured, “the US is now much better situated to weather oil price shocks.”
As for whether the Fed can bring inflation down without causing a recession, Powell admitted that “some have argued that history stacks the odds against achieving a soft landing.” The reason for that pessimism, he said, is that “the 1994 episode [was] the only successful soft landing in the postwar period.”
But, he explained, that depends on your definition of “soft landing.” “I believe that the historical record provides some grounds for optimism,” Powell remarked, striking an upbeat tone, before suggesting that “soft, or at least soft-ish, landings have been relatively common in US monetary history.”
H-Man, if you see this glass half full, you need to keep drinking something stronger to continue that delusion. If you sober up, it is one ugly picture.
Powell and other FOMC members are trying to sound hawkish, but their action at the March meeting was kind of milquetoast.
On the one hand, I don’t think the Fed can actually do much about broad inflation in the near term, except possibly housing inflation. On the other hand, I worry that failing to show that they are vigorously trying could back them into a corner later in the year. I really do wish we’d seen 50 bp and a promise of active QT starting April.
Treasury tidbits related to Fed balance sheet black hole. I’m just curious and sharing FYI.
Treasury Borrowing Advisory Committee
February 1, 2022
Our expectation is that the SOMA portfolio runoff will have a significant impact on Treasury’s financing outlook, creating
~$1.6T in new financing needs over the next 3 years, which raises the question of whether the prior TBAC guidance to
keep reducing issue sizes is still appropriate, or whether that guidance should be updated.
Currency would fall in a higher interest rate environment, which in turn would reduce the size of assets the Fed needs to
hold against its currency liability.