Equities and rates were a hopeless conundrum Tuesday ahead of the March Fed minutes which, if Lael Brainard’s prepared remarks for a Minneapolis Fed speech were any indication, will betray a hawkish skew befitting of what many perceive to be panic inside the Committee.
Fed tightening will proceed “methodically,” Brainard said, promising a “series” of rate hikes and “rapid” balance sheet runoff commencing “as soon as” next month’s policy meeting.
The Vice Chair-in-waiting delved into specifics. Runoff caps will be “significantly larger” and the phase-in period “much shorter” versus the Fed’s last attempt to normalize the balance sheet. She alluded to the combined effect of hikes and QT, noting that rundown “will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing” and the SEP.
As a reminder, a Fed that hikes consistent with the dots (and market pricing) while executing on any kind of balance sheet rundown (to say nothing of a “rapid” QT campaign) will be a Committee that risks overshooting materially. Or at least on some estimates.
“Normalizing the Fed’s oversized balance sheet through QT would curtail the space for rate increases significantly,” SocGen’s Solomon Tadesse wrote last month. “Based on a preliminary assessment of QT’s impact on the sharp tightening witnessed in late 2018, a QT program at the scale of at least the 2018 level… would allow only about half or less of the projected tightening from explicit policy rate hikes, with higher QT generally limiting the extent and number of rate hikes before reaching the tipping point at the cycle top,” he added.
Read more: Why The Fed May Only Deliver Half Its Planned Rate Hikes
One assumes the Fed has done the math themselves, but it’s a bit difficult to reconcile that assumption with the kinds of remarks delivered by Brainard on Tuesday.
Yes, the Fed has publicly and explicitly recognized that it may need to take policy into mildly restrictive territory. But seven rate hikes plus “rapid” balance sheet runoff would almost surely result in a tightening impulse that eclipses the last cycle — possibly by a lot. The (nominal) shadow rate is already more than 200bps off the lows (figure below).
300bps in outright hikes would bring the total tightening impulse to almost 600bps. That includes the initial impact of tapering, but not the additional tightening impulse from runoff. I should note that I’m not entirely sure that’s the “right” way to conceptualize of the situation, but at the same time, I’m absolutely sure it’s not the wrong way. The same goes for the chart (above).
Treasurys were markedly cheaper Tuesday, in a belly-led selloff that was insult to injury for multi-asset investors given a simultaneous rout in equities. In short, it was another day of “diversification desperation” coming out of a very poor quarter for balanced portfolios. The S&P’s 5% decline was set against a 5.5% drop in Treasurys and a near 8% slide in IG credit.
“Given how bad first quarter returns were for both stocks and bonds, most investors (both asset owners and managers) were probably happy to see it end,” Morgan Stanley’s Mike Wilson wrote. The table (above) gives you some context.
“Assuming this is the ‘cycle of more,’ we’re certainly sympathetic to the sharp underperformance in 5s and 7s,” BMO’s Ian Lyngen and Ben Jeffery said, of Tuesday’s action in rates. “All else being equal, our baseline disposition would place us decidedly in the ‘sell the rumor, buy the fact’ camp as it relates to the balance sheet runoff [but] in being intellectually honest, we’ll be the first to admit that Powell continues to push the hawkish surprise envelope and our propensity to attempt to catch the proverbial falling knife has diminished precipitously over the last four months,” they went on to say, adding that “this leaves us comfortably in the go-with camp for the current repricing which has brought 5s to 2.71% and 10s to 2.565% even before the Fed’s second hike, to say nothing of the deeper inversion of 5s30s.”
On some days (Tuesday being one of them), the backdrop seems almost laughably fraught — comically perilous. In addition to the prospect of slower US consumer spending in the face of high (and still rising) inflation and a Fed poised to lean very aggressively into policy tightening in a possibly ill-fated attempt to bludgeon prices into submission, the US Treasury is now apparently prepared to engineer a sovereign default by literally not allowing the sovereign to pay. All of that with earnings growth set to decelerate markedly as the easy comp tailwind disappears and margin pressure bites.
Brainard didn’t skirt the issues. “Russia’s invasion of Ukraine is a human tragedy and a seismic geopolitical event,” she said, in the same Tuesday remarks. “The global commodity supply shock associated with Russia’s actions skews inflation risks to the upside and is expected to exacerbate high prices for gasoline and food as well as supply chain bottlenecks in goods sectors,” she continued, adding that “the recent COVID lockdowns in China are also likely to extend bottlenecks.”
Demand destruction or bust, I suppose. Or maybe demand destruction and bust is more apt.
I’m expecting the Fed plans to target the housing market as it represents a good bang-for-the buck shot against inflation, since housing is both a critical and very broad-based component of inflation and the housing market needs a good bucket of ice right now, anyway. I’ve read that market speculation is around a $100B goal run-off rate this time around (not initially, of course), twice the rate of last time, and presumably comprising $50B treasuries and $50B MBS. What some may not have noticed is that MBS issuance has been dropping lately. SIFMA data shows agency MBS issuance falling from $400B in Feb 21 to $200B in Feb 22. Presumably this reflects the evaporation of the refi segment as much as the current inventory situation. In any case, one can look at this two ways. A 25% increase to monthly new supply might add nicely to the pressure on mortgage rates and help suppress housing demand. New issuance is a pittance compared to daily trading volumes in the MBS market, so I’m uncertain about the effect on rates, but I’m guessing it could be noticeable. On the other hand, the Fed may simply look at the drop in issuance as creating a convenient bit of room in the MBS market to fill with their own inventory. Either way, I suspect they’ll be tempted to be fairly aggressive with their MBS holdings.
Not sure how you can put all of those “fraught” factors together and NOT wind up in a bust, later this year, into next.
How can I mix eggs, flour, water and sugar in a bowl and NOT end up with cookie dough ?
Explicitly targeting housing is too dangerous for the Fed. Every small-time contractor right up through the largest firms (major political donors) would be lined up in Washington DC to demand that Congress do something about the out of control Fed.
That “something” might well be restricting or eliminating the Fed’s independence.
Yes, you’re probably right. I suppose the way to think about this is that Fed, simply following its apparent present course, and considering the current state of the housing and mortgage markets, is more likely to trigger a greater tightening effect in these markets than elsewhere in the economy, and the fact that MBS issuance is falling pretty rapidly as the Fed starts selling will simply amplify the effect of Fed policy on that market.
” the fact that MBS issuance is falling pretty rapidly as the Fed starts selling will simply amplify the effect of Fed policy on that market.” Great point Uptowner.
Demand destruction, that’s abstract as it relates to what the Fed is apparently hoping to accomplish with rate hikes and the magic show with MBS interest swaps, etc. I’d like a diagram to lay this out, as in how flooding the MBS market with supply, which should decrease price helps Make America Great Once Again?
The clever chains and links connected to the swaps essentially help someone structure CDO hedge pools that like sardine cans, can be used in other swap transactions. Obviously adding in treasury swaps into this mix creates a concoction that reduces instability in the economy and apparently helps unemployment and keeps the housing market in a Goldilocks state of euphoria while allowing both bonds and stocks to scream higher.
I get all that and realize inflation is a pain in the ass, but, while that magic show is running full blast like a furnace being fed her fuel, something else is taking place and that’s a decline in GDP.
Our wizard Powell (OWP) said something to the effect that money stopped mattering 40 years ago, correct me if I’m wrong. He claimed that financial innovation had changed to a point where economists view stuff far differently than way back when money was real.
The connection here inside this enchilada is that financial innovation has gone a long way towards making the global economy highly chaotic. That’s obvious, unless you’re totally blind and not paying attention.
In this great time of financial innovation less and less capital is going into infrastructure or the creation of stuff that makes a society stable. Instead of building physical things, society builds fantasy based derivatives that get swapped and traded for other non essential useful trash.
I have 2 Fred links, both related to velocity. In terms of demand destruction, these are the mother lode of everything rolled into the single concept that, as velocity decreases, growth is suppressed. With all the money sloshing around, it’s a simple case of, water, water everywhere and not a drop to drink. Slow money is dead money and by raising rates, I think that’s gonna slow velocity even more.
Velocity of money (M2)
https://fred.stlouisfed.org/graph/?g=NXdW
Velocity of debt
https://fred.stlouisfed.org/graph/?g=NXcw