Over the past two weeks, I’ve been especially keen to suggest that the Fed is either i) very unlikely to hike rates consistent with the dots and market pricing, or ii) very likely to overshoot, on the way to delivering a shock tightening with the potential to seriously upend equities and credit.
Some would argue the whole point is to deliver just such a shock. On Wednesday, for example, Bill Dudley suggested the Commitee may need to orchestrate a controlled (or even an uncontrolled) demolition of bubbles in stocks and fixed income.
Dudley didn’t use the word “bubbles,” but he described the same dynamic highlighted in these pages on too many occasions to count: When stocks rebound, it works at cross purposes with the Fed’s tightening plans.
Ironically, the assumption that the Fed is destined to tighten the economy into a slowdown may be putting a floor under stocks and a ceiling over long-end yields, both of which are conducive to easier financial conditions. In an(other) Op-Ed for Bloomberg, Dudley wrote that,
The S&P 500 is down only about 4% from its peak in early January, and still up a lot from its pre-pandemic level. Similarly, the yield on the 10-year Treasury note stands at 2.5%, up just 0.75 percentage point from a year ago and still way below the inflation rate. This is happening because market participants expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025 — but these very expectations are preventing the tightening of financial conditions that would make such an outcome more likely.
For Dudley, the solution is simple enough. He recommended the Pozsar medicine, suggesting the Fed “force” stocks lower.
Of course, that’s easy to say when you’re no longer a policymaker and thus free to muse about what “should” happen in a sane world. Back in reality, insanity takes precedence because it’s often synonymous with expediency, whereas sanity is generally associated with policy proposals conducive to long-term stability. Just ask the energy transition that isn’t going to be finished in time to save your grandchildren.
What’s far more likely to happen in the event the Fed does summon the fortitude to go the Dudley route and force the issue, is an embarrassing about face when stocks fall 30%. In the course of making the point, I’ve cited SocGen’s Solomon Tadesse, who last month noted that “normalizing the Fed’s oversized balance sheet through QT would curtail the space for rate increases significantly.”
Lael Brainard on Tuesday telegraphed a “rapid” approach to QT and the March minutes, released a day later, confirmed fairly aggressive, albeit mostly consensus, runoff caps.
In the simplest possible terms: The math on all of this doesn’t seem to add up. Tadesse has gone into considerable detail in a series of recent pieces, but suffice to say market pricing for between 200bps and 250bps of explicit rate hikes in 2022 combined with around 200bps in tightening already in the market based on the rise in the shadow rate from cycle lows, would amount to a near 500bps tightening impulse on its own, not counting the impact of balance sheet runoff.
Piling an aggressive QT campaign atop, let’s call it 225bps, of outright hikes seems wholly untenable to me. The implied degree of tightening inclusive of QT effects would almost surely be too much for the economy to handle, to say nothing of stocks, which would buckle long before the US falls into the recession that at least one Wall Street bank is now predicting.
One person who agrees is Tadesse’s famous colleague Albert Edwards. “Against the consensus view, [Tadesse’s] work back in May 2018 exactly pinpointed the peak in Fed Funds at a lowly 2½%,” Edwards wrote Thursday, on the way to exclaiming that “his analysis for this cycle puts the peak of Fed Funds below 1.0%!”
Long-time readers will recall that I covered Tadesse’s 2018 prediction extensively. The annotated chart (above, from Edwards) is a trip down memory lane.
The tie that binds all of the above together is the notion that extraordinary levels of accommodation during easing cycles have perpetuated larger and larger dislocations in asset prices (i.e., bubbles), constraining policymakers in their capacity to tighten. The more egregious the excess, the more precarious the Jenga tower. That’s why the Dudley medicine probably isn’t viable, or at least not if administered in large doses.
Note in the figures (below, from Tadesse), that the ratio of tightening to easing has trended lower over time.
Effectively, subdued inflation made it possible for policymakers to undershoot previous easing efforts in subsequent tightening campaigns. A ratio below one by definition means policy trends easier over time.
As Edwards noted on Thursday, many now argue that the return of inflation means policymakers will now reverse that dynamic. But, again, that’s easier said than done.
“Shouldn’t though, this ratio now return to 1.5x given CPI inflation has comprehensively overshot? Maybe,” Edwards said, before explaining why that might not be the case.
“One key reason why Solomon’s MTE ratio has been lower (at 70%) recently is that tightening cycles have been halted because financial market bubbles, created by excessive Fed easing, then blow up and prevent the Fed from further tightening,” he said, noting that applying the 70% MTE ratio, shadow fed funds will likely max out at around 550bps of tightening.
He then drove it all home. “Prior to Brainard’s comments, the remaining 300bps hike in the Shadow FFR was split between a headline FFR rise to only 1½% with the remainder being QT,” Albert said. “But with the pace of QT likely accelerated, the actual FFR will struggle to get to 1% before the Fed needs to halt the tightening cycle.”
“For Dudley, the solution is simple enough. He recommended the Pozsar medicine, suggesting the Fed “force” stocks lower.”
I think an important dynamic in how this all plays out vis-a-vis the mid-term election. As a non-political body, the FED attempts to not make decisions that they perceive could affect an election, with a crashing market historically being one of the top results to avoid. Yes, inflation is bad, but it is likely to subside some starting with March or April as prior year comps become higher. If the FED were to force (intentionally) a market crash prior to Oct, the expected reaction of the perma-chicken littles (the sky is always falling all the time) would likely be seen as a move to tip an election result.
While being right about the market, but wrong about the timing is the same as simply being wrong, the timing of any “controlled demolition” would be important. I don’t think the FED goes there until Nov/Dec or possibly Q1 next year.
That said, the 1% (possibly 1.25%) makes more sense to me: 50 bps in May, 25bps in July, 25 bps in Sept and then a long pause due to meaningful equity weakness. This would all mean the FED doesn’t need to create the market shock crash as the market would get there on it’s own even with incremental moves laid out in the prior sentence.
H. – Times like this have in the past inspired impulses to cut and run, whether or not it was the best action to take. Your take-aways from analyst comments and the way you weigh their value against the bigger picture very often benefits my understanding and enables peace of mind. In regard to QE & QT, especially as we’re in a QT environment and witnessing hellacious war being fought in Ukraine, I find great value in your ability to provide perspective of the players in the Fed game and the impacts of their roles and actions. Your renderings serve as a balm for my anxiety about the economy and markets, helping me to gain understanding of the bottom line for the Fed’s influence on the state of play for my investments.
Not trying to swell your ego. Just want to thank you for a truly useful and meaningful service! I also want to encourage you to keep telling these stories! Life is short. This exercise is worthwhile. You help to tickle my interest and enable clearer understanding of the murky nexus of politics and economics, which, I feel, is a very healthy place to be in a (mostly) democratic republic like the United States.
I would echo this. I’ve said it before, but I’ll say it again: if I had come across this website years ago, it would’ve saved me years of stupid investing decisions because I had no idea how markets truly operated. If I ever teach a business school course, Heisenberg’s writings will be part of the curriculum.
Ditto
With a fairly limited supply and a strong need (while “demand” may depend on mortgage rates), the housing market is probably not going to see price decreases (or only see token decreases); if I have houses I hope to sell and offers below my target prices, I would just rent the houses and wait for better offers. There is no reason for the housing “bubble” to burst. As MBS are rolled off or sold and bond yields increase, mortgage rates will/should continue rising quickly. This will either force the Fed to end QT and reduce rates or watch a large percentage of the population become permanent renters. My guess is that this will limit the Fed’s options and keep short-term rates low.
Its clear that most readers of this site (myself included) should be scared of a recession and assume the fed will prevent it. We own houses, have mortgages, have investments and debt.
It is not clear to me that a large cohort of Americans should fear a recession, even a prolonged one. Americans who do not currently own a home likely never will and there is not much of a difference between food stamps and a breadline. The more inequality grows, the more people will find themselves in the camp of shrugging at the thought of a recession.
In the meantime I suppose the rest of us can take comfort in the data that ‘proves’ the fed lacks credibility.
FM – I agree with your point about inequality. I also expect that it will persist. I’m sad about the idea of inequality, but what can I do about it, besides charity work and regular donations? In my experience and perception, our country rightfully places a high value on education. But we are also a country of individuals from differing cultures and states. I have to agree with Joe Biden that labor unions provide opportunities to make a satisfying and meaningful living for those who prefer not to work at a desk. I also believe that the experiment with Reaganomics, over time, rewarded large, private, corporate entities with lots of money to spend, and people like me who get a kick out of innovation. Oddly, I recall Reagan had the support in the early 80s from a lot of “Joe six-pack” types of people, not unlike some who followed Trump. But little did they know how distribution of wealth in Reagan’s programs would undercut the life-enabling vocations for those among us who had different views and union cards. I hope in the longer term we can take conscious steps to even out that imbalance. I have to say, I think we hurt ourselves by not supporting union workers. Sure, it can promote the possibility of inflation, but so can big money corporations and their moneyed employees. Furthermore, in recent years we’ve learned more about how the Fed has tools to manage inflation. I’m not worried about that so much. I do, however, believe that inequality is something that must be addressed.
The implication of the article is that inflation and tightening impulses should/must be balanced against the risk/cost of a recession. As inequalities proliferate and as the mass of Americans suffering from economic immobility, or worse, grows the less palatable avoiding a recession will become.
Many Americans now have first hand experience with job loss and social safety nets and can see clearly that the ‘dignity’ of work is a fiction.
The Fed has, cumulatively, purchased approximately $9T of US government issued marketable securities.
From that “pool” of $9T (this includes USTs and MBS) ,the Fed is currently lending $1.7T (the ON RRP, for 30 basis points) to US banks, because the US banks need to borrow $1.7T of US government issued securities in order to meet their liquidity requirements. The ON RRP program does not include any MBS- best I can tell.
fred.stlouisfed.org/…
Therefore, it appears that the Fed went “$1.7T too far”- meaning that the Fed could have stopped QE at $7.3T because the Fed saw/ realized that as they added additional liquidity, the US banks started borrowing the US government securities (ON RRP) which ultimately resulted in the ON RRP lending to where we are today ($1.7 T). See FRED chart above.
The Fed kept QE going because of fear over additional waves of covid and to err on the side of too much ( rather than too little) liquidity.
I am not worried about QT right now.
At $95B/month ($60B US government issued securities and $30 MBS) it will take about 28 months ($60B x 28 equals $1.7T) to bring ON RRP back down to zero (where it should be- see chart). Plus, the US banks do not want to pay 30 basis points to borrow, let alone even more than that.
When and if it looks like the Fed is going to keep QT going after the initial $1.7 T, I will be worried. When Jerome tightened in December, 2018, the ONRRP was pretty close to zero- so the market panicked because any QT was truly reducing liquidity. Now the situation is different.
During the period that the Fed is offloading USTs through QT, the US banks will be simultaneously buying USTs and decreasing their borrowing from the Fed, under ON RRP.
Therefore, at this rate of QT ($60B UST), there will not be any actual liquidity tightening until AFTER the ON RRP program has been reduced back to zero.
To the extent the Fed liquidates MBS- it appears that this will have a liquidity tightening impact.
I think I am right on this, but I have no doubt I will be told if the truth is otherwise.
If the Fed had begun it’s measures last year, we wouldn’t be having this conversation about tightening into an election and the political impacts that applies.
That aside, if the Fed keeps going down this road of “let’s normalize policy but until the stock market begins to crack” then we will 1. never normalize policy and 2. never actually deflate the asset bubble in the stock market.
I still contend that stock market inflation impacts every other type of inflation. Inflated stocks provide inflated valuations to borrow against which increases the spending power of the people and entities who own shares. They have more to spend and will buy at higher prices, especially as an investment, and drive up prices of other asset classes. Housing right now, as it was in the early 2000’s, is a perfect example of the symbiotic nature of the two asset classes as a result of Fed policy.
Considering that it’s been covered ad nauseum here that a fraction of people actually own stocks, why the apprehension from the Fed to let them feel some pain as a sacrifice for the greater good of normalizing Fed policy and ending bubble finance? Or do we want to just rely on debt to drive the economy until the USD ceases to matter?
I will add one more inflationary impact of a highly inflated stock market. If you have enough equities, one does not even need to sell any to live on. Instead, if one borrows against their stock portfolio, it is quite possible to have no income- and therefore, not pay any income taxes. If those people are not paying any taxes, the government has to print more money in order to fund government spending- thereby creating even more inflation.
That’s a crisis multiplier if I’ve ever seen one. What could possibly go wrong?
Interesting to see there are analysts who are not buying the hawkish Fed completely. Really the street, the Fed, and everybody else should take a middle road. Monetary policy needs to be adjusted, but the speed, duration and degree are less certain than most want to admit.
So suppose we believe Fed will only get the start of tightening in, before equities blow up and force Fed to reverse course. Does that suggest you’d rather have fixed income (UST or IG) than equity here? Or is the risk of a QT-triggered fixed income accident too high to “ go there “?
Cash. Cold. Hard. Cash.