October 27, 2023

The current narrative from the recent central bank decisions is one of "pause but perhaps not over". It's the right message. And a good time for reflection on the work done to date. We expect the same from Chair Powell this upcoming week. Today's PCE Deflator offers the Fed little comfort and given the consumer spending numbers it's likely the short-term inflation readings continue to nag, perhaps even surprise to the upside.

We're in the home stretch of 2023. Looking at some dynamics and themes as we head toward this week's second to last Fed meeting of the year. The Atlanta Federal Reserve GDP Tracker had the 3rd quarter at 5.4% versus this week's initial reading of 4.90%. Third quarter growth was an aberration (See our chart below), 10-year UST nominal yields are lower not higher since, and we will continue to hear words of "proceeding with caution" from Chair Powell this week as the economy remains uneven, ridden with pandemic monetary and fiscal policy distortions, and subject to unknown lags, potholes working through one of the largest global rate normalizations in central bank history. 

In general, the economy continues to demonstrate to us that there are two sides to the higher, more normalized interest rate structure. We know this week's meeting will bring no formal change to the Federal Funds rate. But the themes around long end rates, yield curve shape, and the global landscape will matter for policy moving forward. The higher rates go, and in particular on the long end of the yield curve, the greater the risk of breakage within the financial system. Some of the long end dynamics are coming from outside the United States and Federal Reserve's control. 

Let's Take a Look: 

Chair Powell and the committee are very honed in on the month-over-month inflation readings. Yes, the overall inflation numbers have come down from the extremes and the charts look constructive but there are known distortions in the annual numbers. True, some of the inflationary pressures were indeed transitory. But what we are facing now is far from it. We love the use of charts to offer context and, Chart #1 below, highlights the month to month readings for Core PCE going back to 2000. It shows a long period of being in, around, and below the Fed's target to the post-pandemic dynamics of higher and increased volatility. Clear risks to the upside in the near term. 

So, how much inflation will Chair Powell tolerate above 2% is the key question. It's been indicated by a few former influential Fed members that the number needs to have at least a 2-hande. That seems about right intellectually. Because if they become complacent with a 3-handle then they are implicitly accommodating the market's narrative for a higher target level. Hypothetically if the Fed did change their target, it would likely include a new handle. But The Fed has been adamant toward the notion of formal inflation changes, and it was a key component of Powell's Jackson Hole speech. 

Recent Fed Speak: Recent speeches by Chair Powell, Fed Governor Waller, and Dallas Fed President Lorie Logan highlight the continued strength of the US economy, a willingness to push interest rates higher if needed, and the implications of rising long end term premium relative to financial conditions and policy. Economically, we think it's fair that the third quarter growth estimate was an outlier and they'll be giveback moving forward. Chart #2 (Atlanta Fed GDP Tracker is normalizing and quickly). 

Keep in mind the way of this year as Chart #3 (Fed's Balance Sheet versus 10-year UST) highlights. We spent the entire second quarter undoing the expansion of the Fed's balance sheet in March because of the regional bank failures (Federal Reserve balance sheet in White). Additionally, given the debt ceiling issues in June, the Treasury's General Account was siphoned to peanuts releasing billions into the banking system. The big drainage from the Fed's Repo Facility (reserve additive) began its course with the subsequent barrage of T-bill issuance to replenish the coffers of the Department of Treasury over the course of the third quarter. All the while QT and financial conditions loosening from March through late July.  

Fed Governor Christopher Waller, October 18: "Something's Got to Give" 

"But I also can't avoid thinking about the second scenario, where demand and economic activity continue at their recent pace, possibly putting persistent upward pressure on inflation and stalling or even reversing progress toward 2 percent. In such a scenario, failing to take action in a timely way carries the considerable risk of undermining what have been fairly stable inflation expectations and possibly unwinding the work that we have done to date. Thus, more action would be needed on the policy rate to ensure that inflation moves back to target and expectations remain anchored"

Powell's caution will be reiterated: The second and third quarter of this year were very distorted. Above, we highlight some of the dynamics from a higher level. Now, geopolitical tensions rise (more caution). The regional bank issues earlier this year were an aftershock (Mark-to market) of the 2022 extreme rate hikes. Without question when regional banks and deposits were called into question consumers went scrambling. Fortunately, the two-sided coin of the higher rate, normalization story is alive. Normal rates are required for a stable economic society and savers should be rewarded. Likewise, investors should have safer alternatives to risk assets. Flows into money market funds have exploded since the pandemic and higher by a trillion dollars since the regional bank issues. The third quarter was a windfall, Chart #4 (Overall Money Market Assets). The Fed's unabashed continued use of 13(3) emergency lending programs was a clear signal to markets: the separation of financial stability, balance sheet normalization, and formal interest rate policy. The challenge was the ensuing loosening in financial conditions which have now reversed and perhaps too quickly.  

Financial Conditions: We know this is Chair Powell's favorite. Ultimately, this cycle to date has been predominantly about interest rates doing the heavy lifting. Of course, all-in investment grade and high yield rates are higher. Spreads have been resilient alongside a better-than-expected economy. This hasn't been without casualties. Private credit stood front and center when the regional bank issues came into play (not reflected on enough our view). And although Chair Powell offered words of encouragement for a tiered banking system earlier this year, bigger forces between public, private (credit), and technological advances will lead to fewer banks. If anything, and we highlighted along the way, up until recently and following the Federal Reserve's bank lending program, financial conditions were loosening. Be careful what you wish for though of late. Chart #5 highlights the recent re-tightening of market-based financial conditions (The Goldman Sachs Financial Conditions Index). 

Look at Chair Powell's statement, October 19, 2023, at the Economic Club of New York. 

"Along with many other factors, actual and expected changes in the stance of monetary policy affect broader financial conditions, which in turn affect economic activity, employment and inflation. Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening. We remain attentive to these developments because persistent changes in financial conditions can have implications for the path of monetary policy"

The tightening of financial conditions due to higher long end rates is important BUT:        

10-year UST: The bellwether. The globe investment world is glued. The Fed included. The Fed is watching long end rates like everyone else. With a focus on levels in real terms. And speaking vocally about what the rise in yields mean versus policy. Term premium, where does it belong? No change in Fed expectations and rates still move higher. Could be short-lived but doesn't feel that way.

After years of Zero Interest Rate Policy (ZIRP) and Quantitative Policy (QE) it's not entirely clear. Global rate (super important) dynamics have shifted dramatically too around inflation, geopolitical dynamics, and economic de-globalizing factors. The role of China (De-levering, Reserves, US Treasuries, USD's) and Japan in focus (Central bank policy, inflation, currency, and interest rate levels).

But when looking at term premium in a normalized rate world we are still very low. We are running and poised to do so, outsize deficits for the foreseeable future which will require more US Treasury issuance. And when evaluating the structural changes above we have entered a seemingly different pocket of time and volatility. Mind you, all of which at a time we have shifted from structural buying to runoff from the Federal Reserve. It's no wonder term premium is rising. See Chart #6: New York Federal Reserve, Adrian Crump Moench 10-Year Treasury Term Premium. 

Dallas Fed President Lorie Logan, October 9, 2023, Financial Conditions and the Monetary Outlook: 

"Financial conditions tightened substantially in recent months. Much of the tightening came from movements in longer-term interest rates. A rise in term premiums can itself have many drivers, including increases in the stock of debt relative to investors’ demand for debt (Yes), changing correlations between the returns on different asset classes—which can influence the portfolio diversification properties of long-term bonds (Yes, Powell mentioned recently)—and reductions in expectations for the Federal Reserve’s asset holdings (Yes)". Good speech below: 

https://www.dallasfed.org/news/speeches/logan/2023/lkl231009

So, will the increase in long end rates take the place of rate increases? It depends we believe.

Recently, Minneapolis Fed President Kashkari accurately stated if rates are moving higher because the market expects the Fed to act then we may need to act. Short term Fed expectations haven't moved all that much but rates have risen (see term premium). But following the Federal Reserve's release of their Summary of Economic Projections in September, markets took note of the reduction in rate cuts for 2024 with inflation still coming down: See "higher for longer" and the yield curve. Restrictive for longer.  

Fed Governor Waller on the implications of the rise in long end rates versus and replacing rate hikes: 

"Whatever the causes (see above our views), I will be watching how these interest rates evolve in coming months to evaluate their impact on financial conditions and economic activity"

"But if the real economy continues showing underlying strength and inflation appears to stabilize or reaccelerate, more policy tightening is likely needed despite the recent run up in longer term rates"

Summary

We attempt to highlight some of the important themes of late. Structurally, we are in a position to issue more government debt than in our country's history at a time whereas the global landscape has shifted. There is no Fed buyer. Without getting into fancy models it's very clear why term premium is rising. So, on one hand higher debt issuance is doing some of the Fed's work, yet at the same time the deployment of the spending has implications for the economy's neutral rate.  

In the end, all of what we outline would lend anyone to caution. Let alone the Chair of the Federal Reserve. And yes, the transfer of duration, portfolios, movement of risk, market structure, liquidity, regulatory; this all plays into term premium too. It's a good thing the Fed is looking at these nuances because it's vital emerging from years of loose policy. It's time for the microscope here. 

We expect Chair Powell to touch on some, if not all, of these issues. He won't get in the weeds. He will speak about financial conditions relative to long end rates. Ultimately, there is merit to long end rates moving because of "higher for longer and concession on rate cuts". This is true. And we witnessed this in 2006 and 2007. This rate structure is not abnormal given the level of the Fed Funds rate. Different economy, different dynamics, and now close to $25 trillion more in US Treasury debt to finance, however, can lend one to question why 10-year UST yields are not even higher. And they may be soon. 

Higher for longer, or "Even higher for longer". In September the Fed indicated the latter. And rate markets which were already fragile ran with it. Chair Powell has no choice but to leave the door open for more. Transitory is costly. But they are concerned about the move in long end rates. Tighter financial conditions are needed but the Fed wants them on their own terms: always orderly and "just right".

As we're learning it's not that easy. And many of the variables that have resurfaced after a long, long time are out of their hands. In many ways too the Fed's hands are tied in this pocket of time. Risk assets have woken up. They've lagged the rate moves through this entire cycle. The bigger risk; financial conditions that tighten too much with the Fed left with little power to control it. 

Have a great and safe weekend!