Fed Update: A Dovish Mistake?

Despite the concerns, Fed Chair Powell didn’t come out hawkish at all. While his prepared remarks acknowledged inflation as being too high, he dismissed many of the concerns surrounding accelerating inflation outright, including slowing growth, and a deteriorating labor market. In other words, he completely dismissed the notion that the US may be experiencing “stagflation”.

While the Fed seemingly does not have the confidence necessary to cut rates just yet, after one quarter’s higher-than-expected inflation data, they are confident that they are on the path to getting inflation down to 2%, without “breaking anything”.

Powell highlighted the existence of substantial lags between policy implementation and observable effects in the economy, especially in housing where market rents take time to reflect in inflation measures.

He also dismissed rate hikes and talked about policy being at an appropriately restrictive level, i.e., we’re seeing peak rates. This shouldn’t come as a surprise in an election year, although he insisted that the Fed remains apolitical. But, he did at least acknowledge that a discussion about rate cuts at this stage seems premature. What would cause them to cut rates? To see inflation moving down sustainably, and higher unemployment.

And we all know that they’ve set their projections on unemployment at 4%, while the current rate is at 3.8%. We’re seeing payrolls revised lower, quits rates reach cycle lows, and unemployment inching up under the surface. We could be seeing the rate cross this threshold sooner rather than later.

The Fed’s Statement brought about some interesting changes.

• The Fed acknowledges that there is a problem with inflation decelerating from here but, so far has moved towards their goal of 2%.

• The Fed is starting to taper its Quantitative Tightening (QT) program, i.e., slow the pace at which they are rolling off / reducing the balance sheet. This came as a surprise. What came as a further surprise was the amount. The minutes of the last meeting suggested cutting the caps on Treasuries in half, i.e., from $60B to $30B, instead we’ve now got a further cut to $25B.

It’s quite likely this is to counteract the effect of holding rates higher for longer, i.e., possibly having to delay rate cuts, and doing maybe just one cut in September ahead of the elections.

While they’ve discussed this quite a bit during the last few meetings, the taper was meant to be dependent on the level of Bank Reserves. If Bank Reserves fell below the threshold of about 10-11% of GDP, they would begin to slow the pace of decline. This translates to about $2.5T and, once the ON Repo Facility was drained. Right now the Repo Facility stands at a little above $500B and Bank Reserves stand at $3.5T, so there’s seemingly no pressing reason for the Fed to begin to taper QT.

This move could have waited until July or even September because we still have a long way down when it comes to the Fed’s balance sheet.

We think the more plausible reason for this is that the Fed still remains worried about the liquidity that may be available in the US financial system in the coming months and keeping rates higher for longer in this environment. Liquidity in the treasury market continues to remain subdued, with several less-than-ideal auctions of late. Furthermore, the Bank Term Funding Program (BTFP) has now been removed and a hawkish rate environment could lead to higher levels of unrealized losses which continue to put pressure on the banking system (particularly within regional banks).

We also see a situation where holding rates higher could lead to further deterioration in asset values, namely commercial real estate, where components like office building loans in distressed regions continue to be in critical condition, and floating rate debt having to be extended or restructured. We’re seeing more evidence of lenders opting to restructure debt rather than call an outright default, with the hope that the Fed will cut soon and the pressure on interest payments will ease.

Finally, we also have the corporate debt maturity wall for all the 3- to 4-year fixed rate debt that was issued in 2020 and 2021, at extremely low rates. This is a major reason that many companies have been able to withstand this aggressive hiking cycle. They’ve managed to earn interest on their cash, the cash that they’ve saved from having to pay higher coupons on their debt. This all changes if the Fed delays rate cuts and slows down the easing cycle.

Having said all this, tapering QT at this level will definitely alleviate some liquidity constraints and that could possibly help equity prices and Treasury markets. Chair Powell of course, refused to acknowledge that this is any kind of easing, and is being done more to ensure a smooth winding down of the balance sheet.

But, we all know that this may effectively ease financial conditions leading to higher inflation and having to keep rates higher for longer. We think this taper is a bit premature and steep at this stage and could prove to be a bit of a policy mistake if it causes grief and increased inflation further down the road.

While we could see this effectively delaying rate cuts, it doesn’t seem like the Fed has ruled out multiple cuts this year.

Unfortunately, the messaging coming out of the Fed is starting to become unclear again. It’s almost like we’re going back to the days of Greenspan, with mixed messaging, and convoluted ideas of what’s next. We’re also reminded about the time that the Fed kept calling inflation “transitory”, reacting far too late until the problem had become well entrenched.

After seemingly reversing that blunder, the Fed could now be on the path to making yet another dovish mistake.