Descriptions of new Federal Reserve chairman Jerome Powell’s volte-face in policy at the end of January range from the euphemistic to the blunt. It has been termed a ‘pivot’, which perhaps comes under the heading of euphemism, but also, more bluntly, ‘U-turn’ and a ‘180 in four weeks’.
It has also been wondered whether the Fed buckled under pressure from President Trump, who mused whether the Fed had ‘gone loco’ in hiking rates.
But perhaps the misstep committed by Powell was not hiking the Fed Funds target rate to 2%–2.25% on September 26 and then again to 2.25%–2.50% in December (the highest since April 2008) but by indicating in interviews that the rate was a ‘long way’ from neutral. This suggested a lot more hikes were on their way in 2019, and it unnerved the market considerably.
The S&P 500 lost almost US$2trn in October, and there was another vicious sell-off in December, culminating in the worst week for US stocks since 2009 and a 600-point drop on Christmas Eve. “Maybe it was a throwaway remark that the Fed is a long way from neutral, but it was the gong for the market to think that there will be many more hikes and the curve will invert. It was a rookie error; Janet [Yellen] had one and Ben [Bernanke] had one,” said a senior credit strategist at a US bank in New York.
If the Fed chairman called it wrong in the third quarter of 2018, he was quick to redress his error. By the meeting at the end of January 2019, the mood had shifted significantly. Rates were put on hold and the Fed said it would be “patient” in determining any future rate shifts.
On this occasion, Powell stressed that the data will dictate the future path of rates rather than a pre-determined strategy. The effect was instantaneous. The 10-year Treasury, which had been yielding 3.21% on November 8, in the middle of the rate hike panic, rallied to 2.55% at the beginning of February.
“Did the Fed call it wrong? Yes, it got it wrong in reading the data, hiking rates and indicating it would go higher. The reversal of communication probably indicates that they think the policy action at the end of 2018 was a mistake and they’d like a do-over,” said Mark Cabana, head of US rates strategy at Bank of America in New York.
Economic releases so far in 2019 have also not corroborated the impression that the economy is over-heating. The February retail sales data, for example, were particularly anaemic, coming in at minus 0.2% compared to market expectations of a 0.3% rise.
Indeed, those onlookers sympathetic to the Fed’s about-turn say the data in the last quarter of 2018 indicated strength but so far in 2019 has indicated something else entirely.
“They didn’t get it wrong in October 2018. The Fed is data-dependent. When they signalled rate hikes, the economic signals were stronger, but the economy evolves and so do expectations,” said Steven Zeng, a US rates strategist at Deutsche Bank in New York.
There are other factors behind the fall in yields this year. As rates began falling, there was a surge of buying of 10-year Treasuries by mortgage portfolios. Mortgage portfolios are positively convex, meaning falling rates shorten the duration of their assets as mortgage pre-payment becomes more likely.
These positions are offset by buying Treasuries and/or receiving fixed rate in the dollar swap market. Most business is normally conducted in the 10-year tenor. It is a trope of the US capital markets that a sudden collapse in rates is fuelled by mortgage portfolio buying – and this is what happened in the first quarter of this year.
What gave perhaps an even bigger boost to Treasury prices was that the decision to switch to a hiking mode in the third quarter of 2018 was accompanied by a balance sheet runoff. The so-called portfolio balance channel – quantitative easing by another name – was announced by then chairman Ben Bernanke as a Fed strategy in a speech at Jackson Hole, Wyoming, in August 2012.
The reversal of this strategy began in October 2017, and the Fed had been allowing around US$50bn a month of mainly Treasuries and mortgage-backed securities to run off its balance sheet – which at one stage topped US$4.5trn. In mid-December, just after the Fed had hiked rates to a target range of 2.25%-2.5%, Jerome Powell said that the balance sheet runoff would continue as planned.
“I think that the runoff of the balance sheet has been smooth and has served its purpose;” Powell said during a news conference on December 19. “I don’t see us changing that.” The market, already reeling on the ropes, was hit by another straight right. The 10-year note, which had been yielding 2.83% on December 18, was at 2.55% on New Year’s Day.
Responsive But, showing that this Fed is nothing if not responsive to events, Powell backed away from this strategy too. At the end of January, he said in a speech that the runoff could end sooner than expected, leaving the balance sheet larger than the US$3trn some had thought a likely target.
The Fed will decide the appropriate timing for the end of the programme at coming meetings. “The implication is that the normalisation of the size of portfolio will be completed sooner and with a larger balance sheet than in previous estimates,” he said.
Even economists sympathetic to the rate hiking strategy think the suggestion that the balance sheet runoff would continue apace at the same time as the Fed moved into a higher rate mode was a bit of a howler. After all, the Fed has had limited experience of portfolio balance channel strategy, and so far it has only done it one direction. Putting that it into reverse, in combination with a rate-hiking mode, placed it into terra incognito.
“As late as last year, they thought they could unwind the balance sheet through the end of this year (2019). That view has changed. I don’t want to say that they had the wrong model, but they probably thought the banking system needed less reserves than is actually the case,” says Steven Zeng at Deutsche.
Despite the Fed’s best efforts, the three-month bills versus 10-year Treasuries dipped 2bp into negative territory on March 22 – and a negative yield curve is usually considered a harbinger of recession. How reliable an indicator it is depends on who you talk to. As long ago as July 2005, in a testimony to Senate, Alan Greenspan declared of the yield curve obsolete as a portent of slowdown – but not everyone was convinced. By mid-April, the curve was back into positive territory anyway, with an upward slope of 12bp.
There is considerable doubt and confusion about where the economy and rates go from here. The March nonfarm payroll figure came in at plus 196,000, which was about 15,000–20,000 stronger than expectations, but, overall, the first quarter has seen data that have been decidedly mixed.
Forecasts for the 10-year Treasury yield at the end of the year range from around 2.40% to 2.80%, with the consensus around the bottom of that range. As the 10-year note closed at 2.56% on April 13, this suggests the market will tread water for the remainder of the year while trending slightly stronger. But no one has a clear read on which way the data will go.
Global considerations There is the global economy to be considered as well, and, for the first time in many years, perhaps ever, this Fed seems inclined to pay more attention to world events than has often been the case in the past. Most importantly, the likely duration of Chinese slowdown is of key importance.
There are some signs of a rebound here: dollar-denominated exports rose 14.3% in March, it was announced on April 12, almost double expectations. The non-manufacturing purchasing managers’ index also had an unexpectedly robust print of 54.8 in March.
The EU, and particularly Germany, looks less healthy. One might expect the UK, still undergoing its long national nightmare of unresolved Brexit to be the most likely candidate for recession, but Germany, suffering the fallout of the diesel emission scandal and unreasonably dependent on its auto industry, looks a better bet.
So, there is mixed news from around the world. The greater inclination of this Fed to view the US economy as an interrelated part of a larger whole also suggests it is more aware of the effect of higher rates upon the dollar. This circumscribes its freedom of action and might also lie in part behind the pivot away from hiking.
Higher rates mean a stronger dollar, which would put any nascent strengthening at risk through lower import prices, lower inflation and a reduction in multi-national revenues. So, the Fed might not hike so freely, even if domestic conditions warrant it.
“This Fed is paying increasing attention to overseas developments. Much more so than before it is saying this: so, we have an undeclared currency war. Consideration of the dollar is perhaps now the Fed’s third, hidden, mandate,” said another credit strategist at a US bank in New York.
The sharp asset repricing of December seems to have surprised the Fed. The sell-off told it that it had gone too far and that rates were closer to neutral than it thought.
In the face of wanting to court and comfort nervous markets, ongoing concerns about global growth rates and caution about giving a bid to the dollar, Powell’s Fed has become markedly more dovish, and now the market wouldn’t be surprised if there was a rate cut, possibly two, before the end of the year.
There is a final, long-term, backdrop to the question of higher or lower rates which needs to be considered: falling birthrates. Globally, they have dropped precipitously over the last half century from about 4.5 births per woman to under 2.5. In the US, the only age group which saw a rising birth rate in 2018 was women in their 40s. A trend that was already well under way has been considerably exacerbated by the recession of 2008/2009.
The implications of this phenomenon for national revenues, social care expenditures and debt levels are obvious. Pushing rates higher has serious implications for debt service and debt sustainability, and Fed-watchers in New York say that it is well aware of these ramifications.
All this suggests the US is set for a continued and sustained period of lower-than-average rates. It also suggests that the current Federal Reserve chairman has more to consider, and less freedom of action, than many of his predecessor