The Big Conversation
Episode 107: Can the FED stop inflation without hurting stocks?
This week we look at the potential market response when the Fed finally ends QE. Bond yields and growth expectations have historically fallen after QE has ended. Should it be different this time? Asset price volatility should pick up, because it will be harder for the Fed to reverse engines now that they are focusing on price, rather than growth.
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Roger [00:00:00] Strategists are currently trying to outbid each other in predicting the number of rate hikes that the Fed will deliver in 2022. Now the consensus is for between three or four, and yet whenever there's a wobble in the equity market, as there was early on Monday morning of this week, the talk quickly switches back to the potential for the Fed to turn more dovish. So what's the likelihood for the Fed to reverse engines if the going gets tough? Well, that's The Big Conversation.
Roger [00:00:27] The Fed appears to be determined to remove liquidity from the market, or at least dial back on the loose policy that's defined the last 18 months, and indeed, much the decade before that. Two of the questions that follow on from this decision are firstly; what will tighter liquidity mean, and in particular, at the end of their bond-buying programme or QE. And secondly, how sensitive will they be if tighter policy leads to a significant pullback in other risk assets? Well, firstly, we should note that the Fed is currently still executing its loose policy mandate. The Fed's balance sheet is still expanding, though they announced that they would increase the pace of the taper, to allegedly complete the process by March. However, the Fed is expected to raise interest rates almost immediately after, with many forecasting a hike at the March meeting. Now, this is very different to the experience of 2014 to 2018, when the Fed halted their QE operations well in advance of raising rates, before then allowing their balance sheet to contract properly a year later. This quantitative tightening, or QT, coincided with the final few rate hikes of that cycle, but it led to a 20 percent decline in the equity market at the end of 2018 and the need for the Fed to initiate overnight repo operations in 2019 because of the scarcity of quality bonds for banks to use as collateral. The sequencing from taper to rate hikes to QT was at least staggered over a few years, and when the equity market wobbled, the Fed did a famous pivot and ended the hiking cycle, reassuring the market that they'd finished tightening. Today, the shift from taper, to hiking, to QT, could be a matter of months. Within a year of the ending of the last cycle, the pandemic had struck, and the Fed had supercharged its balance sheet expansion while slashing interest rates, which had been falling back to zero in prior months anyway. So why is the Fed being more aggressive today, and how likely are they to reverse their engines if markets come unstuck? Well, the Fed is probably going to be less sensitive to equities today, compared to a few years ago. And that's because the Fed is now switched from a growth mandate, to a price mandate. And this all happened very quickly at the end of last year. Now, you may recall, that the dovish choice of Lael Brainard was being considered for the chair of the Fed, as a potential replacement for Powell. Many assumed that the Democrats wanted to continue down the route of super-loose policy. If Brainard wasn't chosen, it was assumed that Powell would have been encouraged to take a more dovish stance within the Fed, even though prices were clearly lifting off. However, once retained as the Fed chair, the speed with which Powell pivoted towards a hawkish stance, revealed what most people now know. The voting public, had switched from being concerned about Covid and growth, to being concerned about inflation, and the impact that would have on real wages and therefore living standards. Controlling price, has now taken priority over supporting growth. But why does this matter? Well, the previous policy flip-flops by the Fed, had taken place within the growth mandate; where the performance of equities, rightly or wrongly, were considered a barometer for growth. Therefore, if equities struggled, the Fed could move towards a more dovish stance and still be seen as fulfilling their growth mandate. If the equity market takes a tumble today however, the Fed will not be so eager to shift its stance, because if they return towards that looser policy, that could light another fire under higher prices, and fail on their price mandate. Flip-flopping within a mandate, is easier than flip-flopping between mandates. Voters want to see a lid on prices, more than they want to see equity markets continuing to perform. Now, some people may argue that equity holdings have never been higher, and therefore the Fed will want to protect those gains. Those equity gains, however, remain extremely unevenly distributed. The majority of those gains have accrued to a very small percentage of the population. Whilst higher prices and a decline in real wages, are far wider reaching, even as the employment picture continues to improve. It could be argued however, that loose monetary policy was never truly inflationary in the first place. Over the previous decade, loose monetary policy had benefited some assets, but it never created the sort of rampant, all encompassing inflation that many envisaged when the Fed began QE during the great financial crash of 2008. Although the recent rise in the balance sheet dwarfs the initial efforts of the Fed over a decade ago, the percentage change in 2008 was still spectacular, even by recent standards. But that led to a misallocation of capital, that helped create inflation in the wrong parts of the market structure. So although we had QE on steroids during the pandemic, it was the inclusion of fiscal policy, and the ongoing breakdown in supply chains, rather than monetary policy per se. That helped drive the widespread rise in prices that we've seen over the last 18 months. The equity market has performed remarkably well, in line with the size of the QE operation, but wider inflation is due to other culprits. And today the fiscal support has started to wane. And this will become a fiscal cliff in coming months. So if the Fed is unlikely to switch the liquidity spigots back on, what should we expect over the next year? Well, as we have mentioned already, the market is anticipating three to four rate hikes, and an end to QE, and the potential for QT. And the assumption is that under these circumstances, yields should be a lot higher. But it's not clear cut that yields should be higher, at least not once the tightening actually begins. Remember, as of now, the Fed is still in a loose mode, even though it has telegraphed the desire to tighten. But if lower interest rates and the dramatic policy of QE from March 2020 to today, has led to higher bond yields, higher inflation expectations and higher equity prices, why would reversing that lead to higher bond yields, and higher inflation expectations? If the injection of liquidity, whether we want to call it cash or collateral, or simply the build up of regulatory reserves at commercial banks. Well if that's created the trends of the last 18 months, then the withdrawal of that perceived liquidity, should surely have the opposite effect? We should therefore have a look at the historical performance of yields, during periods of QE and periods without QE. For this, I'm going to use the yield on the German 10-year bond or bund. The US. 10-year yield follows a similar pattern, but it's less clear than the German equivalent. Now, firstly, the bund yield is at a very interesting juncture. It looks like it's close to breaking out of a large reversal formation. The yield has been edging back towards zero, having been in negative territory since the middle of 2019, when US 10-year yields were also dropping. That period led to both the US and the ECB re-initiating their QE operations, either directly, or in a roundabout form. But, what the 10-year chart of the bund yield shows, is that when there has been no buying of bonds, i.e. no QE, yields have generally fallen. When there has been buying of bonds, yields have generally risen. This reflects an underlying global economy that has struggled to recover from the vagaries of the great financial crash of 2008. During QE, asset prices have been supported, helping create the sporadic impression that there was organic growth. Bonds sold off to reflect this growth, despite the policy of support. Once the support of QE has been removed, risk assets struggled and bond yields started to fall as investors bought bonds as a safe haven asset. So even though there was no government buying of bonds, bond yields still declined. And now US policymakers are discussing the withdrawal of liquidity, before we've seen the appearance of true organic unsupported growth. And that might actually help to cap some of the inflationary excesses that we're currently experiencing. But first, if the Fed removes support, there may be an asset allocation trade away from bonds and into other assets, which gives the impression of reflation and growth, like we're seeing today. But the bond market is not always as accurate as vigilantes like to think. And here's a couple of examples. In 2019, many commercial banks were being impacted by regulations that required the biggest banks; global systematically important banks, to hold additional capital on their balance sheets. These charges were higher for loans than for government T notes and T bonds. Many banks switched out of loans and into treasuries, driving down yields at the long end and creating a mini inversion of the US two years to 10 year portion of the curve. For many, that was a sign of impending recession, and no it didn't predict the pandemic. And as a result, a lot of investors were positioned accordingly. Yes, slow growth and a lack of investment opportunities were the driver. But the inversion was a false signal. In Q1 2021, we saw US 10-year yield squeeze higher. Today, the US 10 year yield has just exceeded those levels. But the move through Q1 2021 was double the move we've seen so far this year, and it started in the previous year off a much lower base. However, an asset allocation trade was again a significant factor. Most of the selling during this period came overnight during the Tokyo session, driven by pension fund flows from Japan. But higher yields was seen as a confirmation of reflation, which in the end was mainly a US and not a global phenomenon. So could today's move be similar? Yields have really been motoring over the last couple of weeks, which suggests that year-end rebalancing. And first of the year, asset allocation trades are in play. Growth expectations for 2022 have built significant momentum, very much like they did at the beginning of 2021. The main difference between then and now is that most strategists were bearish on the US dollar a year ago, whereas today the consensus is bullish the dollar on the expectation of a policy divergence. But the bottom line today is that we are in the midst of a Fed policy shift, from targeting growth, to targeting price. That limits the ability for the Fed to make a quick reversal if equity markets start to struggle. At the moment, the Fed is still buying bonds, which supports higher yields, whilst the performance of value, versus growth, supports the outlook for reflation once again. But soon, the bond buying will end, and if the Fed is unlikely to switch back to a growth mandate, then asset price volatility should pick up in 2022, because they'll have their hands tied if inflation data remains elevated. But if they continue to tighten, eventually ending QT and moving on to a QT footing, then last 10 years suggest that bond yields and growth expectations will fall again, and that this will bring a natural end to the inflation cycle, and may even require policymakers to return to the unorthodox policies of the last 10 years, thus extending the QE and rate-cutting cycle once more. And as ever, if you've got any questions about this episode, financial markets or the economy, please put them in the comments section or send them to TBC@Refinitiv.com
Episode 106: A rising risk for 2022