Tomorrow the Chairman regales
Us all with the latest details
Of ways that the Fed,
When looking ahead,
Might ever consider bond sales
The one thing of which we are sure
Is ZIRP, for some years, will endure
The worry is Jay
Has nothing to say
On what he’ll do when there’s a cure
Markets have been biding their time overnight and seem likely to do so for the rest of today’s session as investors and traders await the wisdom of Chairman Powell. Tomorrow morning’s speech is expected to define the basics of the new Fed operating framework. In other words, it will describe their latest views on how to achieve their Congressional mandate of achieving “…maximum employment, stable prices and moderate long-term interest rates.”
It was in 2012 when the FOMC decided that 2.0% inflation was the definition of stable prices and formalized that number as their target. (Interestingly, the history of the 2.0% inflation target starts back in New Zealand in the late 1980’s, when inflation there was consistently between 15%-20%. Donald Brash was appointed RBNZ governor and in one of his first actions decided that 2.0% inflation represented a good compromise between rampant inflation and price stability. There was neither academic literature nor empirical data that supported this view, it was simply his feeling. But it has since become the watchword in central banking with respect to price stability. Remember, at 2.0% annual inflation, the real value of things halves every 20 years. Many argue that does not define price stability.) Fortunately for us all, the Fed has been largely unable to reach their target, with measured inflation averaging 1.6% since then. Of course, there are issues with the way inflation is measured as well, especially the Fed’s preferred gauge of Core PCE.
But regardless of any issues with the measurement of inflation, that process is not due for adjustment. Rather, this is all about how the Fed is going to approach the problem of achieving something they have not been able to do consistently since they began the process.
The consensus view is that the Fed is now going to target the average inflation rate over time, although over what time period seems to be left unsaid. The rationale seems to be that with the Philips Curve relationship now assumed dead (the Phillips curve is the model that explains as unemployment falls, inflation rises), and given the current dire economic situation with unemployment in double digits, the Fed wants to assure everyone that they are not going to do anything to prevent an economic recovery from not only taking off, but extending well into the future. Thus, the idea is that even when the recovery starts to pick up steam, and presumably inflation rises alongside that recovery, the Fed will happily allow higher prices in order to help to continue to drive unemployment lower. In other words, the famous dictum of ‘removing the punch bowl just as the party gets started’ is to be assigned to the trash heap of history.
The reason this matters to us all is that future path of inflation, and just as importantly expectations about that path, are what drive interest rates in the market, especially at the long end of the curve. While the Fed can exert significant control over interest rates out to 2 years, and arguably out to 5 years, once you get past that, it becomes far more difficult for them to do so. And given the fact that ZIRP and NIRP reign supreme throughout G10 economies, the long end of the curve is the only place where any yield is available.
The problem for investors is that with 30-year Treasuries yielding 1.4%, if the Fed is successful at getting inflation back above 2.0%, the real return on those bonds will be negative, and significantly so. The alternative, of course, is for investors to sell their current holdings of those bonds, driving down prices and correspondingly raising yields to levels that are assumed to take into account the mooted higher rate of inflation. The problem there is that the US government, who has been issuing bonds at record rates to fund the spending for Covid programs as well as to make up for lost tax revenue from the economic slowdown, will have to pay a lot more for their money. That, too, is something that the Fed will want to prevent. In other words, there are no really good solutions here.
However, what we have begun to see in markets is that investors are expressing concern over a rise in inflation, and so Treasury yields, as well as bond yields elsewhere, are beginning to rise. Now, nobody would ever call 0.7% on the 10-year a high yield, but that is 0.2% higher than where it was just three weeks ago. The same is true in the 30-year space, with similar moves seen throughout the rest of the G10 bond markets. While deflation concerns remain the primary focus of central bankers everywhere, bond markets are beginning to look the other way. And that, my friends, will be felt in every market around the world; equities, commodities and FX.
So, a quick look at markets this morning shows us that equities in Asia had a mixed to weaker session (Nikkei +0.0%, Hang Seng +0.0%, Shanghai -1.3%) while European bourses are mostly very modestly higher (DAX +0.5%, CAC +0.3%, FTSE 100 -0.2%). US futures are mixed as well, although NASDAQ (+0.5%) futures continue to power ahead, the Dow and S&P are essentially unchanged.
Bond markets continue to slowly sell off as they are seeming to price in the idea that if the Fed is willing to accept higher inflation going forward, so will every other central bank. Thus, another 3bp rise this morning in 10-year Treasuries, Bunds and Gilts has been seen. Meanwhile, as interest rates go higher, gold is losing some of its luster, having fallen another 0.6% today which takes it nearly 8% below its recent historic peak.
And finally, the dollar is having what can only be described as a mixed session. Versus the G10, it has gained slightly against the Euro, Danish krone and Swiss franc, and edged lower vs NZD. Those movements are on the order of just 0.2%-0.3%, with the rest of the bloc +/- 0.1% and offering no information. Emerging market currencies have seen similar price action, albeit with a bit more oomph, as HUF (-0.8%) and CZK (-0.6%) demonstrate their higher beta characteristics compared to the euro, while ZAR (+0.5%) continues to find buyers for their still highest yielding debt available.
As I said at the top, markets appear to be biding their time for the Chairman’s speech tomorrow morning at 9:15 NY time. On the data front, this morning only brings Durable Goods (exp 4.8%, 2.0% ex Transport), which while generally important, will unlikely be enough to shake up the trading or investment community. For now, the dollar’s medium-term trend lower has been halted. Its future direction will depend largely on Mr Powell and what he has to tell us tomorrow. Until then, don’t look for very much movement at all.
Good luck and stay safe