The Chair and the Vice-Chair both said
Before we raise rates at the Fed
We’ll taper our buying
While we’re verifying
If growth can keep moving ahead
So, don’t look at forecasts ‘cause we
Care only for hard stats we see
Thus, we’ll be behind
The curve, but you’ll find
Inflation we’ll welcome with glee
The Fed has made clear they are driving the bus looking only in the rearview mirror. This is a pretty dramatic change in their modus operandi. Historically, given the widespread understanding that monetary policy works with a lag of anywhere from 6 months to 1 year, the Fed would base policy actions on their forecasts of future activity. This process was designed to prevent inflation from rising too high or allowing growth to lag too far from trend. One of the problems they encountered, though, was that they were terrible forecasters, with their models often significantly understating or overstating expectations of future outcomes.
So, kudos to Chairman Powell for recognizing they have no special insight into the future of the economy. It is always difficult for an institution, especially one as hidebound as the Federal Reserve, to recognize its shortcomings. This does beg the question, though, if they are going to mechanically respond to data with policy moves, why do they even need to be involved at all? Certainly, an algorithm can be programmed to make those decisions without the added risk of making policy errors. Instead, the Fed could concentrate on its role as banking supervisor, an area in which they have clearly fallen behind. But I digress.
Back in the real world, this change, which they have been discussing for some time, is truly important. It seems to be premised on the idea that measured inflation remains far below their target, so running the economy ‘hot’ is a desirable way to achieve that target. And running the economy hot has the added benefit of helping to encourage maximum employment in the economy, their restated goal on that half of the mandate. It also appears to assume that they have both the tools, and the wherewithal to use them, in case inflation gets hotter than currently expected. It is this last assumption that I fear will come back to haunt them. But for now, this week’s CPI data did nothing to scare anybody and they are feeling pretty good.
One other thing they both made clear was that the timing of any rate hike was absolutely going to be after QE purchases are completed. So, the tapering will begin at some point, and only when they stop expanding the balance sheet will they consider raising the Fed Funds rate. Right now, the best guess is late 2023, but clearly, since they are data driven, that is subject to change.
There is a conundrum, though, in the markets. Despite this very clear policy direction, and despite the fact that bond investors are typically quite sensitive to potential inflation, Treasury yields have seemingly peaked for the time being and continue to slide lower. Certainly, the auctions this week, where the Treasury issued $120 billion in new debt were all well received, so concerns over a buyer’s strike were overblown. In fact, overnight data showed that Japanese buyers soaked up nearly $16 billion in bonds, the largest amount since last November. But, depending on how you choose to measure real interest rates, they remain somewhere between 0.0% and -1.0% based on either Core or Headline CPI vs. the 10-year. Traditionally, headline has been the measure since it represents everything, and for a bond investor, they still need to eat and drive so those costs matter.
Summing this all up tells us 1) the Fed is 100% reactive to data now, so overshooting in their targets is a virtual given; 2) interest rates are not going to rise for at least another two years as they made clear they will begin tapering their QE purchases long before they consider raising interest rates; and 3) the opportunity for increased volatility of outcomes has grown significantly with this new policy stance since, by definition, they will always be reactive. To my mind, this situation is one where the current market calm is very likely preceding what will be a very large storm. If central banks handcuff themselves to waiting for data to print (and remember, hard data is, by definition, backwards looking, generally at least one month and frequently two months), trends will be able to establish themselves such that the Fed will need to respond in a MUCH greater manner to regain control. Markets will not take kindly to that situation. But that situation is not yet upon us, so the bulls can continue to run.
And run they have, albeit not as quickly as they have been recently. In Asia overnight, it was actually a mixed performance with the Nikkei (+0.1%) eking out a small gain while the Hang Seng (-0.4%) and Shanghai (-0.5%) both stumbled slightly. Europe, on the other hand, is all green with gains ranging between 0.2% and 0.4% across the major markets. US futures are actually looking even better, with gains of 0.45%-0.6% at this hour. Earnings season started yesterday, and the big banks all killed it in Q1, helping the overall market.
Bond yields, meanwhile, are continuing to slide, with Treasuries (-1.9bps) continuing to show the way to virtually all Western bond markets. Bunds (-1.6bps), OATs (-2.0bps ) and Gilts (-2.7bps) are rallying as well despite the generally upbeat economic news. There was, however, one negative release, where the German economic Institutes have cut their GDP forecast by 1.0%, to 3.7%, after the third wave and concomitant lockdowns.
Oil prices, which have had a huge runup this week, have slipped a bit, down 0.5%, but the metals markets are all in the green with Au (+0.6%), Ag (+0.6%), Cu (+1.5%) and Al (+0.25%) all in fine fettle.
It can be no surprise that with Treasury yields lower and commodity prices generally higher, the dollar is under further pressure this morning. In the G10, the commodity bloc is leading the way with NZD (+0.25%), CAD (+0.2%) and AUD (+0.2%) all performing well. There are a few laggards, but the movement there is so small, it is hardly a sign of anything noteworthy. The euro, for instance, is lower by 0.1%, truly unremarkable. In the EMG bloc, RUB (-1.2%) is the biggest mover, suffering on the news that the Biden Administration is slapping yet more sanctions on Russia for their election meddling efforts. After that, HUF (-0.4%) has suffered as the central bank maintains its rate stance despite quickening inflation readings. On the plus side, ZAR (+0.65%) and MXN (+0.3%) are the leading gainers, both clearly benefitting from the commodity story today.
One thing to watch here is the technical picture as despite the slow-motion decline in the dollar since the beginning of the month, it is starting to approach key technical support levels with many traders looking for a breakout should we breach those levels. We shall see, but certainly if Treasury yields continue to slide, the dollar is likely to slide further.
We have a bunch of data today led by Initial Claims (exp 700K), Continuing Claims (3.7M), Retail Sales (+5.8%, +5.0% ex autos) and then Empire Manufacturing (20.0), Philly Fed (41.5), IP (2.5%) and Capacity Utilization (75.6%). The Retail Sales data is based on the second stimulus check being spent, and the Claims data is assuming strength based on the NFP from last month. We also hear from a bunch more speakers, but Powell and Clarida are done, so it would be surprising to see anything new from this group of three.
All told, nothing has changed my view that as goes the 10-year Treasury yield, so goes the dollar. That will need to be proven wrong consistently before we seek another narrative.
Finally, I will be taking a few, very needed, days off so there will be no poetry until I return on Thursday April 22.
Good luck, good weekend and stay safe