Most pundits worldwide seem to think
The Fed is now right on the brink
Of both raising rates
And having debates
On how soon the BS should shrink
And so, today’s Minutes are key
To see if the FOMC
Has made up its mind
That they’re now behind
The curve, and need hurry QT
I am old enough to remember the last time the Fed decided that they wanted to shrink their balance sheet and normalize policy, way back in 2018. As I recall, when first mooted, then Fed Chair Janet Yellen (she of Treasury Secretary fame) described the process of the gradual reduction as ‘like watching paint dry.’ Who knew drying paint was so exciting! Of course, she couldn’t bring herself to even start the process. Ultimately, the combination of slowly raising the Fed Funds rate and simultaneously reducing the size of the balance sheet (which all occurred on Powell’s watch) led to a declining stock market throughout Q4 2018 with the largest Christmas Eve sell-off ever seen in stocks as the culmination of the events. Two days later, Chairman Powell explained he was just kidding, and tighter monetary policy was a thing of the past.
But that was then. It’s different this time!
Actually, it’s not. In fact, what we have learned from observing markets for many years is that it is never different. While the catalysts may change, market responses remain pretty much the same time and again. So, here we are three years later with the Fed’s balance sheet having more than doubled in the intervening period, equity markets having made 70 record highs in the past twelve months and the 10-year bond yielding half what it was back then. Inflation is raging, as opposed to the situation back then, and GDP, while higher than back then, has clearly peaked and is reversing some of the pandemic-induced policy giddiness. But human nature is still the same. Greed and fear remain the constants and investor and trader responses to policy decisions are pretty cut and dried. You can be confident that if longer date interest rates rise, whether in a steepening or flattening yield curve, the rationale for the mega cap stocks to maintain their value is going to diminish quickly. And as they are the ‘generals’ of the equity market rally, when they start to fall, so will everything else, including the indices. Ask yourself how long the Fed, whose members are virtually all multi-millionaires and hold large equity portfolios, are going to sit by and allow the stock market to correct just because some Austrian school monetary hawks believe in sound money. Exactly.
However, we have not yet reached the point where the markets have started to decline substantially, as, of course, the Fed has not yet started to even raise interest rates, let alone shrink the balance sheet. But that is the growing consensus view amongst the punditry, that today’s FOMC Minutes from the December meeting are going to reveal the level of interest to begin that part of policy normalization. Many analysts continue to highlight the fact that inflation is becoming such a problem that the Fed will be forced to stay the course this time. I wish it were so, but strongly believe that history has shown they will not. Rather, they will change the inflation calculations and continue to explain that the alternative is worse.
Yesterday, Minneapolis Fed President Neel Kashkari, the most dovish of all FOMC members, explained that he believes the Fed Funds rate needs to rise 0.50% this year as, “…inflation has been higher and more persistent than I had expected.” It is comments such as this that have the analyst community convinced the Fed is really going to tighten this time. But we have heard these before as well. This is not to say that the Minutes won’t hint at QT, they very well could do so. However, when the rubber meets the road and risk assets are falling sharply in price, the Fed will exhibit its underlying Blepharospasm, and tighter policy will be a thing of the past (as will a stronger dollar!)
Now, leading up to the Minutes, let’s take a look at what happened last night. In the wake of a bit of equity market schizophrenia in the US, we have seen a mixed picture. Yesterday saw the NASDAQ fall sharply (there’s that concern over higher rates) while the Dow managed to rally. Overnight saw the Nikkei (+0.1%) bide its time but the Hang Seng (-1.6%) and Shangahi (-1.0%) both suffer on a combination of the ongoing property sector problems as well as more lockdowns in country. Europe, on the other hand, has managed to stay in the green (DAX +0.6%, CAC +0.5%, FTSE 100 +0.2%) after PMI Services data was released a little bit softer than forecast, but still seen as quite positive. In a way, this was a ‘bad news is good’ idea as softening growth means the ECB doesn’t need to respond to Europe’s very high inflation readings so dramatically. Alas, US futures are flat except for NASDAQ futures, which are lower by -0.4%.
In the bond market, while yesterday saw an early sell off in Treasuries, it was mostly unwound by the end of the day and this morning yields are little changed at 1.645%. As to Europe, yesterday also saw Gilt yields rally sharply, 12.5 bps, but they have consolidated today, falling 1bp while the rest of the continent has seen much less movement. Clearly, there is far less concern over ECB activity than either Fed or BOE.
As to the commodity space, oil (+0.3%) is edging higher and NatGas (+2.3%) is firming on the cold weather in the Northeast. (Of course, compared to what happened in Kazakhastan, where the government was kicked out by the president because of high energy prices, this seems rather tame!) Metals prices are mixed with gold (+0.2%) still hanging around $1800, while copper (-0.6%) is clearly less enamored of the current economic situation.
Finally, the dollar is under modest pressure this morning, with SEK (+0.5%) the leading G10 gainer after printing the strongest PMI data around, while JPY (+0.4%) has simply rebounded from its very sharp decline yesterday, although it remains in a very clear downtrend for now. the rest of the G10 is modestly firmer vs. the dollar at this hour, but nothing to write home about.
In the EMG space, ZAR (+0.9%) is the leader, also seeming to benefit on the back of last week’s liquidity induced decline and seeing a rebound. We are also seeing strength in PHP (+0.7%) and CZK (+0.6%) with the latter benefitting from expectations for further rate hikes while the former benefitted from a much lower than expected CPI print of just 3.6%. Meanwhile, on the downside, IDR (-0.4%) was the worst performer as the infection rate rose sharply and KRW (-0.25%) fell after North Korea launched another ballistic missile and rejected further talks with the US.
On the data front, ADP Employment (exp 410K) leads this morning and then the Minutes are released at 2:00pm. Aside from the Minutes, there are no speakers scheduled, so the dollar will need to take its cues from other markets. Keep an eye on the 10-year as a continued rally in yields should see further dollar strength.
Good luck and stay safe