Could The Fed Now Be Making A Policy Mistake?

The upcoming high-frequency economic data are unlikely to sway investors or policymakers. The key issue is whether price pressures are more than transitory, as officials at the Federal Reserve, European Central Bank, and the Bank of England say quite adamantly. Investors are less sanguine. European bond yields rose to the highs for the year last week, but US rates remain soft. After rising by nearly 85 bp in Q1 to 1.74%, the 10-year yield drifted lower here in Q2 and is averaged less than 1.65% in recent days.

Many observers linked the rise of European yields to US rates in Q1, but here in Q2, European yields continued to move higher, even as US rates eased. The spreads over Germany have widened considerably. Last week, the Italian premium widened to nearly 123 bp from less than 100 bp when the ECB announced it would significantly boost its bond-buying under the Pandemic Emergency Purchase Program before easing back to 116 bp before the weekend as ECB President Lagarde hint at the possibility that there were not be a policy change at next month's meeting. The hawks are expected to push for a slowing of the purchases. The premium demanded from Spain has not risen as much, but like the Italian premium, it is above the 200-day moving average (over Germany) for the first time since last summer.

A similar story is evident in the short end of the curve. The paying down of US Treasury bills, ahead of the debt ceiling waiver expiring, and as the stimulus funding is shifted out the curve, short-term US rates are soft. Three-month LIBOR fell to new record lows last week, dipping below 15 bp. The December 2021 Eurodollar premium over Euribor has fallen to about eight-month lows. The US discount to Canada on two-year money is the largest since last April. Still, what draws some foreign investors to the US Treasury market is that one is compensated well to hedge out the currency risk (swap dollars). Under such conditions, the demand for Treasuries is not equivalent to the demand for dollars.

Indeed, it appears the low US short-term rates are forcing global investors further out on the US curve. Consider last week's TIC data. The newswires reported that China's Treasury holdings rose by $41.6 bln in March, the most since 2013. In truth, China was an even larger seller of US bills, and in fact, overall reduced overall Treasury holdings by $3.8 bln.

It is not just China. The hedge funds that transact out of the Cayman Islands were said to boost their holdings by $34.9 bln after selling $100 bln in January and February. This is misleading. Cayman Islands' Treasury holdings finished last year a little shy of $223 bln. They fell roughly to $211 bln in January, to $204 bln in February, and $200 bln in March. Of the top 10 holders of US Treasuries, only Hong Kong and Luxembourg reported an increase. Combined, it was about $2.7 bln compared with a $53.3 bln reduction by the other eight.

This is important because it underscores our understanding of what is driving the dollar. Its broadest expression is that the large budget and trade deficits require higher interest rates, or the dollar bears a greater burden of the adjustment process. The Vice-Chairman of the Federal Reserve Clarida reiterated the Fed's position. He said that after the disappointing April jobs report means that the threshold to tapering (“significant further progress” toward the Fed's targets) has not been met.

That means the Fed continues to buy $80 bln a month of Treasuries and $40 bln a month in mortgage-backed Agency bonds. There will be another nonfarm payroll report before the FOMC's June 15-16 meeting. The early call is for around 600k gain. Even if it were a million, it would not spur the Fed into action. As we have noted before, the market sees the KC Fed's Jackson Hole symposium (typically late August) and the September FOMC meeting as a window of opportunity to recalibrate the Fed's balance sheet expansion. And surveys show that this was the expectation before the release of the April FOMC minutes.

A year ago, we argued that if the Fed were to pull back from its balance sheet expansion, US interest rates would fall because the economy would weaken without the buying. However, now it is a different story. The economy is in a different place. Fiscal policy is fully engaged. The vaccine is allowing a re-opening of the economy, albeit in an uneven way. Thus, if the Fed were to taper its purchases, it would signal recognition of the strength of the US economy that no longer required as much extraordinary monetary policy, and rates would likely rise.

If the market thought the Fed was making a policy mistake, where would one look？ The majority of the Fed did not think a rate hike would be appropriate until after 2023 in the March economic projection exercise. The market thinks otherwise. The December 2022 Eurodollar futures contract, for example, has largely discounted a rate hike by the end of next year, more than a year earlier than the Fed signals. The 10-year breakeven has been above 2.4% since the end of April. The five-year five-year forward has been above 2.3% since the end of March. The University of Michigan's survey of long-term consumer inflation expectations (5-10 years) is above 3% for the first time in a decade.

Fed officials recognize the importance of anchoring inflation expectations. However, reasonable people can observe these measures of inflation expectations and conclude that inflation expectations have become unanchored. Fed Chair Powell explained that “The fundamental change in our framework is that we're not going to act pre-emptively based on forecasts for the most part, and we're going to wait to see the actual data.”

The actual data is elevated. Consumer prices are rising at an annualized pace a little north of 6%. April's PCE deflator, which the Fed targets at 2%, will be released on May 28. It rose at an annualized rate of more than 4% in Q1. Assuming that the median forecast in Bloomberg's survey is correct and the PCE deflator rose by 0.6% last month, which would be the highest monthly print since 2008, the annualized rate closer to 5%.

Numerous anecdotal reports suggest that the anticipation of higher prices, like building materials, encourages a postponement of some projects. That points to the possibility that actual and anticipated inflation is reducing current economic activity, and maybe part of the disappointment with last week's April housing starts (-9.5% vs. median expectations for a 2.0% decline after a revised 19.8% gain in March).

I am not convinced that we know enough about inflation to be so adamant about it. The old relationships (e.g., money supply growth, unemployment, significant debtor issues) have weakened, were never so strong, to begin with, or have completely broken down. Many economists and central bankers continue to argue that price pressures will increase only when the labor market slack is absorbed. Yet, with low levels of unemployment in 2019, inflation was still undershooting targets.

The noted Fed watcher and Queens College President El-Erian expressed the thinking of many when he argued that that the Fed may be making a policy mistake. He concludes that its stance cannot be explained by the normal drivers of monetary policy. This is fair as far as it goes, but it does not do justice to the extent of doubts about recent Fed moves. There are three other areas of concern.

First, the Fed is allowing the pressure to build up in the money markets, driving some rates, like the general collateral repo rate below zero. In the past, the Fed has moved (increase the interest on reserves when the Fed funds rate is within five basis points of the lower bound). It is six now but did dip to five basis points at the end of April. The use of its reverse repo facility reached a new pandemic-era high of $294 bln last week. Pressure is likely to continue for at least the next couple of months as Treasury Department reduces its cash position ahead of the end of the debt ceiling waiver.

Second, the System Open Market Account manager suggested in early April that the Fed's intent to keep its purchases in line with Treasury issuance would necessitate a technical adjustment in the coming months. There does not appear to be a compelling reason this was not done ahead of last week's 20-year bond auction. The result was lukewarm reception that saw higher yields and a lower bid cover. It left dealers with 23.8% of the supply, up from 21.1% at the last auction.

Third, what the Fed is buying is problematic. Consider that it buys TIPS (Treasury Inflation-Protected Securities). Is this really necessary？ To the extent it has an impact, it will boost the breakeven, making it appear to be greater inflation expectations than investors may really have. The Federal Reserve bought $175 bln of TIPS between mid-March 2020 and the end of February 2021, when only $150 bln were issued. It owned 20% of the $1.5 trillion market. It seems convoluted to both buy TIPS and then cite the breakeven as a signal of inflation expectations as Fed officials do.

The Federal Reserve is also buying $40 bln of Agency MBS a month. Is this necessary？ At least two regional Fed presidents think not. The housing market is strong without it. Many metrics are at their best levels since before the Great Financial Crisis. The minutes from the April meeting suggest this was not discussed. Over the longer term, the Fed has indicated a preference that its balance sheets only carry Treasuries. From reading the press, one would hardly know that the US federal government directly or indirectly supports around 70% of US mortgages.

The dollar seems to be particularly sensitive to the small intraday changes in US yields. After the FOMC meeting minutes were released and some headlines made it seem as if tapering was discussed, yields jumped, and the dollar followed suit. However, within a few hours, the yields began unwinding their gains, and the dollar pulled back. The greenback's movement is not about the macro data or risk-appetites or the famous smile. It is about interest rates. The four areas of potential policy mistakes (timing of tapering, allowing money market rates to continue to fall, not following up with an increase in 20-year bond purchases, and buying TIPS, which distort the signal of inflation expectations, and agency MBS that supports a housing market that is booming like it was 2006) collectively do not boost the Fed's credibility as its asks business and investors to trust its judgment.