Fed Raises Target Rate by 50 bps, Powell Rules Out 75 bps Hikes for Now
Fed Raises Target Rate by 50 bps, Powell Rules Out 75 bps Hikes for Now
The Fed had its monthly meeting on May 3rd and May 4th. The market was widely expecting a 50-bps hike despite some murmurs from the hawkish flank. Powell also telegraphed markets could likely expect two more 50-bps hikes. That is what the market got and despite fears of hawkish rhetoric the market got the somewhat dovish surprise of Powell saying that the FOMC is not “actively considering” a 75-bps hike. The 2-yr yield dropped .13% and the 10-yr dropped .04%, flattening the curve. However, the day after yields moved up sharply.
Stocks also moved up sharply in the last hour of trading following Powell’s press conference. The post-meeting rally was erased and more when Thursday saw the biggest loss across the indexes of the year so far. The selling did not appear to be driven by the Fed meeting and didn’t appear to have a direct catalyst other than general uncertainty and the move in rates. As our Head of Research, Tom Lee, has pointed out the bond market has certainly already done a lot of work for the Fed. The 10-yr has doubled since the beginning of the year. Real economy interest rates have reflected this move and evidence of tightening in certain markets, like mortgages, is clear.
The Fed also gave clarity on their quantitative tightening (balance sheet reduction). The Fed’s balance sheet expanded to the prodigious level of $9 trillion during the course of the extraordinary pandemic policy. The pace of balance sheet reduction will begin at $47.5 billion a month in June. However, that level will increase to a steady pace of $95 billion in a month in September. Ultimately, this should reduce the size of the Fed’s balance sheet by about $3 trillion, or by roughly 33% of its current size. Powell also admitted that the new quantitative tightening is somewhat fraught with uncertainty. Referring to the models that try to anticipate the economic effects of balance sheet tightening relative to quantitative easing the Chairman said, “These are very uncertain, I really can’t be any clearer.”
Indeed, there are a lot of uncertainties associated with this process. The Fed holds a quarter of the $23.2 trillion of existing US government issues. It also holds $2.7 trillion worth of mortgage-backed securities. Given the specifics in that market, it may be forced to sell some of these securities rather than just letting them “run off.” We will provide more details on this prospect as the balance sheet contraction rolls out. The spread on MBS over the 10-yr has doubled YTD which likely reflects the market’s growing concerns the Fed will have to sell some in the market.
The FOMC did say on May 4th that it plans to achieve balance sheet reduction by letting securities run off rather than outright selling, but its desired pace of contraction is quite fast. Some are concerned the absence of the single largest buyer from the treasury market could cause some sort of malfunction or issue which we also be on the lookout for. The “flash rally” of 2014 that showed signs of stress in the repo market and the breakdown of treasury markets during the peak of COVID fear have led to elevated concerns about the potential unintended consequences of a rapid QT. Certain regulatory restrictions, like the supplementary leverage ratio, make it harder for key conduits to facilitate the, compared to historical standards, massive expansion in treasury market volume.
The Fed does have a “standing facility” to help key intermediaries swap treasuries for cash. The treasury markets are highly dependent on broker-dealers and some experts favor replacing this existing system with a central-clearing system similar to what is used in derivative exchanges. Obviously, given the centrality of US debt to risk models, disruptions in the treasury market could prove highly problematic. Dollar strength has also continued as most central banks’ dovishness stands in contrast to the Fed’s inflation-fighting stance. Plans for QT can be found here. The FOMC will meet on June 14th and 15th. The yield on the 10-yr was 3.13%. Quantitative tightening begins in June as well.
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