by Guy Haselmann, FETI Group
(The views expressed herein are solely those of the author)
Given the considerable impact central bank policy has had on financial markets during the past decade, 2022 will most likely mark an important inflection point as the Fed pivots away from unprecedented accommodation toward a neutral and even restrictive policy. It has a long way to go to just get to a neutral stance; a necessary first step before it can begin thinking about switching to a restrictive policy.
In my opinion, the Fed is far behind the curve and feeling enormous pressure to catch-up. The days of being “gradual” have passed. I believe the FOMC will act far more quickly and aggressively than most anticipate, even despite recent hawkish comments. The purpose of this note is to provide a rationale behind this statement as well as to outline the timeline for this potential path of Fed policy actions given the FOMC calendar, economic conditions and the political climate.
The Fed is Still Easing
Tapering is not tightening. If you are driving in your car at 80 mph and tap the brake to slow to 50 mph, then you are still moving forward, albeit at a slower pace. At the December FOMC press conference, Chair Jay Powell announced the FOMC would double the amount of the reduction in the level of asset purchases: $20 billion for Treasury securities and $10 billion for agency mortgage-backed securities. Notwithstanding, the Fed is still technically easing by providing added accommodation for several more weeks. Its balance sheet is continuing to expand and will not peak until mid-March when it will tops-out, astonishingly near $9 trillion.
Why the Delay in Fighting Inflation?
The Fed is handcuffed from tightening policy, because it has been stuck trying to end a former policy promise. Despite the economic need for immediate restrictive policy, former promises to purchase assets into March means the Fed is stuck waiting for this policy to end.
It is preposterous to think that by being forced to first fulfill a former promise, the FOMC is actually stuck in the completely opposite policy of what it wants to be, and should be, doing.
Answering a question about this topic at the FOMC press conference in December, Jay Powell said, “...buying assets is adding accommodation and raising rates is removing accommodation”, and then went on to confirm that fully completing the taper was necessary before rates could be raised. At least Powell was honest about it, otherwise its policy might be analogous to my Great Aunt Addy’s unnerving driving style: one foot on the accelerator and one foot on the brake.
The Fed is Playing Catch-up
Let’s put current Fed policy in perspective, starting with some facts: according to the BLS, consumer price inflation for the year ending November 2021 was 6.8; the December unemployment rate fell to an incredibly low 3.9%, and; US Real GDP growth is expected to be 6.5% (annualized rate) in Q4 2021. These are shockingly strong economic numbers.
To further put it into perspective, during the 1990’s, popular FOMC and market nomenclature in conversations often centered around “NAIRU”, or the Non-accelerating Inflation Rate of Unemployment. It was a natural fit with the Fed’s dual mandate aim of “maximum employment and stable prices. The idea was to figure out the natural rate of “full” employment whereby the rate of inflation is not only moderate (i.e., near 2%), but also not accelerating (or decelerating) from month to month.
One often cited study, conducted by the National Bureau of Economic Research (NBER), concluded with 95% certainty that NAIRU was between 5.1% and 7.7%. Yet, the current unemployment rate is 3.9% and the Fed’s SEP dot plot is forecasting that it will fall to 3.5% in 2022. It sure seems to me that the Fed is well behind and needs to play catch-up.
What Should Fed Funds be today?
Take a moment to think about the economic statistics mentioned above. If you were asked to guess what the FOMC’s official policy interest rate should be based on these numbers, what level would you say? No one would have guessed 0%. Logically, most people would have picked a level considerably above 6.8% to ensure, at a minimum, restrictive policy and positive real rates. The gap is enormous.
Could Delay Impact Policy in Future Years?
For decades FOMC members said that “monetary policy has long and variable lags”. Steve Leisman of CNBC stated this exact point in a question at the December 15th press conference. He postulated that the FOMC, by continuing its asset purchases today, is lengthening the lag time when restrictive policy will ultimately have an impact while simultaneously doing nothing today to address soaring inflation concerns.
The delay in being able to remove accommodation is a problem of the Fed’s own making. It is a negative unintended consequence of the Fed’s forward guidance policy which the FOMC adopted as a policy tool in 2008 when rates hit the “zero lower bound” of 0%. The intent of forward guidance was to make long term promises about the path of policy in order to influence aggregate spending behavior and inflationary expectations without having to take direct actions (which was more difficult to do after rates hit 0%).
Unfortunately, making promises well into the future means that flexibility during that waiting period is curtailed. It is difficult to revoke a promise and even more challenging to quickly turn direction 180 degrees. Typically, a neutral stance and/or period of no action occurs between policy pivots. However, the combination of continuing QE in the face of rising inflation, the immediate economic need for tightening, and the impact lags to policy changes means the first hike in my opinion will occur at the soonest possible moment.
How Politics Factor into it?
What makes this time period unusual from most other periods is that the Fed has political support to raise rates. Typically, politicians want the Fed to be accommodative to have the economy grow at the fastest pace possible, simply because that typically keeps voters happiest. However, during the past several months, the Biden Administration and politicians have been blamed and heavily criticized in the press for not doing enough about inflation. It seems obvious that the Fed has the support of the Biden Administration and most policy officials to raise rates.
The Calendar and New FOMC Voting Members
Interestingly, the Fed’s asset purchase program is scheduled to end a few days prior to the March 15-16 FOMC meeting. This is important as it frees March up as a live meeting for the first interest rate hike. More on this later. As Fed policy becomes more flexible and active in 2022, it is therefore wise to be keenly aware of the 2022 calendar of FOMC meetings: January 26th, March 16th, May 4th, June 15th, July 27th, September 21, November 2nd, December 14th.
Furthermore, it should be noted that as part of the FOMC’s normal rotation, 4 new regional Fed members become voters in 2022. They are Kansas City (Ester George), Cleveland (Loretta Mester), St. Louis (James Bullard), and Boston. Boston currently does not have a President, and so procedurally its vote in the interim falls to Philadelphia Fed President Pat Harker. Esther George is widely considered the most hawkish member. Moreover, each one of these new 2022 voters lean to the hawkish side of the dovish/hawkish scale and in 2021 have hinted at withdrawing economic stimulus.
Hike Aggressively While the Window is Open
I believe the FOMC will want to move as quickly and aggressively as they can, while also hoping that its actions will not have too big of an impact on markets. Luckily for the FOMC, the psychology of bullishness, fueled by the belief in the power of the Fed “put”, is so pervasive that aggressive market sell offs might be met by dip buyers leading to sharp rallies. For the FOMC, it is the speed of market declines that matters more than the magnitude. The FOMC would likely not be bothered if the S&P fell by 30% over 2 years but would likely be quite concerned if it fell by 30%, say, in four months. (Think Dec 2018 when the S&P fell 9%).
So where does all this leave us? I believe the January meeting will be dominated by the hawks who will wish to warn markets and further socialize the idea of looming hikes. Expectations have already been brought forward with many believing the first hike will occur in March. I believe the Fed will be more aggressive and hike three times by July and five times in 2022.
After hiking in March, I expect another hike six weeks later at the May meeting in order to demonstrate to markets that the Fed is willing to hike off-cycle, or at meetings when the SEP dot plot is not released. I then expect subsequent hikes in June and September. The November meeting in my opinion is completely off the table for any policy action because the midterm elections happen the following week. I am less confident about a 5th hike at the December meeting. It will depend on financial, social, and geo-political considerations at the time, but if the Fed has the cover, they hike a 5th time in December.
Since adjustments in the overnight interest rate is the Fed’s main and preferred policy tool, it should be noted that successive interest rate hikes will also help the Fed to re-establish its firepower.
QT to Help Prevent Curve Inversion
I also believe that at the June meeting, the Fed will announce a schedule for allowing their balance sheet to shrink via not reinvesting interest and principal payments of maturing securities (Quantitative Tightening). This does not mean that the Fed would sell assets, but rather that it would stop reinvesting proceeds.
By hiking quickly and aggressively, I believe the yield curve would continue to flatten aggressively, but this tool would help the Fed mitigate flattening pressures and help to avert inversion. It would also help the Fed to withdraw about $1 trillion of excess liquidity that poured into its repo facility due to a lack of supply of positive yielding money market instruments. (It is possible that this policy action could be rolled out in lieu of a hike if the Fed wishes to skip hiking at a particular meeting due to, say, market-related or geo-political reasons.)
There was a 2-month period in Q4 2021 where the 3-year 30-year Treasury curve flattened by over 50 bps: where yields of all Treasury maturities inside of 10 years rose, while yields of all longer maturities fell. It is reasonable to assume that aggressive Fed tightening in 2022 would lead to significant Treasury curve flattening pressures and QT could help.
I suspect the 2-year will be impacted the most. It might be helpful to remember that in 1 years’ time, today’s two-year will only have one-year left until maturity, so hikes throughout year 1 impact it significantly. On the other hand, a 30-year can be thought of as 15 successive 2-year periods. This is one reason why long Treasury securities are typically more isolated. It is my experience that long duration Treasuries have proven to be one of the more ideal hedges during risk-off phases.
The US 10-year Treasury Note
The pressure recently in the long end of US Treasury securities has been partially due to elevated levels of corporate supply which has been frontloaded in anticipation of looming Fed action. This pressure has offsets other than curve flattening flows. Treasury yield spreads to other developed world bond markets have an impact on absolute yields. Investors still have quite a bit of yield pick-up in US Treasurys over other sovereign bonds. For example, Spain and Italy 10-year bonds trade around 110 and 45 basis points, respectively, lower in yield than the US 10 -year. I expect a dramatic narrowing of this spread going forward.
I suspect the US 10-year will struggle to rise above 2% in 2022. If it does break this level, I suspect it would be met with significant buying on its way toward 2.25%. 2022 will likely be very volatile with enormous market swings. Yet, it would not surprise me (but would surprise many others) if the US 10 year stayed in a (low-yield) range in 2022 of, say, 2.15% to 1.35%.
Steep bouts of “risk-off” will also likely occur in 2022 simply because rising rates typically have a direct negative correlation with equity multiples. The CAPE or Shiller P/Es are currently near record levels and the high correlation of the SPX with the size of the Fed’s balance sheet is also well-known and frequently cited as a “risk-on” catalyst. This would help flows into US Treasuries.
The Fed however, would not want to be so aggressive as to invert the Treasury yield curve because it is often viewed as a recession warning signal and hurts banks who borrow short and lend long. By announcing QT sometime during the cycle in 2022, it could help prevent this dire market warning signal - and help to keep the back end in a contained range.
You Are Not Alone Mr. Powell
I would also suspect that the Fed will not be tightening alone. Several emerging market central banks have already hiked to combat their domestic inflationary pressures. Major developed world central banks could also be incentivized to hike should the dollar rise too high against their domestic currency.
Could the steep sell-off in Bitcoin and cryptocurrencies be a sign and vote of confidence by the market that the Fed’s policy shift is finally moving into the right policy?
The Debt Wild Card
Lastly, global indebtedness is so high after a decade of zero and negative rates that higher official interest rates will have a non-linear impact, meaning the higher they go, the greater the economic growth headwinds will become. The cost of debt servicing rises quickly and exponentially with higher rates.
I would guess that prior to the 2008 financial crisis forecasts today for the terminal level of fed funds, would have been in the 4%-6% range. Today’s digitalized and indebted world is a different place, so i suspect the terminal fed funds level for this cycle will be far lower, say 2%. The first 4 0.25% hikes are likely to be much smoother and easier than the next four. Let’s get through the first 4 or 5 hikes and QT, and then reevaluate.
The Bottom Line
The Fed no longer needs to be “gradual” like it was for the past decade coming out of the 2008 financial crisis when it was motivated by the “concern of undoing the progress” obtained through its extraordinary accommodation. In 2022, I suspect the behind-the-curve Fed will want to tighten as much as it can, and as soon as it can, before the political, economic and financial market windows close.
“The change it had to come, we knew it all along.” - The Who