Last Week Last week started with Chairman Powell on the Hill where he testified Tuesday and Wednesday, stating that, given the recent economic data, perhaps the pace of the Fed’s policy tightening wou...
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Upon observing the aftermath of the Federal Reserve's Federal Open Market Committee (FOMC) statement and Chairman Powell’s press conference and another massive equity and treasury bond rally, I was left with a thought.
Chairman Powell’s delivery and the way he handles questions exudes congeniality. It feels as if he could say just about anything, and the markets would initially take it as positive. What if he were a curmudgeon like Paul Volcker, blowing cigar smoke with a thinly veiled attitude that his questioners were all morons? What if Powell spoke in riddles like Alan Greenspan? I think that if either of those former Fed chairmen said the exact same things that Powell said yesterday in their form of communication, the markets would have behaved much differently. Imagine Volcker or Greenspan stating these points noted by Chairman Powell:
- Powell emphasized multiple times in his prepared statement that inflation and price stability was the primary focus of the of the Fed and right now it may be the only focus.
- Powell repeatedly stated that the Fed would use all their tools to better align demand with supply. The Fed can’t directly affect the supply side so that means they will hammer down on the demand side (my interpretation).
- Powell stated that supply shocks sharp enough and long enough can influence public thinking regarding inflation psyche, which is the Fed’s biggest fear.
- Powell said it is better to address this now and get it done.
- Powell also said that the Fed will allow the economy to operate below its capacity to achieve the price stability goal.
This morning, we got our second quarter of contraction 0.9% following first quarter contraction of 1.6%, however we also got a GDP price index of 8.7% and Core PCE of 4.4%. This is the definition of stagflation.
Looking at Fed funds futures, the curve now calls for the Fed to stop hiking late this year and start cutting in the spring of 2023. Is that consistent with Chairman Powell’s statement that it is better to address inflation now with restrictive policy and get it over with?
On July 14, real 3-year Treasury yields (as indicated by 3-year TIPs) was a positive 32 basis points. Thursday morning, post-Fed, they are negative 23 basis points. 10-year real yields were 61 basis points July 14 and now 20 basis points.
With the Fed in quantitative tightening mode, ready to go the full on $95 billion reductions a month in September (Powell said they are on track from the current $47.5 billion in reductions), major international buyers of Treasuries and Agency MBS like Japan are backing away as the cost of hedging currency risk is too high. While China might be an outright seller as they deal with their real estate debt disaster and the fallout from Covid Zero policy, do you think you should be getting a negative real yield on 3s and a paltry 20 basis points on 10s?
On a pure rate view, I think the markets continue to either doubt the Fed’s resolve or misread what they are communicating at the FOMC meetings. By quarter’s end, I expect to see the 5-year Treasury yields close to 3.25%, up about 60 basis points from current levels and 10-year yields around 3.15%, up about 50 basis points from current levels.
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