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FOMC: Words not Actions

Summary:
The Federal Reserve's Open Market Committee meeting is the most important event in the week ahead.  It is not that it will take fresh policy action.  Rather its observations about the economy and its forward guidance are the focus.  Since the Fed last met in April, job growth has slowed, and prices have accelerated.  Job growth averaged 661k a month in Q1 but slowed to 419k in April and May. Other labor market metrics, like the weekly initial jobless claims, continue to trend lower.  The four-week moving average used to smooth the volatility has fallen to 402k, half of what it was at the end of February.  Other labor market metrics, like job openings, suggest improvement will continue. Perhaps one of the most disturbing statistics is that the labor force participation rate has averaged

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FOMC: Words not Actions

The Federal Reserve's Open Market Committee meeting is the most important event in the week ahead.  It is not that it will take fresh policy action.  Rather its observations about the economy and its forward guidance are the focus.  Since the Fed last met in April, job growth has slowed, and prices have accelerated.  

Job growth averaged 661k a month in Q1 but slowed to 419k in April and May. Other labor market metrics, like the weekly initial jobless claims, continue to trend lower.  The four-week moving average used to smooth the volatility has fallen to 402k, half of what it was at the end of February.  Other labor market metrics, like job openings, suggest improvement will continue. 

Perhaps one of the most disturbing statistics is that the labor force participation rate has averaged 61.5% through May.  It averaged 63.1% in 2019 and 62.9% in 2018.  This likely reflects the uneven re-opening of blue states/red states and sectors, including school and daycare.  There may have also been an interest in earlier retirement during Covid.  At 61.6% in May, the participation rate is at levels seen in 1976-1977.  

One of the great partisan debates is over the role of federal unemployment compensation in shaping the incentive structure and the decisions about returning work.  Nearly half of US states, all led by Republicans, will be terminating access to the federal government's  $300 a week supplemental unemployment compensation and programs that cover gig workers and long-term joblessness.  The federal program is not set to expire until early September.  Missouri, Mississippi, Alaska, and Iowa terminate access now (June 12).  Another nine states join the following week (June 19), followed by eight states (June 26).  After that, four more states reject federal unemployment assistance over the following three weeks.  

"Anecdote" is often used as a singular form of "evidence," and everyone knows someone.   The emergency federal unemployment compensation began at $600 a week and fell to $300 last September.  It briefly fell to zero and then returned to $300 a week in January.  The vagaries of the compensation did not appear to have a measurable impact on employment.  Moreover, the four US states with the lowest unemployment in April will be early defectors from the Federal programs (Nebraska and New Hampshire on June 19 and South Dakota and Utah the following week). 

Just like the Fed is looking past the short-term jump in price pressures, it appears to be looking through the disappointing non-farm payroll job growth.  Several Fed officials have acknowledged that a discussion about adjusting the pace of bond purchases may be appropriate in the upcoming meetings.  After the US reported that headline CPI accelerated to 5% year-over-year, some observers played up the possibility that the Fed will acknowledge that it has begun talking about the bond-buying pace.  This gradualism is the basic scenario that surveys have long identified, leading to a tapering announcement in late Q3. The Jackson Hole Fed gathering and/or the September FOMC meeting is favored.   

Although long-term asset purchases are adopted by many central banks, the precise market impact is difficult to discern.  The 82 bp rise in the US 10-year yield (Q121) was one of the largest quarterly moves and took place as the Federal Reserve was buying $80 bln of Treasuries a month and $40 bln of agency MBS.  Similarly, since the ECB stepped up the pace of its bond-buying in March, European bond yields have risen, not fallen (and the euro has appreciated). 

Ultimately, tapering is important because it contains information about the timing of the first rate hike.  At the March FOMC meeting, the last time the Fed officials updated their individual forecast, 11 of 18 did not think a hike would be appropriate until after 2023.  

The market disagrees.  As the dollar rallied in Q1, the December 2022 Eurodollar futures contract's implied yield trended higher from 24 basis points on January 5 to 67.5 bp in early April.  The dollar has depreciated as the implied interest rate pulled back.  It finished last week at 36 bp.  Given that the cash market is around 11-12 bp, the market still has one rate hike nearly discounted, more than a year ahead of when a majority of the Fed sees a rate hike being delivered.  

Moreover, what does not appear to be fully appreciated is that there is a reasonably good chance there will be a significant shift in the Fed's leadership well before the time it envisions the first hike.  Consider that Quarles's term as vice-chair (for supervision) ends in October. Powell's term as chair ends next February, and Clarida's term as the other vice-chair ends in September 2022.  

The story is a bit more complicated.  Quarles, for example, could remain a Fed governor until 2032.  It is customary to relinquish one's seat when the official term is up, but there have been some rumblings that Quarles may seek to stay.  Clarida's term as governor ends in January 2022, but he could be re-appointed since he was completing an unexpired term. Powell's term as governor extends to 2028.  If he is not re-appointed chair, he is expected to step down. 

There are three dimensions of the Fed's actions that have sparked criticism.  First, the Fed is accepting a downward drift in some very short-term rates, which is beginning to have adverse effects.  It is thought the Fed would wait until the effective Fed funds rate fell to five basis points above the lower bound (zero) before adjusting the interest it pays on reserves (10 bp on required and excess reserves) and/or offer a few basis points on the reverse repo (now set at zero).  Of course, a significant part of the reserves is being created by the Fed swapping for Treasuries and MBS.  The market is anticipating a technical move (intentions do matter), and this appears to have helped underpin T-bill yields at the recent auctions.  

Second, many thought the Fed had indicated it would adjust the bonds it is buying to match the Treasury's supply.  This implied the Fed would increase its purchases of 20-year bonds. However, when it had the opportunity, it did not do so.  It is difficult to say this has had much consequence. The spread between the 10- and 20-year Treasury has mostly been in a 55-65 bp range this year, and it remains within that range.  At the same time, doing what one says they will do facilitates credibility.  

Third, the Fed is buying some asset classes that challenge its financial stability mandate. One can hold hands with the devil in an emergency to cross the bridge, as Franklin Roosevelt observed, but the emergency is over, and the bridge has been crossed.  The Fed is buying TIPS and owns around a quarter of the market.  It cannot both be such a larger player in that market and then claim that the breakevens reflect market expectations.  The Federal Reserve should not be buying TIPS.  It distorts important information, and specifically, the Fed's actions would be exaggerating inflation expectations.  

The Fed continues to buy mortgage-backed securities while the housing market is booming.  The Mortgage Bankers' Association estimates that in Q1 22, the delinquency rate was around 6.4% compared with 4.4% in Q1 19.  S&P CoreLogic Case-Shiller National Home Price Index has risen by 13.2% over the past 12 months, the most since 2005. New home construction is being tempered by supply chain delays and shortages, and this impacts new home sales and appears to have knock-on effects on existing home sales.  This is not to claim a housing market bubble, but more conservatively, that the Fed's purchases could make financial instability more likely rather than less.   

The Federal Reserve is not the only major central bank that meets in the week ahead, but it is the first.  The day after, Norway's Norges Bank meets.  Of the central banks from high-income countries, it is the most hawkish.  Norges Bank has signaled intentions to hike toward the end of this year.  The small decline in May CPI (headline rate eased to 2.7% from 3.0% and the underlying rate fell to 1.5% from 2.0%) is unlikely to persuade it to change its forward guidance. The deposit rate is at zero, and the market has priced a hike for the end of this year and another in H1 22.  Most see a hike in September.  As a result, the Norwegian krone has appreciated by nearly 3.25% this year against the dollar, and more against the euro, and the Swedish krona, which is nursing 0.4-0.6%, declines against the greenback so far in 2021.  

We argue that monetary policy signals go a long way in explaining foreign exchange developments this year.  However, some suggest that the krone is correlated with oil prices. Indeed, the rolling 60-day correlation between the change in oil and the exchange rate is a little shy of 0.5. However, consider that the correlation with the S&P 500 is even a little greater.  Perhaps the linkage that is being picked up is with risk, not the price of crude per se.  

The Bank of Japan's meeting concludes on June 18. There have been modest policy adjustments that have had little impact and have drawn little attention.  The BOJ has reduced its bond-buying, but no one has confused it with tapering.  For the first time in eight years, the BOJ did not buy any equity ETFs for a month, and still, the Topix rose 1.3% in May.  Without the BOJ's bid, short-sellers may be emboldened.  On the other hand, valuations are lower in Japan than in the US and Europe, and the economy is poised to recover in H2.  



Disclaimer


Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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