Expectations on the Fed and the Credit Market

At the end of the 80’s a book with the title the “ Secrets of the temple”, author William Greider, making an analysis of the previous years, described how the Federal Reserve run the monetary policy: “..the governors decided the largest of the questions of the political economy, including who shall prosper and who shall fail, yet their role remained opaque and mysterious”. At that time the book was focused on the Paul Volcker’s tenure and professional legacy as Fed Chairman (finished in 1987, after eight years in the job), and probably influenced by his complicated and obscure testimonies and statements regarding monetary policy. Greenspan, his successor, was not radically different at the helm of the Institution, and continued the habit of “constructive ambiguity”, as described in another book “ Maestro, Greenspan’ Fed and the American boom” written by Bob Woodward (2000): “Greenspan used a verbal caution that could be maddening, a series of loose boards and qualifications in sentences that would allow him an exit ramp from nearly everything he said”.

The Fed changed a lot over the time, starting from the early years of Bernanke, who was elected as Chairman on January 31st, 2005. Without removing his merits, we must recognize how the journey started in the mid 90’s when the Fed understood the need to communicate better the decisions: until 1994 the Committee did not prepare post-meeting statements, not even when the decision was to change the Fed Funds. Observers and financial markets had to guess the FOMC’s decision by watching the developments in the short-term money markets (the Fed was able to affect the quantity of bank reserves in the system and therefore the Fed Funds rate). Greenspan prepared the first post-meeting statement in February 1994, and he realized immediately the effect that the policy directive could have on the markets. The forward-looking language was introduced in August 2003, and from February 2004 the minutes of the meetings began available. From 2011 Ben Bernanke began holding press conferences on the final day of the FOMC that soon became an anticipated part of the FED’s communication with the financial operators and played an outsized role in shaping market expectations. In 2012 the Fed began publishing what became known as “the dot plot” in its Summary of Economic Projections (various Fed Chairmen cautioned against reading too much into them).

Today the Fed is a different institution and the constructive ambiguity on monetary policy (Greenspan’s memorable sentence:” if I seem unduly clear to you, you must have misunderstood what I said)”) has been abandoned in favor of transparency. A shift toward transparency has been also imposed by the markets and their evolution over time. The smoke cleared “the temple” despite some critics still label the process” a reluctant transition”. The debate is open if the Central Bank, adhering with transparency, should always commit to precise and highly visible targets, clear-cut objectives, and formal policy frameworks, in the moments of high uncertainties as the ones we lived for example during the COVID, which required large parts of the economy to be shut down, and post-COVID experience with the massive fiscal policy response adopted by the US administration for stimulating the economy (Greenspan, again, mastered the idea of “watch what I do and not what I say or how I say”: if people think FOMC texts are complicated in semantic, I suggest to go and read the convoluted communications prepared in the early 2000’s).

What is the current situation on rates and monetary policy? We had high volatility in rates since the Fed started to hike in March 2022 (25 bps, the first increase since December 2018) and peaked in July 2023 at 23-year highs. Monetary action (the most aggressive tightening cycle in decades. In United States the policy rate was raised 525 bps in one year and half) came together with the reduction of the Central Bank balance sheet (QT). Enormous efforts were undertaken to slow down the economy and to bring down the inflation rate to 2% target where it was for over a decade.

But if the interest rates moved higher with the Central Bank becoming more restrictive and hiking the Fed Funds rate, what happened since mid of last year when the plateau was reached? Two year losing streak in the bond market and one straight direction in rates can find an explanation, but the rates behavior since July 2023 is more cumbersome.

Short answer: a lot of volatility as testified by the standard deviations of monthly returns in the bond market.

More complex and long answer: sometimes the data itself drove bonds market prices and rates more than the Fed's response, because while the FED's reaction function remained stable and predictable, the nature of the US data gave support to investors’ confusion and arguments to speculative trading. Unfortunately, in some cases, many investors and traders struggled to understand the Fed reaction function like it happened from June to October 2023 and in the first months of the current year. In other circumstances, for example, the rates and the bond market have tended to move in opposite direction during press conferences compared to the first initial reaction to the FOMC statement. When and if investors needed to remain more focused on the perceived reaction function or to rely instead on economic data to drive decisions, remained a great dilemma over the last 12 months and especially in the first two quarters of 2024.

In my humble opinion, the sectoral mismatches between demand and inelastic supply during COVID, the reduced effectiveness of forward guidance, the resilience of consumers with enough savings accumulated before and during the pandemic and households with fix long term rate mortgages, and the overall fiscal regime changes, have contributed to the Fed’s diminished ability to control the narrative around inflation, and fueled the rates volatility in a regime which adopted zero inflation tolerance after COVID (average inflation in 2022 at 8%; median inflation perceptions around 10%). Communication, a big part of how monetary policy works, lost its importance by judging the rate volatility levels reached over the last 9-12 months. The inflationary pressures from products and labor markets, interacting and mutually reinforcing, made forecasting and policymaking difficult.

I disagree with the other explanations like an inverted curve which prompted many investors to tactically switch in and out the short-end of the curve, or the growing amount of government debt outstanding that needs to be financed and traded together with new debt issues.

Another shallow idea which deals with the fact that most investors have experienced a large part of their careers, from the end of the GFC through 2020, in artificially suppressed yields and volatility, is able to explain in my judgement, only a small part of the total volatility picture. Because people are not used to high interest rates, does this imply the market mean revert, no matter what, to what traders and investors knew for years, pushing the rates down and anticipating the Central Bank shift to reduce the Fed Funds? Maybe this perspective contains elements of truth, but they have not been studied enough.

The inflation expectations since mid-2023 (breakeven inflation rates for example) remained fairly stable and anchored, and they cannot be the drivers of the volatility neither, especially in the short part of the curve. Uncertain times did not alter the relationship between inflation expectations and realized inflation: the Fed communication should have been able to smooth the trading oscillations of interest rates: it did not happen. Long term rates have always been a conundrum- Greenspan, June 2004- but what about the short ones?

Let see the most recent events which prompted the 10Y Treasury yield to range from a low of 3,80% to a high of 5%: The 2Y Treasury bond has been even more volatile, with swings of 100 bps in four main and strong trends in 12 months.

Exactly one year ago (it seems much longer ….)

August 2023: Chairman Powell's speech at the Jackson Hole Economic Policy Symposium. As expected, his speech struck a similar tone to the FOMC Minutes released on the third week of August 2023. Powell continued to stress the Fed “will be data dependent and will consider the totality of the data in determining if further policy tightening could be needed”.

The tone was overall balanced but leaned slightly more on the side of caution. He highlighted that above trend growth could warrant a further hike. On the other hand, he remarked that inflation made progress helped by restrictive interest rates. Powell was extremely cautious on inflation by noting how it was necessary to have patience and how the process of building confidence that inflation was moving sustainably towards the goal would have required time.

November 2023: someone liked to call it “the central bank’s pivot”.

Chairman Jerome Powell signaled that inflation was cooling enough to halt rate hikes and start thinking about when rate cuts could begin. Powell: ”we have been able to achieve pretty significant progress on inflation despite a strong labor market and strong growth. Strong growth might not be inflationary, because of the recent labor force increase”. The financial markets interpreted the comments incorrectly, as it turned out, to mean easing would be imminent and that as many as six cuts of 25 bps each would happen in 2024, sparking a massive stock rally and rates to drop with 10Y Treasury passing from 4,85% to 3,90% at the end of December. The market logic was if in 2024 inflation was projected to fall further, and because the FED targets the level of real rates, to maintain the same level of monetary restriction the Fed needed to cut the nominal rates in line with falling inflation. The view was strengthened in the December FOMC statement when economists and traders focused on the insertion of the word “any” in the official text: “in determining the extent of any additional policy firming that may be appropriate”. For two or three months both the markets and the Central Bank turned more dovish. Several policymakers provided pushback with little success against optimistic expectations in December.

January 2024: unease of the FED Committee around premature rate cuts. Inflation surprised to the upside.

The Fed message introduced a new “upside risk” to both inflation and economic activity, if the momentum in aggregate demand would finally come out stronger than assessed: “without restrictive financial conditions this undue momentum to aggregate demand could cause progress toward price stability to stall”. The accent was on risks around the inflation forecast as tilted slightly to the upside and some members even judged some of the recent improvement in inflation to be a function of idiosyncratic movements in a few series. Given a more optimistic growth backdrop and durable labor market, the FOMC appeared to show continued patience in unwinding monetary policy restrictions. The FOMC was describes as highly attentive to inflation risks and noncommittal on rates path. The 10Y Treasury was back to 4,30%. The market started to be concerned about high growth and the optical strength in the labor market as potential risks for a resurgence of inflation in the classic demand-side framework.

Minutes from the May 2024 FOMC meeting

The minutes contained several hawkish phrases (“there was a lack of progress toward the Central Bank’s inflation target” for example) and confirmed that prospects for eventual rate hikes were discussed at the meeting. Various participants mentioned a willingness to tighten policy further “should risk to inflation materialize in a way that such action became appropriate.” Assessments of progress on inflation and rebalancing in the labor market showed a clear path for a higher-for-longer policy rate. Participants assessed that demand and supply in the labor market were coming into better balance, but at a “slower rate.” The risk of an “unexpected weakening in labor market conditions" was barely mentioned. The 10Y Treasury was at 4,55% (difficult to nudge down if Powell in the Q&A session said he was not sure we reached the peak in interest rates). For the records, the 2Y Treasury was close to 5% at the end of the month.

July 2024: no change for the eighth consecutive time, but…

In the most recent remarks, Fed Chairman Powell adopted a dovish stance (“There was a real discussion back and forth of what the case would be for moving it this meeting”)citing a cooling labor market and emphasizing risks to the dual mandate. In the July press conference after the FOMC, it was revealed a rate cut was a "real discussion" among the voting members (“several observed that the recent progress…had provided a plausible case for reducing the target rate 25 bps at this meeting …” from the July Minutes released on 21st of August). The general tone looked balanced and even if no guidance on the pace of the eventual cutting cycle was provided, the market went to price between 75 bps to 100 bps reductions before the year end. The July statement differed from June’s statement in only one word: the inclusion of “somewhat” related to inflation level and the financial markets judged positively that the FED will be “data dependent but not data point dependent”. 10Y Treasury at 4,10% before the job data. 2Y Treasury at 4,37%.

Annual symposium in Jackson Hole. One year later, we have suddenly a sense of urgency. The path to hard landing runs through data that bear a resemblance to a soft landing, but everything can change without warning. The major downward revision in total employment for the period March23 to March24 issued by the Bureau of Labor Statistic is one of those changes.

We started Friday morning, 23 of August, with the 10Y Treasury at 3,85% after the higher-than-expected unemployment rate, 4,3%, and weak job gains led to a market correction as investors became concerned about the narrative of the soft landing. The CPI for July, around mid of August, was the sort of inflation report the market desired, with the percentage dipping below 3% (core at 3,2%) for the first time since March 2021. At Jackson Hole, Chairman Powell said "the time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks”. The Fed will do everything to support a strong labor market.

The verbal activity prepared the ground for the September cut. 2Y Treasury at 3,90% and 10Y at 3,80%.

Conclusions: unpacking the volatility in US government bond yields appears to be a difficult task. Atlanta FED Bostic said at the beginning of the year: “cutting rate will happen depending on the professional sensibility to the unfolding evidence as any pre-determined plan”. In the first quarter 2024, I realized we were in the same situation when Chairman Greenspan was speaking in ”conditional sentences”. Now, it is worth repeating, the direction of travel is more clear (from Jackson Hole text). Although there isn’t a settled view on the incoming data, we are not left guessing the interest rate direction in similar way people tried to read the tea leaves in Q1. But the volatility is going to persist, because the market is pricing in an aggressive Fed which needs to gain confidence on the economy after the battle with inflation. Implied probabilities will remain at odds with Fed’s messages: where to put the bars for the cuts?

There are four or five points, although, which are worth considering:

a. Judging the tightness of the monetary policy is too complicated to summarize in one number: the level of the nominal interest rates. There is a profound difference between easing rates and easing monetary policy.

b. If a monetary policy is restrictive or expansionary depends on the relative strength of the different policy channels. Assessing the efficacy of a monetary policy requires analyzing the transmission cables from the Fed Funds to financial markets, the credit markets, and the economy. (The ECB under President Lagarde learned this lesson in the previous years).

c. Arguing the current times are more complicated does not say much and ignore how the Central Bank faced the same difficulties years ago: 1970s oil crisis, Long Term Capital Management implosion (leveraged 35 times according to estimates), GFC. Hoping that the next 5 or 10 years will be less dramatic and demanding than the past ten or fifteen, is excessively simple.

d. Central banks can use unconventional tools to increase the message and the potency of the monetary policy: can the tools serve to ease and to smooth the volatility? What is the message that is transmitted to financial operators when they price different asset classes out of the levels of US Treasury curve if this one is distorted?

e. Fiscal-monetary coordination rather than the usual statements “Central Bank being behind or ahead of the curve” may at times be necessary to fight persistent inflation or deflation.

Setting the debate around the interest rate cuts aside, and remembering Milton Friedman’s observation (1968) that monetary policy works with long and variable legs (innovative theories think this is wrong and some Fed members in the past showed perplexities), we remain with another question: what about the credit market?

Europe will follow the US credit trend which I think will be in a widening movement from current levels. I am saying this since over a month and I am in good company now. Credit strategists and PMs discovered from the August experience, that spreads above benchmarks can move by 60-75 bps in 36 hours; they discovered there is a malaise hidden not only “in the rich assets”, but also in IG names. A downside with a big skew is not as remote as it seemed. Staying cautious on corporate credit in a steepening yield curve is a wise strategy. If it is a “bear steepening,” with middle and longer-dated tenors rising faster than short-dated yields, it represents rising funding costs for corporates. If it is a “bull steepening,” like probably the current one, where short-dated yields fall faster than long-dated, behind Central Bank’s action, it may represent expectations for an imminent growth slowdown. A slow rates action from FED could potentially disconnect the risk-on engines of the high yield market and their derivatives: the structured products. The developments suggest increasing downside risks to the weak credits which are highly levered with zero or negative free cash flow production. The economy will not fall off a cliff but there will be sectors which will underperform if consumers will be less buoyant than they have been so far over the latest quarters. In my opinion the focus should be more on unsustainable balance sheets and bloated capital structures related to the earnings’ quality, and less in cyclical names. This is what the European credit market told investors until now since Casino’s default. A&Es and DEs cannot shelter businesses from lower demand and economic headwinds (I should add from poor management).

In the credit market what determines and pushes investor confidence in continuing investing at tight spreads with no concessions in the wrong credits? The momentum. A low conviction market, not even arriving to the landslide occurred on the 5th of August, can dent the momentum, causing spreads to widen 60 bps or 90 bps required to bring back the assets at fair prices and some valuations better associated with their risks, and clearing out the tightening occurred at the last mile (or two) of the no-sense credit market run.

What could go wrong? What is the margin of safety? Those should be the right propositions for an investment plan over the next quarters after the credit market rallied for 10 months driving a compression of 120-130 bps in the European high yield space.

The last lines. I won’t speculate on the FED’s plan and interest rates path, but I point out what I find “special, uncomfortable, and different” from the previous times: 1) the extraordinary monetary policies (or tools) adopted in the crisis and aftermath, risk to become the normality in Central Bank actions (on QT for example: how to understand the decline in the size of the Fed balance sheet when “reserve balances are somewhat above the level judged to be consistent with ample reserves”?....) 2) the world is shaped by economic, technological, and social changes. The changes create new winners but also losers. It is impossible to save all the time those hurt by the change. The monetary policy has always an impact on wealth inequality. When investors charge the Fed with excessive responsibility of what is happening, they forget the lessons of the Volcker’s era 3) the role of financial intermediaries has disappeared, eliminating the cushion against volatility. Big positions, in rates and in credits, are concentrated in few hands which operate with leverage, creating the potential of the next financial firestorm. Financial regulators can still pretend to oversight, but the capabilities are diminished and declining. 4) hedge funds started to trade actively interest rates while they refrained doing so for several years because they were too low and not appealing. When the official rates were lifted many traders were not prepared. Today many managers do not want to miss the train in the opposite direction. Part of the volatility is generated by those new actors 5) the current financial architecture has been stress-tested during COVID. Many imbalances present in the US economy before the pandemic remained unsolved, new ones came out not detected, and formal models on the economy have been poorly equipped to handle the situations. The current economy, where values are embodied in AI and intellectual properties together with physical assets and tangible capital, can be analyzed against the one that achieved the previous soft landing mastered by Chairman Greenspan in the 1990’s? 6) over the last 50 years the real funds rate has averaged 2%-2,25%. Are the current Fed Funds really restrictive if we consider where is the inflation in 2024 and how the credit market is working? 7) how the Fed calibrates the policy to problems that at first observation have changed their nature: the inflation from a slow-moving phenomenon to one characterized by rapid and abrupt changes involving multiple sources and dynamic interactions; the economic and finance problems from fast-moving situations to slow complex outcomes in prolonged economic cycles. But are we sure, ultimately, that they changed? 8) Can the FED and the United States accept a lower trend growth with the current annual deficit- above 6% of GDP- run by the Administration(almost twice the average of 3.7% over the previous 50 years?). How the Fed will cope with populist politics that have been relatively quiescent in recent years (Chairman Greenspan warned about this fifteen years ago and we remember Trump who voiced his opinions on what actions the Fed should take ,back in 2018 and 2019).

The further backward you look, the further forward you can see (Winston Churchill). Does that still hold true?

You can read other Market View here: Market View | Iason ltd