Powell Finds Everything's Not Easing Come, Easing Go

Federal Reserve Chair Jerome Powell is trying to undo some of the damage done by a Federal Open Market Committee meeting from earlier this summer. And he's not doing a very good job of it. During the past six weeks -- from the time of that earlier meeting to now -- markets have begun to doubt that the Fed would stick to the average inflation targeting (AIT) framework. Markets instead bet that hike rates would happen too quickly. This caused long-term yields to fall along with inflation expectations. Here are my takeaways from the Fed's meeting on Wednesday. Tapering's Closer The biggest takeaway from this meeting is that the Fed is getting closer to tapering its Quantitative Easing (QE) purchases. Since the end of last year, the Fed has indicated it would keep buying bonds until there was substantial further progress toward the Fed's employment and inflation goals. In the July statement, the Fed added the phrase, the economy has made progress toward these goals. While this obviously stops short of saying that the substantial further progress bar had been cleared, it is an obvious hint that we're getting closer. The Fed told us all along that it would telegraph when QE tapering would start, and this is part of that telegraphing process. Powell said we have some ground to cover on the labor-market side before this happens, but I'd bet that between now and year-end, that ground will easily be covered. I still think tapering is announced in 4Q and begins in earnest in 1Q 2022. QE: More Harm Than Good At its core, QE involves the Fed buying a long duration asset (a Treasury or mortgage-back security) in exchange for very short duration assets (bank reserves, or essentially, cash). In theory this could cause longer interest rates to fall because of the Fed's direct buying. It also has some effect on the financial system since banks wind up with extra reserves. Unfortunately, QE is a blunt tool. Falling long-term rates combined with huge demand for the Fed's repurchase agreement, or repo, program clearly indicate that there is not enough supply of long-term bonds and too much demand for short-term investments. In a perfect world, the Fed would just slowdown their purchases immediately in this scenario. However, because markets perceive QE as linked to broader monetary policy, the Fed can't just slowdown purchases without appearing to be also tightening monetary policy. Hence, I expect we'll be doing a weird dance over the next few months, where the Fed will try to emphasize data dependency but also inch closer and closer to slowing bond purchases. It will be a tough communications challenge. No MBS Tilt One minor point is that Powell poured cold water on the idea that mortgage bonds would be tapered before Treasury bonds. He said there were some people on the committee who saw a link between QE and home prices, but then said he didn't agree with that assessment. He wouldn't come out publicly with his own point of view in this way if such a move was still up for debate. So when tapering comes, it will be more or less proportionate to their current buying program. Standing Repo Facility The only formal announcement from this FOMC meeting was the establishment of a standing repo facility. In a sense this isn't such a big deal, since the Fed has been conducting repo operations for a few years now on an ad-hoc basis. The hope is that by making the facilities permanent, it would avoid runs on money markets, which have occurred sometimes in periods of real stress like March 2020, but also in periods where cash just happened to run a tight like in late 2019. Presumably if everyone knows the facility will be there, sudden liquidity demands won't case such wild swings in money market securities. It is a sensible policy move, particularly since such swings in short-term rates get in the way of the Fed executing monetary policy. When Will Rates Start Rising? As Wednesday afternoon wore on, interest rates started falling again, with the 10-year closing at its lows in terms of yield. It is my view that the economy will eventually pick back up where it left off in 2019 and that tight labor market conditions will lead to somewhat higher inflation than we saw back then. That should lead to Treasury yields at least as high as 2018-2019, or maybe a bit higher. In other words, somewhere between 2% and 3%. Unfortunately, we lack an obvious catalyst for what could cause such a move. Near-term economic data will probably be sequentially slower, including inflation. That will feed into a bond bull narrative. But the longer-term question for rates (and inflation) isn't about the pace of economic growth, but the degree of spare capacity. In other words, growth can slow from its current pace but still be quite robust, and ultimately push us toward a tighter and tighter economy. I'm positioning my portfolio to be cautious but also having enough income generation to have staying power. That way if it takes many months before rates rise, I'm not worse for the wear.

Powell Finds Everything's Not Easing Come, Easing Go

Here are my takeaways from the Fed meeting and why the chair is struggling with messaging as we're getting closer to seeing Quantitative Easing purchase tapering.

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