Hawkish Fed Flies Fast and Furious as Economic Outlook Fogs

The Federal Reserve, we have now learned, plans to get aggressive in selling down its bond holdings. We learned this after the Fed on Wednesday released the minutes from its March 16 meeting and after a speech on Tuesday from Fed Gov. Lael Brainard. Here's what this means for investors -- and my take on other tidbits from the Fed minutes, including increased recession risk. Fast and Furious There are times when the Fed seems to use the minutes as a purposeful communication tool. This seems to be one of those times. We learned from Brainard on Tuesday some of the details: Quantitative Tightening -- for reducing the size of the Fed's balance sheet -- will begin in May and will follow the same broad framework as the 2017-2019 QT period. Specifically, the Fed will set a cap for how much it is willing to let the balance sheet shrink per month. If total principal receipts are above the cap, the Fed will reinvest the rest. The minutes gave us a bit more detail. The Fed will look to set the maximum cap at $95 billion per month, which breaks down to $60 billion. It'll start QT aiming a bit below that cap and ramp it up, probably over a period of three months or so. The Fed's current QE portfolio totals $8.9 trillion, which is up $5.1 trillion since the Covid pandemic began. At $95 billion per month, it would take a bit more than four years to get back to pre-Covid balance sheet levels. Of course during the prior QT period, the Fed wound up halting QT early, as reserves wound up too tightly, and a riot in the repurchase agreement, or repo, markets ensued. The Fed acknowledged that risk in the minutes as well: Participants agreed that lessons learned from the previous balance sheet reduction episode should inform the committee's current approach to reaching ample reserve levels and that close monitoring of money market conditions and indicators of near-ample reserves should help inform adjustments to the pace of runoff. How Aggressively to Hike? In the weeks leading up the March 16 Federal Open Market Committee meeting, there was considerable speculation that the Fed might hike by a half percentage point. The Russian invasion of Ukraine injected new uncertainty into the economy, and markets quickly concluded that an outsized rate hike was subsequently much less likely. The minutes show that many thought a half basis point hike would have been appropriate had the Ukraine invasion not occurred. This isn't surprising. A look at the dot plot shows that seven of 16 FOMC members thought that at least a 200 basis point -- or two percentage point -- of hikes would likely be appropriate. Since there are only seven meetings, that implies at least one half-point hike. So, while maybe members backed off the half point hike due to the geopolitical uncertainty for this month, it seems very likely that at least one 50bps hike is imminent. Moreover, since the March meeting, Fed speakers have been talking openly about having half-point hikes at upcoming meetings. Note that while FOMC members are free to speak their mind when giving public appearances, most of them are loath to give specifics about policy unless it is a committee-approved talking point. There are exceptions: James Bullard is the obvious one on the current committee. But usually if you hear multiple members say the same thing, especially if it is something specific about policy, you can assume it is something the board wants the markets to hear. This is why it has been notable to hear people like San Francisco Fed President Mary Daly and Richmond Fed President Tom Barkin recently suggest they were open to a half-point hike in May. I don't think either of them would say something so specific if it wasn't an approved message. In other words, I don't know that the Fed has officially decided to hike a half point in May, but that the Fed wants us to know that it is a very real possibility. Does the Fed Want Steeper Yield Curve? The Fed wants to reduce its balance sheet size for several reasons, the main one of which is inflation. If QE has any inflationary impact, then maybe QT will have some deflationary impact. The second is that banks have more reserves than they want, and their search for something to do with the extra money is probably causing distortions in the money markets. Another reason that is sometimes cited is that the Fed might want to steepen the yield curve. Ostensibly by selling off longer-term bonds, the Fed might put upward pressure on those yields and perhaps uninvert the curve. What we've heard this week should finally put that completely to bed. Both Brainard and the discussion within the minutes suggest the Fed is planning on following the basic framework from 2017, which achieved balance sheet reduction entirely through not reinvesting principal payments. If they wanted to actually raise longer-term yields directly through bond sales, they wouldn't be following this framework. They'd be talking about outright sales. That said, we did see the curve steepen a bit from two year-10 year after Brainard's speech and then again after these minutes. I believe this is related to the idea that a more aggressive QT could reduce the need for as many rate hikes. That makes sense to me on a certain level, but in my view, any such effect will be small. The balance sheet just isn't anywhere near as impactful as rate hikes. What QT Risk to Other Markets? How exactly QE influences financial markets more generally is a hotly debated topic. We've all seen the charts where the size of the Fed's balance sheet is compared to the S&P 500. Any claims that there's some kind of direct link between the two is highly dubious. What is much more sensible is that easy money in general is good for risk assets. So when the Fed is doing QE, it is clearly keeping money easy, and all else being equal that's good for financial assets. So, when you are thinking about how QT might influence stocks or other assets, I recommend not thinking about QT as separate from monetary policy more generally. In other words, the risk to stocks is that the Fed is tightening policy overall, with QT being part of that process. Recession Risk Rises One thing that is different between when QT began in 2017 vs. now is the acute pressure inflation is putting on the Fed. In the prior cycle, the Fed could afford to take it slowly, both with rate hikes and QT. This allowed them to see the nascent slowdown in 2018 before it became a recession. First they stopped hiking and eventually cut three times in 2019. It is very likely that had Covid not happened, the Fed would have averted a recession entirely. Now the Fed doesn't have the luxury of going slow. As discussed in the minutes, the committee members want to move the stance of monetary policy toward a neutral posture expeditiously. We know from the dots that most members think they will need to hike beyond neutral in 2023. Once the Fed gets above neutral and into restrictive policy, recession risk rises a good bit. The problem is that no one actually knows what neutral is. The Fed only knows it's hiked beyond neutral when the economy slows. When it was hiking very slowing in 2015-2018, the Fed at least had a little time in between policy moves to see its effect. This time the Fed will be moving so quickly that this will be impossible. In 2018, it took the Fed about six months to realize it had hiked too much, but since it was only hiking once per quarter, that meant rates were only about a half point or three-quarters of a point too high. Now it will be hiking by that amount per quarter, which at least opens up the possibility that the Fed will have hiked a full percentage point or one-and-a-half point too much before realizing the damage it's done. One analogy I've used before is that the Fed hiking is like backing a car into a parking space without a rear-view mirror. You only know you're in the space when you hit the curb. Hiking with inflation this high is like trying to do the same thing but doing it at 45 mph. In theory you could nail the parking job perfectly, but that is a very thin margin for error.

Hawkish Fed Flies Fast and Furious as Economic Outlook Fogs

The Fed is getting aggressive in selling down bond holdings, so here's my take on what that means for investors and recession risk -- and why the Fed's moves are akin to backing into a parking space quickly with no rearview mirror.

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