Is it Fall yet? I would welcome a break from the heat! But the season will turn soon enough, and as the year has marched on, so has the evolution and development of the current Fed regime. I thought it a measure of Chairman Powell’s maturation that we went through a Fed meeting and Q & A with minimal disruption in the US Treasury market. He is doing a better job of pre-communicating the Fed’s intentions and has started to master that special way of speaking that leaves one just unsure enough about the next step that one doesn’t feel forced to take any new and sudden action. The era of habitual consensus under Greenspan’s more autocratic leadership seems (and is) long in the rear-view mirror. This last meeting there were three dissents with two voters preferring no hike and one (Bullard) in favor of a 50bp cut. Longer term “dots,” which are the individual Fed Governor’s best guesses as to where the target rate should be in the future, continue to inch lower, but there is a broad consensus that we might be near the end of this recalibration in the funds rate. This is interesting to me on several levels. First, because the degree of uncertainty regarding the path of the economy and rates at the Fed appears unusually high. Second, because not only was the bond market reaction relatively benign, but the equity market’s response was also ho-hum. I thought the knee jerk reaction to a less dovish Fed would have been a sell-off in equities, but on closer inspection it feels like the equity market is taking the Fed action as a sign that the economy has weathered the body blows of the “Tariff Tiff” a bit better than expected, and couldn’t sell off on a surprise attack that impacted 5% of the world’s oil supplies, so why should it take aggressive action when the market is telling it that modest action is salve enough? We are left with a seemingly practical minded Fed that realized they went too far last year, has made course corrections, and is now waiting to see if fair winds prove that current steps taken are enough to ensure the continuation of this long and ongoing economic expansion. On a different note I think it is noteworthy that having gotten away from the zero bound, the correct path of monetary policy is not as clear, and its ability to counter issues that are non-monetary in nature (global trade wars) is cast into doubt. In Wizard of Oz terms, the man behind the curtain is no longer all seeing and all powerful. I call this a welcome development, and it should put some pressure and accountability on the legislative and executive branches of government.
While we are on the subject of the Fed, I think it is worth pointing out that there was a lot of ink spilled on the topic of the repo market last week. This is the real short rate that matters, and it is the one that the Fed tries to control at a distance by targeting the Fed Funds rate. Well last week the Repo rate divorced itself entirely from the Fed Funds rate and traded MUCH higher (over 5% with the target under 2.25%). The last time this market behaved this way was during the credit crisis and there were public musings as to whether we were on the cusp of a credit event. Chairman Powell was asked about this at the press conference and he acknowledged that while the Fed knew they were in a tight overnight borrowing situation because of corporate tax date and US Treasury auction settlements, the speed with which rates moved higher and the magnitude of the rate move caught them flat-footed. The Repo market is a high-quality collateralized loan market that is the grease for funding the positions held by dealers and hedge funds. It is utilized as a short-term investment by money funds and corporations with spare dollars on their balance sheets. Those spare dollars were in short supply last week. The Fed supplied those dollars and by week’s end, with the promise of more repo operations in the future, that market had calmed down. Regulatory changes that were meant to wring leverage out of the capital markets and the reduction (albeit from very high levels) in the Fed’s balance sheet in concert with the higher than normal financing needs were long- and short-term factors behind the persistently higher than desired rates. Because this dislocation was exposed so dramatically the week of the Fed meeting, there wasn’t time to put a formal response in place. My guess is that we will see the Fed active in the repo mkt through quarter end, and that at the next regularly scheduled meeting they will expand a portion of the Fed’s balance sheet and establish a permanent repo facility that will try to limit future upside spikes in repo rates.
The equity market chose to take the Chairman at his word and treat this as a plumbing problem and not the proverbial canary in the coal mine. I don’t like ignoring the canary at the bottom of the cage, but I think he’s right on this one, and given the large amount of dollars that the Fed’s payment on excess reserves takes out of the system, the system needs more dollars to function smoothly, and the Fed will have to supply them.
If we take ourselves back to last year at this time, the Fed was still in a tightening mode and the Q4 equity market sell-off was in the offing. That sell-off really gathered steam after Chairman Powell indicated the Fed was on autopilot to higher rates in 2019. Fast forward to today. Not only was the tightening cycle ended, but a mini-ease cycle has begun. US Treasury 10yr note yields which reached 3.25% and looked like they were headed higher reversed and just a few weeks ago hit 1.43%, not far from their all-time lows of 1.32%, reached during the Great Recession. That bond market spike has reversed, but the market’s perception of what constitutes neutral interest rate levels continues to drop.
The equity market is within sniffing distance of the all-time highs. What gives? For certain, low rates help justify expanded PE multiples. But, I also feel like the constant focus on the trade war, the age of the current economic expansion, the President’s legal troubles, weak growth in the rest of the world, and uncertainties surrounding the 2020 election cycle made the market susceptible to a “wall of worry “ climb. Now we can add heightened tensions with Iran to the mix. Will how these resolve in the long run matter? Yes. But in the short run, the market has shown resilience, the Citi surprise index has turned up and hope springs eternal that a trade deal with China could get inked. After good gains through almost three quarters we have positioned a little more defensively and have dry powder ready to deploy if any of the previously mentioned situations resolve in a way that dictates action.
Here’s to cooler temperatures!