Federal Reserve Chairman Jerome Powell at a U.S. House Financial Services Committee hearing in Washington.
Al Drago/Bloomberg
Was Jerome Powell channeling Paul Volcker this past week by admitting that inflation has ceased being transitory? Or will he wind up being more like Alan Greenspan, facing a conundrum if the bond market fails to follow the Federal Reserve’s lead to higher interest rates?
Powell, the current and likely future head of the central bank after being nominated for a second four-year term, told Congress that the much-maligned “transitory” modifier to describe inflation should be retired, with prices climbing at the fastest pace in three decades. As a start, he suggested that the Federal Open Market Committee could discuss stepping up the pace of its tapering of securities purchases.
At its confab a month ago, the policy-setting panel said it would trim its monthly buying by $15 billion, reducing it to $105 billion. Far from abruptly taking away the monetary punch bowl (to invoke the metaphor of another former Fed chief, William McChesney Martin), the central bank would be slowing its pour only gradually, adding another $420 billion to its balance sheet, which stands at $8.6 trillion, by the time the buying splurge is done. But ending its bond buying would permit the Fed actually to tighten its policy by raising its federal-funds rate target.
The only surprise about Powell’s suggestion of a quicker taper was that anybody was surprised, given it was previously brought up by other senior Fed officials, notably Vice Chairman Richard Clarida. If anything, winding up the Fed’s massive bond buying seems overdue, given that it was part of the extreme emergency measures put in place during the worst of the financial and economic crisis triggered by the pandemic in March 2020. Moreover, many of Powell’s congressional inquisitors let him know that soaring prices have become their constituents’ top concern.
Just how inappropriate current Fed policy is in the context of the robust and inflationary economy is evident in the record gap between the gross domestic product’s growth rate in current dollars and the yield on the 10-year Treasury note, writes Alan Ruskin, macro strategist at Deutsche Bank, in a research note. Nominal GDP increases and this long-term interest-rate benchmark usually track each other, with boom times bringing high rates and slumps being associated with low ones.
Now, however, nominal GDP is tracking “gangbusters” 11% year-over-year growth, while inflation far exceeds the Fed’s official target. But the 10-year yield “languishes” below 1.5%. There has been nothing like this since the end of World War II, he observes.
The growth is a result of massive, successive rounds of fiscal injections, starting with the Cares Act in 2020 and continuing with the American Rescue Plan this year. The Fed has effectively funded about half of the resulting deficits by buying approximately $3 trillion of Treasury securities since March 2020, Ruskin adds, more than doubling its holdings to $5.6 trillion.
Combined with the purchase of $1.2 trillion of agency mortgage-backed securities, the Fed’s quantitative easing has tamped down long-term rates. But the long end of the bond market seems to be ignoring the prospect of this QE ending, a poorly understood behavior that appears in part due to technical market bets.
Most surprising is that, as the short end of the Treasury market has priced in multiple Fed rate hikes for 2022 and beyond, yields on the long end have fallen. The 30-year bond traded late Thursday at 1.756%, its lowest level since 1.71% right after the turn of the year, while the two-year note changed hands at 0.622%, just below its 2021 high of 0.641%, touched before Thanksgiving and the first reports of Omicron.
The fall in longer-term interest rates, combined with the rise at the short end, has produced the flattest slope in the yield curve in years. Measured between two and 10 years, the spread was 83 basis points—each equal to 1/100th of a percentage point—late Thursday, the lowest since early January and down sharply from 124 basis points at the end of the third quarter, according to Tradeweb. At the long end, the spread between 10 and 30 years was just 32 basis points, the lowest since January 2019. A flatter yield curve is a leading indicator of lower inflation, slower growth, or both.
The persistent low yields on long bonds seem to indicate a belief that when the Fed removes its thumb from the market scale, there will be no consequences, Ruskin notes. However, these low long-term rates are a major determinant of overall financial conditions, notably for equities. The less long yields move up, the more the Fed would have to lift short-term rates to rein in inflation, he concludes.
That recalls the period from 2004 through 2006, when the Fed raised the fed-funds rate by 25 basis points at every meeting, from a post-dot-com crash low of 1% to 5.25%. But longer-term yields failed to respond, a circumstance that Greenspan called a conundrum, resulting in accommodative financial conditions that inflated the massive housing bubble.
The markets’ fear is that the precedent for the present is 2018, when the Fed, with Powell at the helm, steadily raised fed funds to nearly 2.50% while truly tightening money by shrinking the Fed’s balance sheet. The result was a near-bear experience in that year’s fourth quarter, with the drop in the S&P 500 stopping barely short of 20%.
What’s different this time, according to a research note from J.P. Morgan Treasury strategists Jay Barry and Jason Hunter, is that Fed policy is much easier now. The real fed-funds rate is about minus 4% (based on the core personal-consumption expenditures deflator, or PCE, the Fed’s favorite inflation gauge), versus almost positive 1% in late 2018, when the central bank’s tightening flattened the yield gap between the two- and 10-year notes to just 12 basis points—one-seventh of the current spread.
The futures market now looks for the liftoff in the fed-funds rate to begin with a 25-basis-point hike in June from the current 0%-0.25% target range, according to the CME FedWatch site, with odds currently favoring another boost in September, and possibly a third by next December. That would put the key rate at 0.75%-1% a year from now. And other derivatives point to a fed-funds peak around 1.50% three years down the line, an eternity in market time. Even if inflation miraculously eases back to the Fed’s 2% long-term target, that would still be a negative real rate.
Finally, history shows that after fed funds peak, a year passes before the stock market is hit, according to Evercore ISI. The S&P 500 peaked in 2007 after 14 hikes to 5.25%, and in 2018 after nine increases to a peak of 2.40%.
While Powell talks like a traditional central banker about having to curb inflation before it becomes entrenched, Fed policy, on its likely track, will go from super-crazy easy to merely highly accommodative. That presents a conundrum to bond investors who, for now, are accepting yields far below inflation, which in turn provide the main underpinning to high stock valuations.