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The minutes of the last Fed meeting were released last night, and the coverage today is all about a 'more hawkish than expected' Federal Reserve. 👇
"This is news. This is more hawkish than expected," said David Carter, chief investment officer at Lenox Wealth Advisors in New York.
False narrative or genuine?
Let's take a look at the charts. Below is the December 2022 Fed Funds futures contract. This is generally used as a guide to where markets think the Federal Funds Rate will be at any given point in time, in this case December 2022.
Note how much of the move towards higher rates was priced in the period between the red lines (after the meeting on December 15th, and before the minutes were released).
What's the chart showing?
You subtract the figure from 100 to get the idea of where the market thinks the rate will be on contract expiry. In this case:
100 - 99.15 = 0.85%
Or you can take a look at CME's FedWatch Tool for the probabilistic view:
Obviously, these are implied rates, not perfect measures, but still a decent gauge of expectations.
Anyway, onto the point. The idea that this came as a shock to markets doesn't really stand up to scrutiny.
Markets have 'expected' approximately three Fed rate hikes this year for a while, and that didn't drastically change yesterday. It was just more of the same.
From the minutes:
"Participants pointed to a number of signs that the U.S. labor market was very tight, including near-record rates of quits and job vacancies, as well as a notable pickup in wage growth," the minutes said.
"Many participants judged that, if the current pace of improvement continued, labor markets would fast approach maximum employment."
Wednesday's ADP report of +807,000 jobs certainly added credibility to that viewpoint.
And tomorrow's NFP could strengthen the case even further.
Back to the minutes:
"Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.
Perhaps as soon as March, when the QE taper ends? Got to raise a smile that the Fed are already talking about quantitative tightening, even though they still haven't finished quantitative easing yet 👇
"Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve's balance sheet relatively soon after beginning to raise the federal funds rate,"
The idea will likely centre around letting assets mature/expire, rather than outright selling. But even this is contentious.
Excellent read via Bloomberg here 👇
Effectively, the Fed could end up 'managing' the yield curve to stimulate lending, rather than relying completely on rate hikes as the policy tool.
“some” policy makers made the point that relying more on balance-sheet contraction than on rate hikes could help to limit a flattening in the yield curve. That’s when short-term rates rise by more than longer-term ones.
In theory, by shrinking its bond holdings, the Fed could prop up longer-term yields.
Relying less on rate hikes would meantime reduce the amount by which short-term rates rise.
“A few of these participants raised concerns that a relatively flat yield curve could adversely affect interest margins” for lenders, the minutes said, referring to a sub-group of those favoring greater reliance on balance-sheet measures. Such a yield curve “may raise financial stability risks,” according to these officials.
A study by economists at the Federal Reserve Bank of Kansas City released in October made a similar argument -- “we conclude that normalizing the balance sheet before raising the funds rate might forestall yield curve inversion and, in turn, support economic stability.”
- By hiking less, short term rates wouldn't rise as quickly
- By reducing the balance sheet, longer term rates could rise
- A steeper curve increases lender margins (difference between short and long term rates) so they'll keep on lending while interest rates (gradually?) return to 'normal'.
That's the theory.
Some argue the Fed could create financial instability by withdrawing liquidity from the treasury markets, in a repeat of the 2017-19 period.
Either way, the debate around rate hikes is becoming more nuanced, and there'll be a lot of communication to come from the Fed this year as they try to manage their way out of it.
This Fed 101 guide from Wells Fargo will come in very handy.
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