The Fed’s uncertainty doesn’t scare markets

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The Fed’s outlook and the market’s response

The market liked what it heard from Jay Powell and the Federal Open Market Committee yesterday. No one was doing cartwheels, but stocks, which had been enjoying a solid day before the statement and the press conference, rose further afterward, though enthusiasm waned a bit at the end of the day. Treasury yields fell — the two year by three basis points, then the 10-year by one. A dovish meeting, then?

Not really. It’s easy to imagine a world in which investors listened to what the bank had to say yesterday and didn’t like it one bit. The committee reduced its outlook for growth meaningfully, increased its outlook for unemployment by a hair, and bumped up its inflation outlook, too. Here are the median numbers as presented in the Fed’s summary, with arrows added by Unhedged:

There is a word for this sort of thing, and it is a bad word: stagflation. Not that the Fed is forecasting a bad case of the big S, but still, expectations are trending the wrong way on both sides of the central bank’s mandate. And the Fed was clear about the reason for this: the sharp decline in investor, business and consumer sentiment precipitated largely by worries about the Trump administration’s policies, particularly tariffs.

Yes, the projection for interest rate policy stayed the same. But that projection is an average, and it conceals a move towards tighter policy. Trim the three highest and lowest individual estimates and the “central tendency” expectation for policy went from a range of 3.6-4.1 per cent to 3.9-4.4 per cent. That’s not nothing. In the press conference Powell drew attention to committee members’ rising uncertainty about their projections — uncertainty that is not just higher, but asymmetrical and almost entirely on the side of slower growth and higher inflation. Below is the Fed’s chart of committee members’ uncertainty about the unemployment rate (relative to historical levels) and which side they place it on:

This is all a bit spooky. So why the unruffled market response? There are a few possibilities:

• The Fed delivered a message the market had already received. The market knew the policy worries have increased the risks to growth and inflation.

• There was relief that the Fed didn’t really show its teeth on the inflation risk posed by tariffs. Powell took a measured tone, emphasising that it might be appropriate to look through tariff-induced price increases so long as long-term inflation expectations stay under control. This is not a central bank looking to pick a fight with the executive branch.

• The market, desperate for good news after a bruising month, has decided to anchor its attention on the unchanged interest projections, to the exclusion of all else.

We leave it to readers to decide their own weighting among those three. 

The end of QT

The Fed surprised the market yesterday by announcing a dramatic slowdown to the pace of quantitative tightening: a change from allowing $25bn of securities to roll off the balance sheet each month to just $5bn. It is not surprising that QT is coming to an end; by most measures, we are close to the Fed’s goal of “ample”, but not abundant, bank reserves.

Most forecasts from the end of last year suggested that QT would end sometime in the first half of the year, likely in June. The picture has changed since then — the minutes from the January FOMC meeting showed that the Fed governors were considering ending QT earlier than planned if there were “swings in reserves over coming months related to debt ceiling dynamics”. Even so, analysts we spoke with before the meeting suggested sunsetting QT would start in May, not March. 

Yesterday, chair Powell said the slowdown was just part of the normal course of QT and did not reflect concern over the debt ceiling. That’s a different message from the notes of the January meeting. And such concern would be justified: the debt ceiling, or the limit to what the US can borrow to fund ongoing deficits, was reinstated at the start of this year, after a two-year suspension. Until the debt limit is raised or suspended again, the Treasury cannot issue net new debt. Instead, it is spending down its $414bn account at the Fed.

The clock is ticking. Even with new tax revenue, the Treasury is set to run out of money “sometime this summer, potentially August”, according to Brij Khurana at Wellington Management. After that, the Treasury will need to take “extraordinary measures” to keep the US government from defaulting.

Congress will most likely raise the debt ceiling before that happens — though there will almost certainly be political theatrics around doing so. After that the Treasury will need to issue new debt to rebuild its coffers. If that were to coincide with QT, there would be a double strain on financial system liquidity that the Fed would want to avoid, says Guneet Dhingra, chief US rates strategist at BNP Paribas:

When the Treasury is running down its cash balance, that adds liquidity to the [banking] system. But when the Treasury rebuilds its cash balance [by issuing more Treasuries], that money goes from the banking system back to the Treasury’s Fed account. That draws liquidity from the banking system. QT is also taking liquidity from the system.

The Treasury did issue new debt in 2022 when QT was in full swing. But at that time there was more liquidity and more sources of liquidity (such as funds in the reverse repurchase programme). If QT and a burst of new Treasury issuance had occurred simultaneously, a liquidity crunch may have threatened.

The slowdown of QT is welcome news for the market. Equities appreciate the added liquidity. And, though the effect of QT and QE on Treasury yields is likely small, all else equal the end of QT should slightly reduce Treasury yields too.

We are happy to take Powell at his word. But it just so happens that slowing QT will take some pressure off during what might be a tense summer on Capitol Hill and in the financial system. Some Republicans are focused on the national debt, while most Democrats are looking for ways to push back against Trump. That raises the risk of fiscal brinkmanship as Congress decides what to do about the debt ceiling. Best to take risks off the table where you can.

(Reiter)

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Bros.