Oil prices are under pressure, the US short-term funding market has been squeezed and the Federal Reserve has begun a two-day policy meeting that is expected to deliver cuts in official borrowing costs on Wednesday. A busy slate indeed.
The main event this week — and one that eclipses other central bank meetings (for the likes of Japan, Switzerland, Norway and the UK) — is the message from the Federal Open Market Committee and how Jay Powell guides US bond market expectations.
Bond traders are primed for the risk of a “hawkish” rate cut, where the FOMC’s policy statement and Mr Powell (at his press conference) push back against market expectations of an easing path that runs into 2020.
John Velis at BNY Mellon says:
“Given past statements by Chair Powell (at Jackson Hole in late August as well as in Zurich a little over a week ago), we don’t expect a firm commitment to lower rates in line with market expectations.”
The FOMC meeting will also provide an updated Summary of Economic Projections, which includes changes to Fed forecasts of interest rates for the coming years, known as the “dot plot”. This may well be a way the FOMC damps bond market expectations and indicates a shallower and limited easing path. But the risk with this approach is that it could lead to further US dollar appreciation as other central banks signal a willingness to keep easing.
Despite the bond market scaling back easing assumptions of late, the FOMC is still expected to have sliced nearly 100 basis points off its fed funds rate by the end of 2020. The January 2021 futures contract implies a rate of about 1.30 per cent, and while that has risen from a recent nadir of 0.85 per cent, the message is pretty blunt in bond land: it smells like a late cycle and the US economy is not immune from global headwinds.
A slowing but resilient US economy, aided by the vaunted consumer and low unemployment, would normally not warrant a cut this month. And Tuesday’s release of August industrial production figures arrived above estimates at the strongest pace in a year. HFE says US manufacturing for the current quarter is up 1.5 per cent at an annual rate after contracting during the first and second quarters.
For all the US’s economic resilience, a Fed rate cut beckons as the lack of one risks triggering a volatile market response.
As Lena Komileva at G+ Economics observes, “the outlook for fed fund rates over the past several months bears no resemblance to US fundamentals”; rather she says:
“It reflects how dependent the market is on Fed liquidity when global macro risks get reappraised upwards” and “how dependent the outlook for the economy has become on this symbiotic relationship between Fed liquidity and market volatility”.
The rationale for a September easing also comes down, in part, to the FOMC’s role as the “global central bank”, given the importance of the US dollar and how global trade and manufacturing are suffering a case of the chills.
Lou Crandall at Wrightson Icap notes:
“The slowdown in capital spending is due to uncertainty about the outlook for global trading arrangements, and that is a problem that the Fed is powerless to resolve. The Fed really has no choice but to throw away another quarter-point rate cut this week, even though it knows that there may come a time in 2020 when it wishes it still had that rate cut in its hip pocket.”
Indeed, the worry that more easing looms and ultimately cuts US borrowing costs towards zero animates plenty in the bond market and beyond.
Over a coffee on Monday, Thomas Costerg, senior economist at Pictet, outlined his thoughts on the FOMC and the US consumer. Thomas thought Mr Powell would look at any US and China trade truce as “being very fragile”. He warned that consumer spending was also showing signs of cracking and he was concerned that low official rates and US bond yields were not reducing the cost of credit card debt.
BNY Mellon, for its part, foresaw “the data softening further” and noted that “consumption and employment are coincident and/or lagging indicators”.
Like many in the bond market playing a long game, the expectation is that by 2020 current market pricing for rate cuts will be affirmed by the FOMC, in stark contrast to any reluctance by FOMC members to outline such a course on Wednesday.
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Quick Hits — What’s on the markets radar
A US funding squeeze, which intensified earlier on Tuesday, prompted action from the New York Fed’s markets desk via an old fashioned overnight repo operation for up to $75bn ($53.2bn was spent buying securities from dealers). This type of action was common before 2009, when the Fed maintained a much smaller balance sheet and controlled its effective overnight interest rate via daily- and term-open market operations, with primary dealers that added or drained liquidity when appropriate.
As noted in Monday’s MF, this week’s funding squeeze (that sent overnight repo to 4.75 per cent on Monday and towards 10 per cent earlier on Tuesday) reflects a couple of catalysts. There is a lot more Treasury paper settling in the market, which this week sparked higher repo rates, while at the same time companies meeting their September 15 tax payments pulled cash from money markets. A higher repo-financing rate should arise from such events, but not to the extent seen in the past 24 hours or so. In turn, the repo squeeze affected other US short-term rates, as it pushed the effective fed funds rate to the current ceiling of 2.25 per cent, up from its usual median of 2.12 per cent.
Tuesday’s action by the NY Fed was deemed likely by Wrightson Icap before markets opened in New York, and the firm believed the central bank could look at various solutions to handle such a situation in future. These include reducing the rate paid on excess reserves held by banks, but such an incremental shift does not address the issue of disorderly trading that sparks a sharp climb in funding pressure. Wrightson says there is “a short-term expedient” of pre-announcing repo operations ahead of peak funding stress dates, such as quarter end. And while Wrightson thought the Fed would “introduce a standing repo facility at some point in the coming six to twelve months” the issues “of who would have access, at what price and for what specific purpose remain to be determined”.
Another solution involves the Fed reversing the sharp decline seen in excess reserves held by banks, as the central bank has shrunk its balance sheet. Less bank reserves means less scope for dealers to soak up the rising tide of Treasury debt that in turn reflects a rapidly climbing budget deficit — trends that are not fading and suggest the Fed needs to address the issue sooner than later.
Joe LaVorgna at Natixis says:
“Rising financing needs effectively drain reserves from the banking system because primary dealers need to take down the Treasury auctions. The ensuing shortfall in reserves leads to a bidding up in the cost of overnight financing.”
In terms of rebuilding bank reserves, it effectively means the Fed resuming Treasury purchases from the market, albeit on a modest scale.
As Lou at Wrightson Icap points out:
“This may have been the single most popular suggestion in our conversations with customers, but we think it is highly unlikely that the Fed would rush into something that would be perceived as a resumption of quantitative easing in response to a couple of days of technical pressure. Our own view is that this week’s squeeze reflects temporary seasonal flows and can be best addressed by temporary open market operations.”
Still, some think the resumption of QE as a way to rebuild reserves looms at some stage and this week’s funding squeeze highlights the need for such a solution.
Here’s Jon Hill at BMO Capital Markets:
“Powell has been extremely clear that the Committee is willing to be flexible with regards to balance sheet policy, and the Fed is learning as it goes since nobody really knows where abundant reserves end, and scarcity begins — perhaps in hindsight that moment just occurred.”
Financial plumbing is geeky and technical, but it matters. Expect Mr Powell to face questions at Wednesday’s press conference where he’ll most likely say he’s mulling things over.
Oil prices were in reversal mode on Tuesday, courtesy of reports that the restoration of Saudi oil output may take two to three weeks, rather than months. After Monday’s surge of some 20 per cent, prices are down 7 per cent at about $64 a barrel for Brent. Plenty of volatility, but the attack over the weekend is seen leaving a higher risk premium for oil and that’s the legacy for the market and the global economy.