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Reactions to the December 2021 FOMC - High Quality Credit Spreads

FICC Podcasts December 15, 2021
FICC Podcasts December 15, 2021

 

Dan Krieter and Dan Belton discuss their takeaways to this afternoon’s FOMC statement, economic projections, and press conference. Topics include what factors might change the Fed’s view that the economy is not experiencing a wage/price spiral, discussion around balance sheet normalization, and how Chair Powell was able to generate a dovish interpretation while messaging three rate hikes next year.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:
Hello, and welcome to Macro Horizons High Quality Spreads for the Week of December 15th, reactions to the December FOMC. I'm your host, Dan Krieter here with Dan Belton as we discuss our takeaways from the Fed's December meeting and the impact we expect it to have on credit spreads going forward.

Dan Krieter:
Each week, we offer our view credit spreads ranging from the highest quality sectors, such as agencies in SSAs to investment grade corporates. We also focus on us dollar swap spreads and all the factors that entails including funding markets, cross currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at Dan.krieter K-R-I-E-T-E-R @bmo.com. We value and greatly appreciate your input.

Speaker 2:
The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Dan Krieter:
Okay, Dan. Recording this just minutes after chairman Powell concluded the press conference, following the December FOMC meeting. And from a high level, I guess we'll start with what the fed did, which was not overly surprising.

Dan Belton:
No, of course the headline was that they doubled the pace of tapering. That was pretty expected. It would've been quite the surprise if they didn't alter their pace of tapering at the meeting today. My overall take, I thought it was pretty balanced. Maybe skewed a little bit dovish. Of course, we had the hawkish surprise in the SEPs with the dots forecasting three hikes next year, rather than I think two was probably consensus.

Dan Belton:
And then in the press conference, I thought generally balanced. You probably skewed a little bit more dovish overall. And we saw that reflected in some of the market pricing as chairman Powell's Q and A went on. You saw stocks rally, you saw bond yields start to move lower with a steeper yield curve. And then break evens really started to rip higher too.

Dan Krieter:
Starting with the reaction, certainly the market is reading this as dovish given everything you just described. As I walk away from it, I don't know. I guess, balanced is the word you used. And I think I agree with that. It certainly didn't come across as hawkish to me, but it didn't come across as overly dovish either. I think I found this month's Q and A to be somewhat disappointing. I mean, in comparison to Q and A's in months passed, it just sort of felt to me like same question over and over again, for the most part.

Dan Krieter:
And the main impression that I walked away from was Powell kept coming back to this idea that we have to make policy now. I feel like he said it a couple different times. We make policy in real time and things like that. And to me that says that the fed at its heart probably still believes that inflation is going to moderate on its own.

Dan Krieter:
They talked about the prediction services with long track records and well funded and everything, and that they expect inflation to come down, but we make policy now. And there is a real risk that we are in a wage price spiral, and so we have to move now. That was my main takeaway. And I suppose that actually could be interpreted as dovish, really, if that means that the fed is going to maybe air on the side of caution, if they still firmly believe that inflation's going to fall. I don't know. I'm curious how you read that.

Dan Belton:
Yeah. I thought the same thing. So just back to your initial point, given all the fanfare surrounding this meeting, I think I saw somebody call it the most watch fed meeting in years. The Q and A was really quite boring, I thought. There really wasn't a whole lot to take away from it. I thought to your point, yes, he did make a comment about how they were increasing the pace of tapers so that the fed would be allowed to better address the possible range of outcomes with respect to inflation.

Dan Belton:
I read it the same way that you did, that there was an implication from chair Powell's part that they want to be in position to raise rates aggressively in case inflation doesn't start to moderate as they kind of tacitly assume that it will. I thought it was very interesting. He talked a few times about how, even though wages were increasing, he talked about this ECI measure of inflation, which was really first metric that started to make him rethink his stance on inflation being transitory.

Dan Belton:
That we weren't in a wage price spiral, at least not yet. And to me, that skewed very dovish. If chair Powell doesn't think that elevated wages are contributing to heavy inflation right now, there should be less risk to assume that inflation is going to run rampant and require the fed to really choke off the recovery.

Dan Krieter:
Yeah, certainly a moment in the sun for the ECI, huh? Definitely more coverage during the press conference than I was expected going in. But you hit on something that I had definitely circled in my notes as an important theme from the presser, which was this idea that wages were not yet contributing to the inflationary picture. I have to admit, I didn't totally understand that. He said it during the prepared remarks before the Q and A and then again, later in a follow up to a question about the ECI, talking about how the ECI was very high right before the November meeting.

Dan Krieter:
And that question was actually, I thought the best question of the whole press conference really, was asking him what has changed in the fed's view on inflation in the past six weeks. And that was really one of our main question. Because as you pointed out in our last podcast Dan, the fed has clearly started to take the inflation threat a lot more seriously, even just since the November meeting.

Dan Krieter:
And he talked a bit about the broadening of the sectors that they're seeing inflation, but now it turns out it was this ECI component. That was really what was getting them to change their view. And then in the follow up to that question, which was if that is what caused you to change your view, how is it that wages are not really contributing to inflation yet? And I wrote down his answer, but I don't really understand it. I'm having a hard time seeing how the fed is coming to that conclusion. Did you get any more clarity on that than I did?

Dan Belton:
I was surprised by that characterization as well that we are definitively not in this wage price spiral and that even more or significantly wages are not playing a role in inflation. It's particularly surprising given the difficulty in labor supply that he talked about a little bit today too.

Dan Krieter:
Yeah. And he mentioned in his answers, we're not seeing wages above productivity growth. If we saw wages above productivity growth, that might be an indication that wage increases were contributing to inflation. But I think maybe the bottom line here is just the way he wrapped up the answer was by saying, we're not seeing that yet.

Dan Krieter:
You need to see something consistent. You need to see something significant and we're not there yet. Which brings me back to the point I made earlier, which is the headline of this whole fed meeting to me was we have to make policy now. We don't think that wages are contributing to the inflationary spiral yet. We don't know yet, but we don't have the luxury of waiting around to find out. So is that idea why we're getting a risk on reaction or a dovish interpretation of the fed?

Dan Belton:
Yeah. I think that played a role. There's a couple other things that I highlighted as skewing dovish. He played up the importance of fine financial conditions. He said that financial conditions can change quickly. And he also talked about being a little bit more prudent with the balance sheet. I think the balance sheet discussion that he talked about is actually probably worth talking about right now, that he said the fed had its first discussion about the balance sheet today.

Dan Belton:
Didn't really give many details, except he said that this situation is different when comparing it to the last time the fed had to start to wind down its balance sheet. I was curious what your take on that was that he said this situation is different. Do you think that skewed towards a quicker balance sheet reduction or a slower balance sheet reduction given that last time they started unwinding the balance sheet when the fed funds were it was at 1%.

Dan Krieter:
It struck me as a quicker move towards running down the balance sheet for sure. And he harped on multiple times in the press conference, how accommodated financial conditions were. I definitely don't see it as they were going to take longer this time around, but I also didn't walk away from the meeting with the impression that that was something that they were going to be doing imminently. It didn't change my opinion that this is not probably going to be on the discussion for 2022. Or maybe at the very end of 22 they set the table for beginning to normalize the balance sheet in 23. I didn't really read it as either super dovish or hawkish. What was your read on it?

Dan Belton:
It definitely struck me as surprising that he was talking about it. Particularly because he offered it up, not in response to a question directly about the balance sheet. It was in response to a question about the lag time between the end of QE and raising rates. And he just decided to share that the FOMC had its first discussion about it.

Dan Belton:
And it seems a little bit early to me, particularly because in the response to the actual question he was asked, he said that they hadn't made a decision about the amount of time between the end of QE and the beginning of rate hikes, but they are starting to talk about balance sheet normalization. Which to me, I sort of thought was more of a 2024 story like you. So it does seem to me like that might be coming earlier than expected. And that to me skews very hawkish.

Dan Krieter:
I mean, yeah. Obviously Dan, I think that would certainly be hawkish. For me, it didn't get to the point where I thought he was bringing that timeline significantly forward. I mean, I guess, it's surprising that he even mentioned it, especially without really needing to. So maybe that is a bit more hawkish than I originally took it as, but it didn't meaningfully change the timeline for me.

Dan Belton:
And Dan, one more thing on this. He mentioned that they had their first discussion about it today and that there'll be another next time, which I thought was significant as well.

Dan Krieter:
Yeah, certainly that'll be something to keep an eye as we go into the next meeting here. It doesn't seem like the market has taken that as a worrisome signal so far just given the reaction here, but that's certainly something. We've already seen some market participants starting to talk about that. It wouldn't be surprising if that started to get a bit more focused in the days ahead as investors have more time to unpack the meeting and the press conference and everything that came with it.

Dan Krieter:
Looking at my notes here, Dan, not a ton much else really standing out to me. We talked a bit about the participation rate, what was driving the participation rate, staying very low. Nothing there that I thought was overly surprising. COVID childcare, more savings, stuff for we've all talked about. And he said something to the effect of the evidence is growing that it might take more time for the participation rate to recover.

Dan Krieter:
That's in line with what we've observed in other recoveries, is that the part rate tends to recover more slowly. I would just say this economic cycle and everything else that has come with it, it's probably, it's number one defining characteristic is that everything is happening much more quickly and in a much shorter time span. So I guess, yes, it's true. The part rate hasn't jumped back up since the expiration of extraordinary employment benefits.

Dan Krieter:
As an aside, I thought it was interesting that Powell framed it that way, because remember in the summer press conferences, they kept saying, "We don't really think that it has much to do with extraordinary employment benefits." And then today he says, we didn't see that come up after that in the fall. But anyways, putting that aside, we haven't seen a big increase yet, but it's only been a couple months. I wouldn't be surprised that the part rate actually continued to come up rather quickly, this time around as a departure from previous cycles, like how this whole cycle has been much faster. What are your thoughts?

Dan Belton:
Yeah. So the discussion here also struck me as hawkish. And I don't think the press conference as a whole was hawkish, but maybe the only other hawkish point I took from it was he talked about how you can't look at the pre-COVID labor market as the definition of maximum employment. So labor force participation.

Dan Belton:
He almost implied that he's going to take that as a given and say, well, if we have maximum employment given this labor force, then the fed is going to be ready to hike without waiting for the labor force participation rate to come back up, because that could take a while. I thought that was an interesting point by him where he's maybe a little bit more hawkish than he typically is when talking about labor markets slack and how in the past he's been more willing to allow the labor market to really run hot before talking about raising rates. A little bit different fed here.

Dan Krieter:
Yeah. That actually, you saying that just triggered something in my head where he did actually have a question about that to the effect of, would you raise rates even before you were confident that full employment has been reached. And he said something like in their framework, this is called the balanced approach or something like that. And when you're in a balanced approach, you have to look at the distance from either goal as well as the speed heading in.

Dan Krieter:
And basically, got to in a long winded way of saying that yes, we would raise rates before we're confident that we've reached full employment. And I actually had that marked as something hawkish as well. So I mean, as we talk this through, there were hawkish components to it. And I'm sort of struggling to come up with what the dovish offset there is that paved the way for this risk on.

Dan Belton:
Yeah. So I thought there were some dovish components to it, but more than that, I thought the overarching theme was one of positivity with respect to the economy. He talked a lot about stronger GDP growth in 2022 than they forecast in September. And so I think that could explain some of the risk on reaction, at least as it pertains to equities. The recent rally in front end yields is a little bit more of a head scratcher to me.

Dan Krieter:
Or is it simply a sell the rumor by the fact thing where we saw an adverse reaction to expectations for the accelerated tapering earlier this month and in late November. And now when it actually happens, the fed comes out and well, they weren't overly dovish. They weren't super hawkish. I wouldn't say that they were setting the table to be raising rates rapidly.

Dan Krieter:
They reiterated, they wouldn't be raising rates before their done tapering. No surprise there. But outside of the SEP, which is a bit of a hawkish surprise. Powell went out of his way to, again, stress that the SEP is not a formal communication of what the fed expects to do. It's just a survey. It is what it is, but it didn't come off to me like this meeting was setting the table for imminent rate hikes.

Dan Belton:
And also to that point, I think he acknowledged inflation enough where he maintained some credibility on the matter where he might have instilled a little bit more doubt around the seriousness with which he was taking inflation at past meetings.

Dan Belton:
But he reiterated that he doesn't think the fed is behind the curve. He thinks they're in a good position right now and that they are going to take the steps that they have to take. And he said in a thoughtful manner. He really reiterates that he expects the fed to be taking some measured rate hikes here, but nothing where they are playing catch up to this out of control inflation.

Dan Krieter:
Yeah. Exactly. I mean, he essentially said we're not in a wage price spiral right now by saying that wages weren't contributing to the inflationary environment. And then he did characterize the rate hikes again to bring it back to the key point ahead on this meeting is that we have to make our policy now. So it's almost like we've heard the notion of an insurance cut before.

Dan Krieter:
It's almost like this is an insurance hike by the fed. We're raising rates just to make sure in case we are in a wage price spiral and inflation does fail to moderate on its own, we're taking a rate hike now and setting the table up, increasing our flexibility for having to do more in the future in case we're wrong. Is that sort of the way you read it as well?

Dan Belton:
That's certainly how I'm thinking about the increase of the feds pace of tapering here. They want to stop tapering, not because they need to raise rates in March, even though that is now a live meeting, but more because they want to clear that hurdle where they're in a position to raise rates if they deem that they have to. It's not an insurance hike yet, but really more of an insurance. Be done with QE and then allow yourselves the flexibility in order to raise rates as soon as possible if necessary.

Dan Krieter:
Yeah. So then why don't we unpack what that means for credit spreads? Okay. Because we know that inflation's going to remain very high for the next few months. Powell knows that. He said in the Q and A. So what [inaudible 00:15:07] struggle with is where is the fed going to draw the line? Because as he said today, they have to make policy in real time. Well, if we expect inflation to remain heavy for the next six months, at least. If you're making policy in real time, that says to me, you have to hike within the first six months of next year. No?

Dan Belton:
Yeah. To me, it's going to come down to, in terms of what to be looking for into the new year, what might change the fed's response to elevated inflation. It seems clear to me that Powell's looking at wages and the wage side of things. He doesn't think we're in a wage price spiral yet, but he said that we could be.

Dan Belton:
And so any real hawkish turn from the fed from this point, I think is going to stem from an increase in wages that is going to precipitate higher inflation than the fed currently expects. And then the other thing is financial conditions. Credit spreads are likely going to follow financial conditions at least as they relate to the impact of fed policy. And the response of financial conditions to today's FOMC as far as we can tell, pretty benign. Stocks are up. CDX is down on the day and the yield curve is steeper.

Dan Krieter:
Yeah. I mean, with all liquidity in the system, it's hard to really envision a significant tightening in financial conditions in the near term. I just struggle to see how it could even happen. There's so much liquidity. A new record in RRP volumes today. I can't even get my arms around what it would look like to have a tight financial landscape right now. So it goes back to those data series that you talked about.

Dan Krieter:
And I agree with you, we're going to have to be looking very closely at the ECI going as well as the labor force participation rate, because wages is that linchpin to the wage price file that they have not yet identified. They've seen a broadening inflation across more sectors than they thought. It was narrow at the beginning. It's now broadened, but we don't see wages yet contributing to the inflation. So it's going to be a part rate and a wage price story in the first half of next year.

Dan Krieter:
And I really think the fed will likely have to raise rates within the first six months of the year. And so to talk about our view, which our listeners know quite well, we've been advocating for spreads to be moving narrower in the first quarter of next year. Partly because of this, we expected a risk on reaction coming off of the December FMC. We have seasonal supportive technicals. We think that spreads are going to peak next year around the midpoint in the year. And I think that still holds true even after today's FOMC meeting, which comes off on the dovish side.

Dan Krieter:
I still think we're going to get a hike in the first six months. And I still think the market's going to be worried about that. And we're still going to have elevated inflation and more concerns around corporate earnings. It's going to send credit spreads wider. It's at that point then that we expect inflation to moderate. Also in at least in part, because of more hawkish fed policy. And spreads resume narrowing at that point as fed rate hikes are priced out. Did your view change substantially in any direction after today's fed meeting?

Dan Belton:
No, not really. Again, I think the announcement was really balanced. I mean, it's amazing that we sit here and say the fed messaged three hikes next year yet the statement was dovish.

Dan Krieter:
Yeah. You talk about a departure from pre-pandemic. That's quite the departure. I mean, I think that that wraps it up for the most part. I mean, any other odds and ends? He talked a bit about financial stability. I guess, the one takeaway there was, he did talk about money market reform, which was put forth formally by the SCC this week. This is the money market reform package we've been expecting that we think will effectively end prime funds.

Dan Krieter:
I do think that has been a significant cause for the widening in LIBOR [inaudible 00:18:27] spreads we've seen in the past two months. But past that, I didn't really take much away from the financial stability discussion. All seemed pretty in line with what we'd expect him saying,, what he has been saying in previous meetings. Did you have anything else you think was noteworthy, Dan?

Dan Belton:
I thought one thing that we haven't touched on yet was somewhat interesting. In the statement, there was a change with respect to the fed's dual mandate. In November they said that they would keep rates at zero until inflation has risen to 2% and is on track to moderately exceed 2% for some time. And in this meeting, they said that that part of the mandate has already been met and they're just waiting on the employment mandate.

Dan Belton:
Not shocking, but I think it's worth mentioning that now it really is, the inflation mandate has been met. They've allowed inflation to run hot, which they talked about doing for years. And now they're waiting on labor force conditions to be met. Not a big thing there, but I thought something worth mentioning. Other than that, I think we've covered it all.

Dan Krieter:
Yeah. So I mean, view pretty much intact here. We'll probably see a little bit of risk on here tomorrow and then it's probably going to be it for the rest of the year, I think for the most part. So will this certainly be our last podcast of the year. So just want to take a moment to thank you all, all of our listeners during 2021.

Dan Krieter:
We hope that you have found our conversations helpful. And we would like to reiterate that if there's ever a topic you'd like to hear us discussed, or even just want to talk to us directly, please feel free to reach out to us. We always love to engage with you guys. Otherwise, we just hope you have a very happy and safe holiday season, and we'll see you all in 2022.

Dan Belton:
Thanks for listening.

Dan Belton:
Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at Daniel.belton, B-E-L-T-O-N @bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our a team here at BMO, including a FICC Macro Strategy Group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:
This podcast has been repaired with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated and BMO Capital Markets Corporation together, BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services including without limitation, any commodities, securities, or other financial instruments.

Speaker 2:
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Speaker 2:
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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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