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Reactions to the July 2022 FOMC - High Quality Credit Spreads

FICC Podcasts July 27, 2022
FICC Podcasts July 27, 2022

 

Dan Krieter and Dan Belton discuss their reactions to the July FOMC meeting including the risk-on response and Chair Powell’s suggestion that the Fed would offer less clear guidance going forward. Other topics include the implications for credit and what might drive spreads in the near-term.


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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 July 27th. Reaction to the FOMC. I'm your host, Dan Krieter here with Dan Belton, as we bring you our main takeaways from the July FOMC meeting.

Dan Krieter:
Each week, we offer our view on credit spreads, ranging from the highest quality sectors, such as agencies and SSA's, 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 [inaudible 00:00:32]. 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.

Dan Krieter:
Well, Dan, recording now immediately following the conclusion of Chair Powell's press conference, and obviously the high level theme to talk about is the strong risk on reaction to the FOMC today. Equities much higher since the press conference began, credit spreads as much as four basis points lower, I think as measured by CDX when I walked away from the desk. So clearly risk sentiment liked the FOMC. Are they justified in that takeaway?

Dan Belton:
Yeah, I didn't take today's meeting as overly dovish. I think you could make an argument that this was something of a relief rally. Certainly the markets liked Powell's notion of taking it meeting by meeting from here, as opposed to offering more clear guidance as they have in the past. And I think there's a couple different interpretations you could have there. One, you could argue that they were planning on moving expeditiously to neutral. And now that they're there, there's less reason for clear guidance and that's the reasoning that Powell offered. I was expecting them to offer less guidance at this meeting, partly because the recent guidance that they've offered failed. They had to publish that Wall Street Journal article ahead of last month's meeting. And just with the data coming in so wildly unpredictably, and inflation continuing to surprise to the upside, that offers less reason for the Fed to really message what they're going to do when they don't necessarily know what they're going to do.

Dan Belton:
Plus we have two CPI reports coming before the September meeting. So that's another reason to expect that the Fed isn't going to offer strong guidance in terms of what they're going to do at the meeting that's eight weeks away.

Dan Krieter:
Yeah, I definitely think the Fed has learned its lesson on trying to provide forward guidance in such an uncertain environment. Like you said, going meeting by meeting. I mean, I really think there were two main drivers of the risk on tone, I read it as a bit more dovish than you it seems. I mean, I think high level, it was mostly a neutral FOMC, but if anything, on the dovish side. And for two reasons. The first you alluded to earlier, when you talked about the Fed is at neutral. Chair Powell basically said as much. Twice, he alluded to now being at neutral. Now going forward they're going meeting by meeting as opposed to what they were doing prior to neutral. So with the Fed now viewing itself at neutral policy, any rate hikes from here obviously would be moving further and further into restrictive territory, which is something I think this Fed is a little bit hesitant to do.

Dan Krieter:
But the main driver of the dovish takeaway, I think was obviously just one line from the prepared remarks actually before the Q and A began, where Powell said that as monetary policy tightens further, it would become appropriate to slow the pace of rate increases while we assess how cumulative policy adjustments are affecting the economy and inflation. So, I mean, there you have it in one sentence, the Fed telling us that they're going to be slowing the pace of rate hikes soon, if not at September. I mean, the Chair did say that an unusually large rate hike, which I guess translates to 75 basis points, may be required at the September meeting. Once we see the evolution of the data. But even if we get 75 at September, it does seem that the pace of rate hikes is going to slow here at the next couple meetings.

Dan Belton:
Yeah. I mean, I think I took that as largely a given. If we have another 75 basis point move in September, that gets us to 3 to 325. What are we going to do, go to 4 in November? I think this has always been sort of part of the Fed's plan, where they get to neutral as quickly as possible, and then they're going to move into what he called moderately restrictive territory. And when asked to put a number on that, he said, well, the June SEP's say that's around 3 to 3.5, and that's their year end target I think he implied. And so that didn't strike me as much of a change from what I was expecting before. That always stood out to me as the plan, the market took it as dovish, no question.

Dan Belton:
And I agree, it probably did skew a little bit dovish, if anything. I'm with you. It was probably more neutral than that, but the market did take, I think it was around 8 or 9 basis points off of the year and implied Fed funds rate from around 339, I think, to around 330 just before we walked into this room. So yeah, not a huge change there, but like I said, I think it's mostly a relief rally. The unknown event risk is behind us, now the market can focus on earnings.

Dan Krieter:
Yeah. I was just going to say your characterization of relief rally is probably right. And I look at it like this, the FOMC meetings themselves now, I mean, they're always going to be tradable events, but there may be not the most important things now. Because the Fed has told us, and this is to a greater degree than the Fed has been in the past, that they're going to be data dependent, that's always true. But now it's going to be the actual data releases that are going to be the market moving events. And we're going to take the data alongside the Fed. And if we see inflation running high, we already know what the Fed's going to do and vice versa. So the actual FOMC days, unlike years past, may not actually be the market moving events now. It's going to be the economic data. I mean, we'll wait and see. I think at this point, a larger neutral meeting, like we've only got today, has increasingly been met with risk on reactions from risk assets.

Dan Krieter:
I think in each of the last three or four meetings we've seen equities higher and credit spreads lower on the day of the FOMC when they really maybe didn't deliver anything unexpected, just not being more hawkish than people might have feared.

Dan Belton:
And what's interesting is we've also seen that risk sentiment reverse in the couple days following the FOMC meeting. So that's something to watch out for here, who knows where risk assets will open tomorrow. But the pattern recently has been for credit spreads to move wider, equities to move lower in the days following one of these FOMC meetings, at least since the November meeting when the Fed really started to pivot in earnest and started to taper in November, then removed accommodation increasingly quickly at each meeting since then.

Dan Belton:
And I think the price action itself becomes a lot more interesting when Powell talked a lot today about how their goal is to tighten financial conditions. And when you see risk assets respond so favorably to the FOMC meetings, it can undermine what the Fed's trying to do. Equities are up 10% now from their lows at the last FOMC meeting. And I'm curious if that might entice the Fed to maybe talk down markets in between now and the September FOMC meeting, just seeing the tightening in financial conditions that's been going on most of this year, start to reverse a little bit over the past month or so.

Dan Krieter:
I understand your point. I don't necessarily agree with it. I mean, I think it's in line with what the Fed's trying to achieve, a soft landing. I mean, clearly financial conditions have tightened a lot. The Fed doesn't obviously want to drive the economy into recession, or particularly a bad recession. So I think outside of a massive comeback when equities or a big easing in financial conditions, as long as things sort of stay the way they are, I think the Fed is okay with where we're at, as we just wait for more data. I don't think that the Fed is in any way displeased by higher equities. I think that's probably something they're cheering for.

Dan Belton:
Oh, I disagree. We'll see.

Dan Krieter:
Okay. We'll see. Well, and we can just go I guess through the whole FOMC piece by piece. I mean nothing in the statement... They did put a nod to the slowing economy in the top line of the statement. Did you read anything into that worth talking about?

Dan Belton:
I think that was one of the question marks heading into today, to what extent would they acknowledge the slow down and growth. I didn't find it surprising, that was in my base case. But nonetheless, worth mentioning the Fed said that spending and production are softer, but job gains remain robust. And Powell talked a little bit more about the labor market, obviously. One thing that he said in the press conference that I found interesting was he talked about how the recent increase in initial jobless claims could be more of just a seasonal glitch. And I think he even said that he doesn't view them as real.

Dan Krieter:
Yeah. He said, we're not sure they're real or not yet. I definitely made a note of that too, but I really don't know what to make of it. I mean, yes, jobless claims are moving higher, but on the long term chart, they're still by no means elevated. I guess that's something to watch to see the way that unfolds. I'd be lying if I said understood the seasonal adjustment that goes into a weekly data series like initial jobless claims. Perhaps if we start to see a bigger deviation where jobless claims continues to move much and much higher, we can look into that. But definitely notable there that the Chair said that he's not sure it's real. And I think it does have an impact on the way the Fed is viewing the economy. If they're not convinced that this increase in jobless claims is real, obviously they haven't seen the tightening in the labor market that they want to see yet, which I guess could be a moderately [inaudible 00:08:54] signal. I don't think one that we're going to read too much into in the near term.

Dan Belton:
Yeah, I agree. And this goes back to the point about financial conditions that I was trying to make. I don't think their goal is to see some slack in the labor market directly, as much as it is to see some amount of demand wain, and some amount of tightness in broader economic conditions.

Dan Krieter:
Interesting. Because again, we disagree here. And maybe we're splitting hairs, but I thought at the press conference today, Powell was explicitly stating that they wanted to see the labor market cool a bit. And that they had started to see some slowing in the demand for labor. They had started to see some potential increase in initial job scams that we talked about. And it wasn't discussing like it was a bad thing. I think looking at a slowing labor market as a necessary byproduct of the fight against inflation, I think they... Again, it's all depends on magnitude. I mean obviously a large enough increase in unemployment rate would be not something the Fed wants, but I think it's safe to say at this point that a modest increase in unemployment is something the Fed is actively trying to achieve at this point.

Dan Belton:
Yeah. Well I think the Fed is primarily right now concerned about fighting inflation. I think they're going to do that effectively at all costs right now. And the slack in the labor market is going to come as a byproduct of that. I don't think they're looking for that slack to necessarily emerge right now. I don't think they're hoping for that to happen, but I think that's a fore gone conclusion.

Dan Krieter:
I see what you're saying. I think we're basically saying the same thing two different ways. So let's move on from that. Yeah, looking at my notes over the rest of the Q and A, I really don't have much that I thought was overly noteworthy. I mean so many questions about recession. Shockingly, the Chair does not currently believe the US is in recession. Still hoping for a soft landing, again, acknowledging the challenge to that and that the challenge has increased in recent months. But obviously the goal is still a soft landing. He mentioned that multiple times. We fielded a question here, two questions actually, on what the Fed would do if headline starts to come down because of falling commodity prices, but we see core continuing to increase. What was your takeaway from that? If any.

Dan Belton:
It seemed like it was a little bit inconsistent with what he said in June. Probably not broadly inconsistent. I might be missing some of the details. But he did mention that their mandate is headline inflation, but core inflation is more indicative of real underlying inflation, probably more predictive, he might have said. And so there's some of a distinction there that he drew, but in June he definitely said that what they're looking to fight is headline inflation.

Dan Krieter:
Yeah. And it was just interesting because he talked about that a few months ago because we were all concerned about what would happen if headline stays high and core slows down. So now it's the inverse. I think you made the point that matters. The Fed told us they're targeting headline inflation. Will certainly be watching core inflation because of its predictive powers. But it's headline inflation that came straight from the Fed. One some interesting question the Chair fielded was on the risk of not doing enough versus the risk of doing too much. Does the risk of not doing enough to fight inflation still outweigh the risk that you're going to go too far? Now he equivocated here and we're going to do just the right amount. So then as Goldilocks answer there.

Dan Krieter:
But as he went to explain it a bit further, he did insinuate pretty heavily that the risk of not doing enough still did outweigh the risk of going too far. Just going back to the same mantra of being inflation fighters, that in the long term, bringing inflation down is necessary to have a strong labor market and a strong economy overall. You can't let inflation get embedded. So, I took that answer as, yes, but he didn't quite give us as direct an answer there.

Dan Belton:
Yeah. And I think the memory of the 1970's Fed is pretty apparent there, where the Fed was kind of playing with the trade off between inflation and growth and they were hiking and then cutting and then hiking again. And ultimately the problem of inflation was never really resolved until Paul Volker took over as Fed Chair. And I think that's probably something that Powell's thought a lot about and something that he's trying to avoid here. And so that's really underlying the Fed's mantra of really a single mandate Fed effectively right now until inflation comes down.

Dan Belton:
I also took a lot of notes around the focus with which Powell talked about the pain that inflation brings. And that's not something that I was surprised by, but just to hear him over and over talk about how price stability is what makes the whole economy work, and things like that, which really underpin why inflation is such a priority for the Fed. And even if there is a growth slowdown, the Fed's not going to pivot here until inflation comes under control. And that just goes to that point about the risk of doing too little and pivoting too early is something the Fed's going to avoid.

Dan Krieter:
Otherwise, things slowing appropriately. He harped on that a few times. We got a question on NAIRU, that NAIRU is now higher than it used to be. That probably is in line with expectations. We did get a question on balance sheet normalization and then a following question on taper tantrum, I guess the two are at least quasi related. First we can talk about the balance sheet normalization because there not much here I'm sure. Powell basically just said that quantitative tightening was on track, that we're still 2 to 2.5 years away from model estimates of the minimum level of reserves, that certainly falls in line with R and street expectations that the level of reserves is still well above any type of scarcity level.

Dan Krieter:
He mentioned that the markets have adjusted well. And I guess that feeds into the taper tantrum question, which is something they were trying to avoid. He used the words tapered up, which was a weird way of thinking about the quantitative tightening. But yeah, I mean, nothing really there other than it's ongoing and we haven't seen any type of market disruption yet, which I think in and of itself is probably something the Fed should be encouraged by.

Dan Belton:
Yeah, absolutely. And I thought it was interesting that he did give the 2 to 2.5 year guidance. I don't know if we've heard that from Powell, at least maybe not after an FOMC meeting. So I took that as somewhat interesting. And it's consistent with what we've been expecting in terms of the timing.

Dan Krieter:
No, for sure. It's a good point. I don't think we've had Chair Powell actually give a timeline. It's nice to see that his timeline falls in line with ours. But I guess lastly, he got one question on financial stability towards the end, which I think is always worth talking about. Because if we do go to recession, obviously financial stability is going to be an extremely important indicator of whether or not that recession will be of the "garden variety" or if we get something more severe. And he said that we're in a good spot. Asset values are down. Banks will capitalize. Households are as strong as they've ever been. I don't necessarily disagree with any of those assessments. So, [inaudible 00:15:04] single level of corporate leverage as a whole is somewhat elevated compared to history, but it's definitely been coming down and it appears that both households and businesses alike, and the financial sector, are prepared to weather an economic downturn should we get one.

Dan Belton:
Yeah, that was definitely a takeaway. I don't think that's dovish or hawkish. I just think it's probably encouraging about the state of the economy and the state of the financial system that, like you said, everything that he mentioned looks to be at least in line with historicals or pretty constructive.

Dan Krieter:
But it's at least worth noting that he gets that same question every press conference or every other press conference. And he has at times in recent months talked about corporate leverage as being slightly uncomfortably high. He'd say something like, okay, corporate leverage looks a little elevated, but overall it looks okay. He didn't even say that this time. He just said that things are looking good. So I think that's in line with de-leveraging we've seen, the Fed has obviously seen it as well. And the Chair feels that we're in a strong position from a financial stability perspective there.

Dan Belton:
And he's also talked about asset values being a little bit elevated in the past. Earlier this year he mentioned that a few times.

Dan Krieter:
Yeah. So this all falls in line with, as the Chair said, things are moving along appropriately. One final note, he got a question about tomorrow's GDP print. And if that would, in any way, change his opinion of whether or not we're in recession or stance on monetary policy or anything like that. And he basically said to not pay attention to tomorrow's GDP print, even talking about how first look GDP numbers are often revised and can be revised pretty substantially. So I don't know if that's any type of foreshadowing, but clearly it's nothing that the Fed is going to be too worried about. So on the FOMC, that's really all I had written down unless you have anything else that you think merit's talking about?

Dan Belton:
One thing we've been tracking with recent FOMC's is Powell's characterization of the likelihood of achieving a soft landing. And he did say today that the path has clearly narrowed to avoiding a recession. He said, there's still a path to achieving a soft landing, but he did say it's narrowed. So something to keep in mind there. Obviously as inflation continues to come in higher than expected, he talked a lot about how the June number was a disappointment to the Fed, that just narrows the path to a soft landing.

Dan Krieter:
Yeah. He said that for the past few meetings now that it's outside of their control and that it's getting more challenging. So only time will tell. But I think for the July FOMC meeting, pretty in line with expectations and a risk on response that I think should have legs. I mean, I guess before we wrap up here, now with the July FOMC in the rear view mirror, what's your view on credit from here? Obviously things have bounced back. We're still at pretty elevated level historically. What's going to drive spreads in the next couple weeks? And what's your take on the market now?

Dan Belton:
Yeah. I'm looking at earnings right now. I've actually been thinking that earnings this week are probably even more important to the near term path of credit spreads, then the Fed in today's meeting really reinforces that expectation. I think that we could still see some weakness in the near term with credit spreads. Another thing to watch is the technicals. They've been pretty bad for most of the second quarter, but getting a little bit better over the month of July. And it'll be interesting to see if this risk on tone. Now we've started to see some durability in the risk asset rally now over the last month or so, start to see if that entices some borrowers to come back into primary markets and invigorate some demand from investors. I mean, we've had a fairly heavy July in terms of issuance, but it's been really concentrated among the large US banks and a couple jumbo deals. So it'll be interesting to see what happens in primary markets going forward.

Dan Krieter:
Yeah, I agree with you. It does feel like primary markets are in a much better spot, but that's coming off of what we were talking about in podcasts in previous weeks is, arguably the worst technicals in the history of the market. So we've gone from the market was basically closed for periods of June. To now, okay, the markets are open, capital is flowing again, but concessions still remain in the double digits, which is quite elevated historically. And we've seen that lack of issuance in borrowing patterns, I mean you talked about the heavy financial supply but if you look at non-financial, we've seen the lowest amount of non-financial supply in the IG space since 2016, at least, this year. Only very, very heavy financial supply is keeping IG supply in line with recent years. And we have seen an increased reliance on commercial paper funding.

Dan Krieter:
Non-financial CP outstanding, the Fed's data series is up to the tune of 60 billion this year. So market volatility and challenging primary markets have clearly enticed some borrowers to look at short term funding as a way to get money raised. Does that imply to you that we might have a backlog that we could see CP come down if market conditions are more attractive? Or do you think that CP has just been an attractive way to get some money done with overwhelming demand at the front end of the curve and that light issuance patterns thus far could be sustained?

Dan Belton:
Yeah, it's probably a little bit of both. I think as long as concessions remain elevated broadly, which I think is probably going to be the case, at least into the medium term, CP might be more attractive for a lot of borrowers. So is there a backlog there? Maybe over the longer run once primary market conditions really improve, that could entice some borrowers. But I don't expect to see second half supply really rebound at this point.

Dan Krieter:
Yeah. I agree with you, but we'll see. I mean, there's a lot of uncertainty right now with where inflation data's going to come in, how earnings are going to unfold. That's been a very mixed bag. We had very disappointing results from retailers and very strong results from tech companies. A lot of mixed signals here. And so there's going to be a lot we're going to learn in the next couple weeks, which could certainly favor the bold who take a step in here. And if we see risk sentiment improve, we've said in recent episodes that we think from a long term perspective, current spreads are going to be attractive. The question is, have they peaked yet? I don't have a good answer. My gut says no, but I'm becoming increasingly open to the idea that I'm not right in that assessment.

Dan Belton:
Yeah, I agree. I think you could make an argument here that spreads are near fair value in that we could have seen the worst already.

Dan Krieter:
Time will tell. Well, I think that wraps up today's episode. One final plea to our audience out there, especially if you've listened all the way to the end, the institutional investor fixed income survey, this is the last week that it's open. If you find these Fed episodes helpful or any of our work really, please consider supporting us. It is very meaningful to us and we greatly appreciate any support. Otherwise, we'll be back here in two weeks. Next week, we have a macro monthly edition with the full team, which puts us off our schedule. So we'll be back in two weeks. So everyone have a fantastic two weeks and we'll see you in August.

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 team here at BMO, including the FICC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:
The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries. This podcast has been prepared 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. We are not soliciting any specific action based on this podcast. It is for the general information of our clients.

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

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