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Reactions to the June 2022 FOMC - High Quality Credit Spreads

FICC Podcasts June 15, 2022
FICC Podcasts June 15, 2022

 

Dan Krieter and Dan Belton discuss their takeaways from the Fed’s first 75bp rate hike since 1994. Topics include Chair Powell’s apparent change in tone around a soft landing, the commitment to fight headline rather than core inflation, and the likely cadence of upcoming Fed rate hikes.


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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 Spread to the week of June 15th, reactions to the FOMC. I'm your host, Dan Krieter here with Dan Belton, as we discuss our takeaways from the June Fed meeting just moments after the press conference concludes.

Dan Krieter:
Each week we offer a view on credit spreads, ranging from the highest quality sector such as agencies and 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 3:
The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Dan Krieter:
Well, Dan, certainly one of the more memorable fed meetings in our career, if not the actual meeting itself, at least the run up to the meeting with the Wall Street Journal article earlier this week, and rapid changing for expectations for what the Fed would do in terms of the headline rate. Obviously, we got the 75 increase the largest since 1994. I thought a lot to unpack with today's meeting and press conference. Why don't we start, as we always do, with the statement itself. We also did get the very exciting summary of economic projections this time. So let's start there, I guess. Anything that you want to note in the statement and/or the SEPs?

Dan Belton:
Yes, the statement I thought was pretty consensus. There was the omission of one line that said with the appropriate firming and the stance of policy the committee expects inflation to remain to its two percent objective and the labor market to remain strong. Some admission of some economic weakness there, at least projections of weakness in the labor market. And then the SEPs, I didn't think were that surprising, again, they came in pretty much in line with where the market was pricing. Although, for the first time I feel like we had some estimate of where the top in the Fed funds rate is going to be this cycle. And Powell talked about that a little bit more in the press conference, but the median dot for 2023 shows a policy range of 3.75 to 4 percent and then the FOMC projecting a cut in 2024. So the committee, I guess in some sense, saying that there's another nine quarter point hikes to go this cycle and the rest I guess comes down to how quickly we get there.

Dan Krieter:
Yes. You'll forgive me for not reading too much into the Fed's projections for how much they're going to raise rates given how effective and useful those have been so far in the last six months. But from the SEPs, I think the one thing that, I guess, stood out to me, if anything did, was the downgrade to GDP that was in the SEPs just, I guess, confirming what you mentioned in the statement, a nod to weakening expectations for GDP with the Fed so aggressively fighting inflation. But high level, I agree with you not much to look at in the SEPs of the statement, pretty much hitting expectations with the 75 basis point rate increase and really not much notable elsewhere.

Dan Krieter:
So I guess we can move on to focus on the press conference and the Q and A where I did think there was some more notable things. First, why don't we start with the way the market reacted to the press conference and the Q and A because looking at just equities, we see the intra day lows, essentially right as the press conference started, I think there wasn't a big drop following the statement slash SEP, but we did see a reduction in risk appetite there potentially reflecting what we just talked about with the Fed acknowledging more threats to growth, but quickly after the press conference started risk sentiment, obviously reversed, sending equities much higher.

Dan Krieter:
And I think the interpretation there has to be that market participants got a lot more bullish. Once chair Powell said that this rate hike of 75 basis points was not common and we should not expect that going forward.

Dan Belton:
Yeah, he did keep it on the table. He said that the July meeting will most likely at this point feature a 50 or 75 basis point rate hike. Whereas the market had been priced fully to 75 basis points at the next meeting. I don't think it matters too much incrementally, but the market did react to that statement about it not being common going forward again though, I think we're just sort of talking about timing here in terms of what meetings get 50 basis point hikes versus 25 or 75. I don't think it matters too much in the grand scheme of things, whether we get 75 or 50 in July.

Dan Krieter:
I'll agree with you there. And why don't we start the conversation here by talking about the credibility issue, because obviously coming into the FOMC today, credibility was going to be at the top of everyone's mind after chair Powell said at the main meeting that the committee was not actively considering 75 basis point rate hikes, to then raise rate 75 basis points today after leaking an article to the Wall Street Journal during blackout last month.

Dan Krieter:
Credibility was always going to be potentially the most important factor coming out of today's meeting. And so I'm interested in your thoughts on the credibility issue, because I look at the chairman saying this is not common. Look for 50,75, next time, now after July was fully priced for 75 heading into the meeting. Now, as you walk away from the desk, it's roughly 50-50 between a 75 basis point rate hike and a 50 basis point rate hike. I struggle with that a little bit. I mean, even during the Q and A, he refused to rule out a hundred basis points. So where are you on the credibility with the Fed now, given the events of this week and having now listened to Powell at the press conference?

Dan Belton:
Yeah, I think the Fed's in a tough spot right here. Clearly the data is very uncertain as it's coming in and he probably wishes he could walk back some of that language that he put out there after the May meeting, when he said that they weren't actively considering 75. And I think that's probably part or all of the reason that he didn't rule out a hundred basis points today because what do you really gain by ruling out certain policy decisions, unless you're really trying to employ some explicit forward guidance.

Dan Belton:
But I think it was interesting when he talked about what drove the committee to hike rates by 75 basis points. So it wasn't just that CPI print last Friday, it was also the university of Michigan long term inflation expectations number, the upside surprise there to 3.3% from 3%, he called that eye catching. So yeah, to the credibility issue, I don't know how much it really matters going forward. Again, I think we're seeing Powell's best forecast for what's going to happen in the meetings ahead. He probably wishes he could have some of that language back now, but according to him, he thought it was worth it to go today instead of wait six weeks given the data that came on Friday.

Dan Krieter:
Yeah. I actually thought the chair did a really admirable job at the top of the press conference, talking about the credibility issue and talking about why 75 versus 50. He's faced criticism before for not going too much and waiting too long. So the committee gets together and decides they need to move now after seeing the main inflation report. And so they move now. I mean, that makes sense. Clearly, yes, maybe they wish they weren't so strong at 50 basis points, but they're being nimble, which has been probably if I was going to use one word, that's been the Fed's key mantra in the past six months, nimbleness has been what they've been trying to stress. So that was put on display. I guess, where I'm getting hung up a bit is, why is 50 now 50% priced for July? If anything, 75 would seem to be more likely to me and who knows, it could be a hundred and we're going to get one more inflation pit between now and then, like the Fed has told us they're going to be nimble.

Dan Krieter:
They showed us today that they're going to be very nimble. And I guess to your point, if we're talking about 50 in July versus 75 and then 25 later, when does the exact timing, probably doesn't ultimately matter much except for short end participants who are trying to time that out. I guess I'm just looking at the risk on reaction in equities and in at least in IG CDX, if credit spreads don't appear to have tightened yet, but maybe we'll get back to the desk and that will be changed. Personally, I don't see the impetus to that risk on for me. I didn't think it came off overly dovish, but interested in your thoughts.

Dan Belton:
Yeah. So the way that I took it was basically just that we're not now on 75 basis points on autopilot until we get to some level where we're going to pause or declare that we are in restrictive enough territory and then we'd see the data unfold. I think what Powell tried to convey today was that 75 basis point hike was due to an especially strong upside surprise to inflation, to inflation expectations. And then maybe the default going forward is 50 or probably more accurately there isn't a default going forward, but it's not like we're on a 75, 75, 75 cadence at this point in the cycle, it's going to be data dependent. And that's probably something he should have stressed a little bit more after the May meeting when he made the market think that 50 was sort of a done deal for June. But in fact, it's just going to be data dependent. We'll see how inflation comes in and then take it from there.

Dan Krieter:
Yeah, it's interesting. Even the word credibility itself, I think the Fed probably gained it credibility as inflation fighters at today's meeting, looking at credibility on their forward guidance, maybe less so, but ultimately does that truly matter at this point. We know that they're going to be very hawkish as he talked about over the course of the Q and A, at some point, inflation is going to start to slow and ultimately drop. And it's at that point that we're going to begin considering slowing the pace of the hawkish turn or whatever that is. So for all of the conjecture around credibility from us and many others heading into today's meeting, I think that this was somewhat of a best case scenario. Would you agree with that?

Dan Belton:
Yeah. I think you made an interesting point about the Fed's credibility. You know, it's twofold, their credibility is inflation fighters versus following through with the guidance that they provide. And the Fed was just in a really tough spot today. They had to maintain credibility as inflation fighters. And I think they just chose that over sticking to the prior messaging that they gave. And I think Powell gave himself enough of an out at the May meeting where yeah, he did say that it was dependent on the incoming data and that 50 basis points was the base case, assuming that the data unfolded in line with their expectations. And then when it didn't, he said, okay, well we have enough cover to go 75. Even if a lot of market participants weren't really happy with it.

Dan Krieter:
So then let's walk away with this being a sort of a large takeaway from the beginning of the press conference, the Fed has credibility as inflation fighters. We know that they are going to be fighting inflation, at least in the near term until they see significant improvement on that front. So then I want to talk about what I thought was the most interesting question, the entire press conference, which was a question that came on, what type of inflation are you fighting? Particularly headline versus core, and I think he used the word, are you just chasing oil prices? This was huge for me because in my medium to long term view, I thought that the Fed would eventually start to stress the difference between core and headline, and how their tools aren't necessarily equipped to fight headlines.

Dan Krieter:
So if you started to see some of these rate hike projections proving too optimistic later this year, it would come from the Fed stressing more on core inflation. That's not at all how the chairman responded. He said, in terms of the law, we are tasked with fighting inflation, in terms of the law that's headline inflation. But the far more interesting answer for me came when he talked about inflation expectations, which was something he was focused on pretty strongly today.

Dan Krieter:
He made the interesting and accurate observation that consumer expectations for inflation aren't going to be based in core. They're going to be based in headline. And in fact, the price of food and oil is probably more determinant of inflation expectations than really anything else. So the Fed is going to be fighting headline inflation, which I think is an extremely important distinction coming out of the June meeting here since every indication is that headline CPI is going to be much more difficult to bring under control. Given one, just that the Fed doesn't necessarily influence that with its tools, but two, that oil prices in the ongoing war with Ukraine may stay very high for a very long time. So does this say to you that almost regardless of anything else, until we see significant improvement in headline inflation, the Fed is going to be in full on restrictive mode?

Dan Belton:
Yeah. I mean, it's hard to say, I don't know if I would go that far because I think Powell probably does recognize that he can only really control core inflation, but you made a great point that I was going to make as well, which is that yeah, oil prices and food prices to a lesser extent, have a greater bearing on inflation expectations than inflation itself.

Dan Belton:
There's many reasons for that oil prices are very visible at the pump and they're more volatile, but they have a bigger bearing on actual inflation. So that's some justification for why you should be fighting headline inflation, but he could have taken the route of saying that all we can really control his core inflation, but he kind of declined to do that. And that to me is a pretty hawkish move. Now, does he continue with this tact and if there is a serious divergence between core inflation, and energy prices, and food prices, is he going to continue to be on a really hawkish tilt? I don't know. I'm less convinced of that. I think if generally prices are pretty well contained, but there's a shock to energy prices, I don't know how hawkish the Fed is going to be in that scenario.

Dan Krieter:
Yeah. I put you in a bit of a tough spot making it a black and white question, potentially like the Fed, I regret that question, but seriously though, it was a hawkish interpretation for me, obviously there's gray area there, but this is just another step in the direction of the Fed being inflation fighters, outside of a serious divergency core and headline or a significant slowdown potentially I'll use the word recession here just because it communicates what I'm trying to convey. The Fed is going to remain focused on restrictive policy and bringing inflation down until they see significant improvement in headline. And I think that was a key distinction we got from today because I mean there's no other way to slice it, the economic numbers are deteriorating rather rapidly, even before today's FOMC meeting we got the retail sales numbers for May, which for lack of a better word were pretty dismal, and contributed to the Atlanta Fed's GDP now number projecting 0.0% GDP growth for the second quarter.

Dan Krieter:
So from that perspective, there is actually a risk that the U.S. is currently in a technical recession while the Fed is embarking on the most restrictive policy in many decades. Whether or not that's true is immaterial likely, the more important thing is the spirit I'm trying to convey here. The economic data is deteriorating rapidly and chairman Powell had to field numerous questions at the June meeting on whether not the economy would be able to withstand the impact of more restrictive Fed policy as he has dealt with at both of the last two meetings, at least I guess I'll kick it to you. What were your thoughts on his characterization?

Dan Belton:
We wrote about this in our daily publication today, when he was asked about the chances of soft landing after the March meeting, he conveyed a significant amount of economic optimism, and I thought he really sold the market on the optimism he had for the economy. He said the economy was in a place not only to be able to withstand the rate hikes the Fed would deliver, but it would flourish amidst those rate hikes. And today it was noticeably weaker. I thought he was asked point blank, do you still think we can get a soft landing? And he kind of just said, well, yeah, I do. I kind of stamered. And then he said, I'm going to stop short of handicapping that, I'll let you guys do that. But I think there's a chance that we can achieve a soft landing still.

Dan Belton:
So significantly, much less optimism as there probably should be. Right. We have the data already starting to turn over, the SEPs are projecting year end policy rates 150 base points higher than the FOMC thought just three months ago. And inflation data just continues to come in stubbornly high. So yeah, I think he's being more realistic about the odds. He's not trying to oversell the odds of a soft landing because frankly they're probably much more diminished than they were even three months ago.

Dan Krieter:
Yeah. I mean, he got the same question, probably three different ways. You talked about the soft landing one, maybe my favorite one was the first time he commented on it when the questioner asked, are you concerned it will require more than just some pain? And his response was, yeah, our objective really is to bring inflation down to 2% where the labor market remains strong. I think that what's becoming more clear, is that many factors we don't control are going to play a role on if that's possible or not, the war on Ukraine, et cetera, monetary policy doesn't affect those things. And he said it more than once, at least three times, he said, while talking about the odds of a soft landing, and I agree with you, he was certainly less optimistic on it than either of the previous two meetings, but he kept indicating factors outside of our control. What did you make of that? Because I guess I struggle with if we don't get a soft landing, it's not because of what we did. I don't know. Is there more nuance to it that I'm missing?

Dan Belton:
I actually just took that to be more of a reflection on what's happened over the past year or so. The war in Ukraine, which has really made their job a lot more difficult than it would've otherwise been with the shock to oil prices. That's all I took it as is just sort of, there have been things that the Fed didn't project that the Fed frankly couldn't have projected that have made the job much more difficult.

Dan Krieter:
Well, I'll certainly agree with the statement that their job is very difficult. I don't envy the position that the FOMC and frankly, global central banks, we saw the emergency meeting from the ECB this morning. They're in a very, very tough spot right now. But bottom line in here with each meeting, the chairman himself is growing decreasingly, optimistic on the path of the economy. And it seems like a discussion over recession is quickly transitioning from an if to a when proposition. And so to put this in the context of credit spreads, we are not far off, we're single digits off of year to date highs with the index trading and the vicinity of 145 basis points right now. What's your view on credit here? I mean, is it worth trying to take a stab? We've given all the uncertainty going on here. I mean, sure rates are higher, but I almost want to play a mini game of making the case. I'm trying to come up with an argument for why now would be a good time to look at credit spreads and I'm coming up with very little.

Dan Belton:
Yeah. I mean, we were advocating for range-bound credit spreads for much of the second and early part of the third quarter. And I think it's time that we kind of come off of that view. I mean, just given the balance of risks, the things that the Fed is looking at today, are really a microcosm of just all of the threats facing the economy. I don't see a great case for credit spreads moving anywhere but wider in terms of a target. I do think 155 to 160 basis points, so not a significant amount of widening, but I do think in the near to medium term, we're going to just drift wider. Slightly wide of long term averages. And then I think the credit spreads are going to take their next queue from how the economic data and Fed policy unfold. And it's going to really become a question of how bad do things in the economy get.

Dan Krieter:
Yeah, I think I'd probably take the over there, Dan, even just looking at the relative value proposition of credit now it's once again, into terrible territory after the violent move higher in rates we had in treasuries since last Friday. Even at 145 basis points, we're down to a yield enhancement of in the low 40% range, which is near the bottoms of the last 20 years. So even just from a yield enhancement spread, you're getting over Treasury's perspective, it's pretty bad, but then you layer on the ever increasingly odds of recession, the potential for higher interest service costs for corporations, the impact on balance sheet, the potential for a true downgrade default cycle like we haven't seen in arguably since the financial crisis. I think that there's still a lot more repriced than it needs to go to accurately reflect the risk that corporate market investors are facing here.

Dan Krieter:
So I'm with you on, we were neutral on spreads, looking at a range-bound Q2 environment. That's more or less come to pass, but I think at this point, an underweight on credit has to be maintained until like Powell said today, many times, until we start to see inflation improving and allowing the Fed to potentially take their foot off the brake pedal and hopefully guide this to a soft landing. But until we start to see that, I don't see how credit is an attractive proposition at this point. I'm looking over my notes here Dan, do you have anything else from the Q and A or the press conference that we didn't touch on so far?

Dan Belton:
No. I think that pretty much covers all that I have.

Dan Krieter:
All right. Well then just a quick programming note for anyone who does listen to our podcast with regularity, obviously we've just had a pretty long hiatus. This is our first episode in six weeks. That is not going to be the case going forward. Mr. Belton here was out with paternity leave, congratulations again to him. And then we had a vacation in business travel back. So it's been a while since our last podcast, but we are back today and we will once again, be returning to our once a week cadence going forward. So apologies if anyone noticed the long layoff and it's just a one time thing and we'll be back next week. As always, please let us know if you have any thoughts or reactions to today's episode. We'd love to hear your thoughts on this afternoon's Fed meeting, certainly very interesting one at very interesting times at financial markets in 2022. Thanks for listening.

Dan Belton:
Thanks for listening to Macro Horizons, please visit us at BMOcm.com/macro horizons. 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 dot 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 a thick macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:
This podcast has been repaired with the assistance of employees, of Bank of Montreal, BMO NBE Burned 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. It does not constitute a recommendation or a suggestion that any investment for strategy referenced herein may be suitable for you.

Speaker 3:
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Speaker 3:
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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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