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Reactions to the March 2022 FOMC - High Quality Credit Spreads

FICC Podcasts March 17, 2022
FICC Podcasts March 17, 2022

 

Dan Krieter and Dan Belton discuss their reactions to the latest FOMC meeting including the strong rally in risk assets after the market priced a more aggressive path of rate hikes and several yield curve tenors inverted. Other topics include Chair Powell’s optimism on the economy, surprises from the SEPs, and balance sheet normalization.


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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 March 16th, reactions to the FOMC. I'm your host, Dan Krieter, here with Dan Belton, as we discuss today's Fed meeting that began the much anticipated rate hiking cycle as well as the market's reaction to it.

Dan Krieter:
Each week, we offer our view credit spreads ranging from the highest quality sectors such as agencies and SSAs to investment grade corporates. We also focus on U.S. 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:
Well, Dan, heading into the FOMC meeting today, we had a pretty strong risk on tone in the market. Equities were higher. Long-term yield were higher, and now with the meeting and Q and A now over, those two things hold true. So just looking at that, you'd expect that today's Fed meeting mostly met expectations, and we really didn't see much reaction in markets. However, we of course know that wasn't true. We saw a surprising round trip with equities falling into the red right after the statement, and then rallying all the way back. We saw yield curves inverting, and then giving that move back and so on and so forth. So I guess before diving into the meeting and the press conference as a whole, let's try to make some sense of how the market reacted here. What's your read?

Dan Belton:
Certainly surprising reaction. We saw risk assets fall right after the release of the statement. Most likely that was attributable to the dot plot, the median FOMC member projecting seven rate hikes in 2022. That's more than the five or six that I think most in the market were expecting, and that corresponds to one each meeting for the rest of the year.

Dan Belton:
So equities fell a little bit red giving back some of the overnight optimism that was generated from some overseas headlines, but then I think the strength that we saw when Chair Powell started talking was mostly due to the optimism he had about the economy. He said many times that the economy was strong by all indications. It's a lot more optimistic than I think you and I have been on the economy, at least in recent weeks, and he mentioned several times that the economy was well positioned to handle the rate hikes that the Fed was likely to deliver this year and into next year. And so as we record this just after the conclusion of the press conference, we have equities near session highs and CDX at session tights. Despite what I thought were some fairly hawkish statements by the Fed chair and from the statement and the SEPs.

Dan Krieter:
So let me put it to you this way, which surprised you more, the initial risk off move from the statement or the ensuing recovery?

Dan Belton:
I actually read the statement and the SEPs is pretty hawkish. Like I said, the seven rate hikes in 2022, 3.5 In 2023. That was pretty hawkish to me. And also from the SEPs, a couple things that stood out to me, we had PCE inflation up to 4.3% for 2022, that was up from 2.6%. Similar upward revision to 2023 PCE inflation, so I understand the reasons for the initial risk off tone after the statement. I was more surprised that Chair Powell's optimism really resonated with the market.

Dan Krieter:
Yeah, I have to say both really surprised me. I mean, I think the statement and the SEPs, they were hawkish, I think we were expecting them to be hawkish, so the magnitude of the risk off was surprising to me. I get it. They had seven rate hikes in the dot plot instead of five or six, but I don't know. And I'm on record as not being the biggest fan of the SEP, but I don't know how that is such a game changer that we saw the moves we did following the statement, but at least I can understand it. The recovery you've seen over the press conference is more difficult for me to understand. I hear what you're saying about the optimism and Powell really reinforcing the strength of the labor market and saying that the labor market and the economy more broadly has the strength to withstand tighter monetary policy.

Dan Krieter:
I get that, but a large part of me says, "What else is he going to say?" You know, we're going to raise rates, and it's going to break the economy? He really doesn't have many choice. I mean, you can talk about how strong the labor market is and how strong the economy is, but the truth is there are some reasons to be concerned here, the leading economic indicators showing some degree of softening, certainly not sounding the alarm by any stretch of the imagination, but to really just keep harping on it, how strong everything is, it was almost wishful thinking to me. And maybe I'm being a bit strong with that, I'm just saying that he's not going to say anything else. So I have a hard time understanding why the market then suddenly completely retraces the risk off we saw after the statement, is suddenly back in risk on mode. I have a hard time believing that's because the Chair of the FOMC was positive on the economy.

Dan Belton:
Yeah. I thought the same thing. I think for Chair Powell, to say that the economy was strong by all indications, that seems a little aggressive for me just given where some of the recent data have come in. In University of Michigan, consumer sentiment at its lowest since 2011. There's certainly indications of economic weakness. The impact of oil prices are certain to continue to eat into consumption.

Dan Belton:
So yeah, the optimism, I think not surprising, and we generally see the Fed Chair being more optimistic on the economy than most market participants are, and that's just due to the fact that sentiment has on the real economy and how if the Fed Chair were to be very pessimistic that could actually do some real economic damage, at least according to economic theory. I want to go back to the dot plot for a minute, and you and I disagree on the dot plot. I don't think it's necessarily the most useful tool for gauging the path of policy, but don't you think it's interesting that we had Chair Powell write down his expectation for how many great hikes they're going to be this year? Like if we assume that he and the other members of the board are generally near the median, don't you think it's somewhat informative that they're saying that they're going to hike at every single meeting this year?

Dan Krieter:
Yeah, no, I get it from that standpoint. To me, the SEP represents a snapshot of what the committee's thinking right now, and they can say these are meeting projections, we don't plan these out, this is just the way things shake out, but it's just, look at where the dots were in December. I mean, we're essentially saying with the March SEP that if we had read into the December SEP that interpretation was utterly worthless. Like it has no bearing, and who's to say that come time for the June SEP release that the March one won't look similarly worthless. You get these questions in the Q and A like, "Well, how do you square 3.5% unemployment with policy rate being above neutral by the end of 2023?" And the answer the Fed gives on that is, "Well, they don't really mean that. That's not what they really mean." So if they're not informative, why do we react so strongly to them?

Dan Belton:
So I agree with your second point. I think trying to marry different projections and see what that implies for the economy, I think that can be silly pretty quickly. But to your point about the dots from December being stale, well they were both in line with market pricing. The rate hikes from 2022 in December were in line with the market pricing at that time. Rate hikes today from the SEPs were in line with market pricing. So yes, they were stale, but it's still in line with market pricing, and from that standpoint, I think you can view it as a sort of reinforcement of market pricing that, yeah the market's not really off base with where Powell and the Fed think that policy's going to go.

Dan Krieter:
Sure. But then I don't see the utility to it. What's the point of it, if you're going to have it just says what the market is pricing? I don't know. Maybe we don't need to spend too much time on it here. I'm just saying that to me, the most hawkish outcome that came out of the entire meeting today, the statement, the SEP, and the press conference, the most hawkish thing to me was Powell revealing that May is on the table for balance sheet normalization.

Dan Krieter:
And now probably appears to be the base case, particularly if we get some settling in financial conditions or any prospect of a resolution in Russia, Ukraine. Them pulling forward QT to May, to me seems a lot more hawkish than them adding one or two more dots than we were expecting in the SEP which we know not to be informative, but we saw risk sentiment drop sharply in response to the seventh SEP dot and inflation projections and all of it. But then when the Chair reveals that we're probably going to start letting the portfolio run down, starting in May, and now the market's railing. Like I have a hard time squaring that.

Dan Belton:
Yeah. I also think that the discussion about quantitative tightening was the most important thing that came out of the press conference. So broadly, I am surprised by the strength in risk assets stirring the press conference. And I think we should spend a little bit of time on that. I think that was a really interesting question he got, and you could tell he was waiting for that question. He thanked the questioner for the question, and he really had some prepared remarks it seemed like. He talked about how they're going to use the same framework as they used before, so we are going to get the same cap structure that we saw back in the 2017 to 2019 episode of balance sheet normalization, and then he previewed that there'll be a lot more to come in the minutes. So I imagine we'll get some discussion about what this range of caps might be in the minutes that are released on April 6th, but he did preview today that it's going to be much faster than it was last time.

Dan Krieter:
Yeah. I don't think that the pace of rundown being faster represents a surprise and ultimately, moving it forward a month or two, that's not going to have a huge impact in the long run, but it just goes further to speak to the Fed significant turn hawkish here. And he talks about every meeting is live, we're going to have seven hikes this year, according to the SEP, and depending on how you do the math, Chair Powell says the balance sheet runoff is worth another hike.

Dan Krieter:
So technically like eight hikes this year and harping numerous times on the fact that if the incoming data tells us we need to move faster, we will. He kind of dodged any question on what's the bar for a 50 bp hike, that's not surprising, but he certainly left the option on the table. And even looking at the potential for an inter-meeting hike, which he didn't get a question on that or anything, but you look at the statement, the statement said that the committee would be prepared to adjust the stance of monetary policy as appropriate if risk emerged that would impede the attainment of the committee's goals. Does that potentially imply to you that the Fed would be open to hiking between meetings, particularly if some resolution on the geopolitical front?

Dan Belton:
That's interesting. I didn't pick that up from the statement. It sounds like that, but that would really surprise me. An inter-meeting hike would be not something I'm expecting especially given that we're now in the midst of a measured hiking cycle where the Fed is slated to go basically at every meeting. I would think the bar to do an inter-meeting hike would be extremely high, much higher than the bar to do a 50 basis point hike at an upcoming meeting. So I wouldn't expect that, but that's interesting. I didn't really pick that up from today's statement.

Dan Krieter:
I mean all it really captures is what everyone's talking about right now is the Fed is firmly an inflation fighting mode right now and has even gone so far as to say that, not in so many words, but imply that if it comes down to now a choice between taking action to restore price stability or to ensure full employment, they're going to firmly fall on the side of restoring price stability saying that the best thing we can do to support a strong labor market is to promote long expansion, and that is only possible in an environment of price stability. So the Feds already told us, we've seen and stagflationary fears, a lot more chatter around stagflation recently. The Feds already told us what they're going to do if we get stagflation, they're going to continue to fight inflation. So the Feds going to stay very, very hawkish. We know that. And so, a risk off type of reaction yield curves flattening seems to be the appropriate response to me. So is this most recent reaction with the full retracement, is that an opportunity to just fade that move?

Dan Belton:
I think it just depends on the big picture, where you think market pricing should be. Because I agree, I don't think we learned a ton today. We saw a couple weeks ago when Powell was testifying in front of Congress. He was asked point blank, are you willing to do all that you can to get inflation under control? And he responded unequivocally, yes. I thought it was actually, he could have gone a little bit further today when he was asked by a reporter from Bloomberg, who called it the Volker question, I think he kind of gave Powell the opportunity to go a little bit further in his commitment to fighting inflation at the expense of growth, and Powell didn't really take that. He just said, "It's not going to come down to that dichotomy. We can hike rates while supporting a strong labor market. It's not going to break the economy."

Dan Belton:
Now whether that's justified or not, time will tell. Again, I think he had more optimism about the strength of the economy than a lot of market participants do, but I think he could have gone a little bit further in that stagflation hypothetical, and he didn't really bite on that.

Dan Krieter:
Let's transition to talking about the press conference and Q and A in a more broad sense now, because first and foremost, I didn't find the Q and A to be overly compelling today. It was a lot of variations of the same question asking how the economy will stand rate hikes? How far behind the curve with inflation are you? In hindsight, would you have raised earlier? A lot of the same themes, just talking about inflation, what will ultimately come down wind do you expect, and stuff like that.

Dan Krieter:
But I guess high level, the main impression I walk away with today was that Powell had two goals, and you could see him going back to them multiple times throughout the press conference. The first was to present a very strong place on inflation and talking about they're acutely aware of the need for price stability. He sees a committee strongly committed to that. And second to be somewhat of a cheerleader for the labor market and for the ability of the market to withstand rate hikes.

Dan Krieter:
And I'm looking at my notes here and looking at specific questions. I don't really see many that really jump out at me, but I guess maybe where we can go next is looking at the labor market in particular. He talked about how strong the labor market was. 1.7 jobs open per unemployed worker. I mean, that applies of course, that the unemployment rate could drop to 0%, and we would still be in a labor shortage. When looking at it through that lens, certainly that would imply that the labor market will withstand rate hikes. But what does that really mean when you have 1.7 jobs open per worker when you're moving forward into this more hawkish phase of the monetary policy cycle?

Dan Belton:
Yeah, I thought the most interesting thing that he said about the labor market today was that it's very, very tight. It's tight to an unhealthy level. I don't think he's used that verbiage before. I thought that was interesting. He's kind of painting a picture that it's too tight and that in order to help the labor market, they're going to hike rates to try to get labor force participation back and that they need to slow the job market.

Dan Krieter:
But let me ask you a question, and it goes back to the dichotomy you talked about where Powell passed on being potentially more hawkish when talking about the trade off between unemployment inflation and saying it won't come to that. Throughout the press conference today, he talked about how wage inflation will come down, but not to concerning levels. We want wage inflation to fall, right? And he was asked, "Are we in a wage price spiral?" And he said, "Wages going up is a good thing. The labor market is unhealthily tight, we need to see that come down." And didn't really directly address the part that when wage inflation comes down, that leaves the consumer in a weaker position to absorb inflation that's high due to supply factors. So it seemed like all together, he kept reiterating, basically not saying in these exact words, but basically saying like, "We're going to have a soft landing." I'm not sure at this point how the Chairman can be so confident in that, or is it just that, what else is he going to say?

Dan Belton:
Yeah, I think it's the latter. I think it's really hard to engineer a soft landing, that's what history has told us time and time again. But what else is he going to say? Is he going to talk up the risks of the Fed over-hiking the economy into a recession? Probably not. But it's pretty clear to me that this is going to be one of the hardest hiking cycles by the Fed in recent memory to engineer such a soft landing where they're going to have to go the much quicker than they might otherwise prefer, likely twice as fast as they went in the last cycle, going at every meeting, potentially even faster. And balance sheet runoff much faster than they've done ever in history, which is only the second time, I guess, but it's going to be much harder for the Fed to engineer that soft landing, and so it's hard to take that confidence with much more than a grain of salt to me.

Dan Krieter:
So before moving on, Dan, anything else from the Q and A that you think we should talk about here? I really don't see much.

Dan Belton:
One last point. He talked a lot about how it was sort of his goal to tighten financial conditions because that was how rate hikes were going to impact the economy. I think that was worth noting. Financial conditions obviously the tightest they've been since we really came out of the depths of the pandemic.

Dan Krieter:
Yeah. And Powell stopping just short of saying that he wanted financial conditions to continue tightening. I mean, he heavily implied it. I think we all know that, and it doesn't come as a big surprise. You know, that's how monetary policy is conducted through the financial system, but you're right. I mean, financial conditions is something to keep an eye specifically with our focus on the credit markets.

Dan Krieter:
And lastly, I did have a note here. He did get a question on the withdrawal of Sarah Bloom Raskin for consideration from the Vice Chair of Supervision Post, and nothing really surprising in his answer, but he did talk about how all issues for regulation are now coming before the full committee, the regulatory committee is not functioning now. Maybe not functioning as a strong word, you know what I'm trying to say, that committee's not meeting. So any regulatory matters that need to be dealt with are coming before the full committee.

Dan Krieter:
And I can't help but think that despite the Fed continuing to function, at least to some degree, they're getting what needs to be done done. It's hard to think that the Fed is now being very proactive on the regulation front which concerns some of the longer term things that we've been monitoring for a while, money market reform, SLR exemptions, things of that nature, hard to see any of that really getting any traction or progress until there is a Vice Chair, and who knows when that's going to be at this point.

Dan Krieter:
So then before we wrap up, why don't talk about the ramifications of today's meeting for credit markets? Because we expect financial conditions can be tightening, we know the Fed's going to be very hawkish. Is this now priced into risk assets? Is this hawkish turn with this balance sheet runoff at a quicker pace coming in May, is that priced in? And I don't necessarily mean the mechanical impacts of QT. We've covered that in our written work. We think that's just a long term sustained upward pressure on credit, but setting aside that mechanical impact of QT, have we reached a point where we're pricing in essentially as hawkish as the Fed can be, and we can no longer see risk off moves in response to a hawkish Fed outside of you a 50 basis point rate hike?

Dan Belton:
So I think at this point we are, but that's not to say that there can be more of a hawkish response by the Fed that's priced in. I mean, if you take a look at where markets were pricing in December, pricing to three rate hikes in 2022, I think that might have been adequately priced at the time, and over the past three months, market pricing has caught up to an increased Fed response to elevated inflation. And so I think right now we're probably appropriately priced to the Fed. We had CDX finish the day near several day lows, and so I don't think that today's FOMC really does much to change my medium term view on credit.

Dan Krieter:
Yeah. We needed to come a long way to get to where we would be considered fair value. I think we've come that long way now, and there's a lot of uncertainty out there obviously. If we saw resolution to the Russia situation, we could see spread snap significantly tighter in just a single day. And then going forward, it's going to be, at the risk of sounding overly obvious here, it's going to be very dependent on the way the incoming economic data unfolds both in the inflationary front, but also on the labor markets slash consumption side where we haven't necessarily seen as much strength to Chair Powell. Certainly we saw strength, but this notion that the economy is going to be able to withstand rate hikes for sure, I'm not as sold.

Dan Krieter:
So that really fits in with the narrative that we've held on credit for the past couple weeks which was to expect some stability and spreads once we got, we had our targets of 125 to 130. We knew once the Russia situation escalated, those were not going to be where spreads leveled off. But that once we got up to the 140, 150 basis point range and geopolitical risk was now adequately priced, we should see some stability in credit, and I think you look at funding stress today that came down significantly. Commodity markets seem to be settling down.

Dan Krieter:
Hopefully the worst is behind us on the Russia front, we've thought that a few times though now, so you can't say that with any degree of certainty, but hopefully the worst is behind us now. And I think it really opens the door to this range-bound trading environment where maybe some tactical positions of high credit quality spread products make some sense here, but long run, as we look at the potential for stagflation which I think needs to maybe price in more, I think long run, we still hold a more bearish view on spreads, but maybe some tactical trades now make some sense.

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 a FICC macro strategy group in 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. 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 or strategy referenced here in may be suitable for you.

Speaker 2:
It does not take into account the particular investment objectives, financial conditions, or needs of individual clients, nothing in this podcast constitutes investment, legal accounting, or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures, contracts, and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the U.S. Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you or in your best interests in you to the extent applicable will rely solely on advice from your qualified independent representative in making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

Speaker 2:
You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative if applicable. BMO assumes no responsibility for verification of the information in this podcast. No representation or warranty is made as to the accuracy or completeness of such information, and BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast.

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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