Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

Reactions to the June FOMC - High Quality Credit Spreads

FICC Podcasts June 16, 2021
FICC Podcasts June 16, 2021

 

Dan Krieter and Dan Belton discuss their takeaways from the June FOMC which featured a more hawkish outlook from the Summary of Economic Projections, an acknowledgement that the Fed might be underestimating the likely path of inflation, and a technical adjustment to the Fed’s administered rates. They conclude with a brief discussion on what tapering will likely mean for credit spreads later this year.


Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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.

Podcast Disclaimer

Read more

Dan Krieter:                                           Hello, and welcome to Macro Horizons, high quality spreads for the week of June 16th. Reactions to the June FOMC. I'm your host Dan Krieter, here with Dan Belton as we discuss our main takeaways from the somewhat more eventful Fed meeting than we were expecting.
                                                       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 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 then, why don't we start with the details of the release itself. We're moving on to the contents of the question and answer, because I think we did get a few more fireworks than we were expecting at the release itself. First, we did have an adjustment to the IOR RRP rates. We'll talk more about that later. I think obviously any conversation around today's FOMC release has to start with the dot plot, the 50 basis point hike the price into 2023 seems to be the headline of the day Treasury rates in the tenure sector off as much as 10 basis points at times during the day, but how did you read it? It might be a bit of an overreaction.

Dan Belton:                                            Yeah, I thought the SEPs were definitely the story of the release. Like you said, the two hikes in 2023, I don't think anyone was really expecting that. I also thought the 7 of 18 dots showing a hike in 2022 was more than I was expecting. It kept the median dot at the zero lower bound for 2022, but still see 7 of 18 dots off of that zero bound by the end of next year was somewhat surprising. From the statement itself, I actually thought there was an opportunity for that to have been more hawkish than it actually was. And there were two places where I was expecting for some more of a change in the language than we actually got.
                                                       So first there was the language that inflation has risen and it's largely reflecting transitory factors. That was unchanged, which I thought there was some risk that gave more credence to the growing inflation in recent months. And then the second thing that I thought was notable from the statement was also unchanged when the Fed said that there was substantial further progress needed to reduce purchases, not groundbreaking there, but I thought given that the Fed had tipped its hand that they were talking about tapering from the April minutes, that there is a potential we saw the Fed maybe lowering the bar for the potential removal of accommodation.

Dan Krieter:                                           Yeah, it was an interesting sort of dichotomy there before the press conference started, because I agree with you, certainly the dot plot came off as way more hawkish than we were expecting, but then the statement itself where they could have been more hawkish, they weren't. So was this an instance of, okay, this is the dot plot, it's individual assessments, and it just ended up coming off more hawkish, but it's not what the committee intends. We'll find out at the press conference. And then we did, and maybe going in, I was expecting it to be more along the lines of described before that actually the dot plot was more hawkish than the Fed may be intended to communicate.
                                                       But then I thought that Chair Powell, particularly in his prepared remarks, which was interesting, that's usually sort of the least exciting part of the process. I thought the prepared remarks today, had a few nuggets in there that are worth talking about on the hawkish side. And particularly at one point you have to forgive me for paraphrasing, because you can only take notes so quickly, but he said something to the effect of bottlenecks and labor constraints raise the possibility that inflation could turn out higher than we expect. So at least as I first heard it and I'd have to go back and listen to it again. But my memory of the reaction was this is the Fed opening the door to inflation not being transitory. Did you interpret that the same as I did?

Dan Belton:                                            Yeah. The quote that I saw was that he said inflation could turn out to be higher and more persistent than we expect. That was certainly the headline I thought from the prepared remarks from Chair Powell, there are certainly a lot more there than there was in the statement. He did sort of walk that back later where he said a couple of times that while we don't dismiss the risk that inflation pressures are lingering and higher than we expect, that's not our base case. And we still think we are not behind the curve on inflation. So he's acknowledging that there is the potential for inflation exceeding their expectations, even if it still is not in their base case. The other meaningful development I thought from their prepared remarks was he front ran the question that he was inevitably going to get about the talking about talking about tapering. And he acknowledged that they did discuss it at this meeting. They would continue to discuss it, but any developments would be messaged well in advance of any change in policy.

Dan Krieter:                                           So in other words, the Fed basically just met expectations for tapering. Thankfully, we never have to hear the term talking about talking about again, as the Fed officially retired that during the Q&A section, but before moving on from the prepared remarks, I want to circle back and make the point that this was prepared. He put this in his speech, you know the exact quote could turn out higher and more persistent than we expect. So more persistent is literally the opposite of transitory. So struck me was really surprising that in the prepared remarks, the chairman sort of opened the door to inflation not being transitory. And I couldn't really shake that feeling throughout the rest of the Q&A. We'll get into some specific questions on the Q&A, but obviously it was primarily focused on inflation, probably eight to 10 different questions, just asking about inflation in a different way.
                                                       And the general feeling I got the sense I walked away from it with was Chair Powell really seemed to stress the uncertainty around everything. He talked about the drivers of transitory inflation. We all know the bottlenecks, the base effects. He talked a bit about the labor supply and how that's been being constrained. He listed three main drivers of those labor constraints. Again, pretty well known here. Some safety concerns regarding the virus. Some caregiver concerns with children not going to school necessarily, parents having to stay on to watch their kids. But then the third one, he explicitly acknowledged unemployment insurance and the impact that stimulus funds could be having on labor supply. And this is the first time that he really admitted to that potentially being a factor. I think at the last press conference, he sort of alluded to it kind of hand-waving only this time it was built into his prepared remarks that that was something that was impacting labor supply.
                                                       And in every question he kept harping on how these factors should be transitory. And at some point in time, they should start to fall. He had a specific example talking about lumber at some point that should start to fall, but he kept harping on the timing on this is very uncertain. We're sort of flying blind here. This is a never before seen thing with the pandemic and a reopening of an economy. All that's very true, very honest and good to hear from the Fed. But it struck me as saying like, well, we don't know when this stuff is going to fade. And then it's like, okay, well, then what's transitory? When is transitory no longer transitory? After six months, a year, two years? It didn't seem to me that the Fed had a very high conviction definition of inflation when they expected things to turn around and how they would feel comfortable characterizing inflation as transitory. I'm curious what you took away from the Fed's characterization of inflation, just in general, over the course of the Q&A.

Dan Belton:                                            Yeah. I thought that generally the same, they did certainly waiver for the first time that I've heard in their conviction that inflation was going to be transitory. And maybe that's by virtue of just the fact that we are starting to see these prints. It's no longer a concept out in the distance where he's been saying for most of this year that we're going to start to see inflation due to base effect and transitory nature in the spring. Now we've seen those high inflation prints and he's saying, well, we still think it's transitory, but it very well may not be. Certainly part of that has to do I think with the supply chain bottlenecks that he talked about. But I think more broadly we've talked about how he was much more hawkish than most were expecting. And I think Chair Powell is by nature a pretty dovish Fed chair, but it's a pretty difficult time to deliver a dovish message.
                                                       You have some of the highest inflation prints we've seen in the past decade of an economy that's by many accounts booming with a lot of pent up demand being released in real time. And when you look at it from that standpoint, yeah, it is probably appropriate for the Fed to start to really begin the process of removing all of this accommodation and need to talk about some of these secular and structural changes that the economy is going through as a way to say, well, we're not definitely sure that things are heading down that path, even though it certainly seems like that. A couple of times today he talked about how in the past cycle, we thought we were near full employment for many years before we actually were in the labor market just kept tightening and tightening. And there's no reason to think that that couldn't unfold this time around too. So I thought that was a slightly dovish message, but yeah, overall there wasn't a ton of room for him to deliver his usually dovish tone.

Dan Krieter:                                           I hear what you're saying that at this point in time, it's tough to deliver a dovish message, but I just think they could have been more dovish. Just seemed like an almost intentional hawkish step to me. He even said at one point in time during the prepared remarks, again, the bottlenecks on the supply side were larger than anticipated, which precipitated some FOMC participants to adjust their readings of PCE higher or something to that effect. Again, I'm reading my notes, not the actual transcript here, but that was right along the time he was admitting that potentially inflation would be higher and more persistent than they thought. They're talking about how well, we didn't have great visibility into the bottlenecks. And that ended up making inflation higher than we thought. Okay. Well, if you are already surprised by the inflationary pressure of bottlenecks, who's to say you're not going to be surprised in the future?
                                                       And that those pressures are going to continue alongside a labor supply and demand mismatch is going to continue. So I don't want to belabor the point, I just thought particularly when reading into the prepared remarks that it was an almost intentional hawkish step. And so the market reaction here was 10 sling off inequities, notably lower here. I think that all makes sense in terms of credit. We don't really have a good way of measuring that now. I'll be surprised the spreads aren't at least a little bit wider in reaction to the FOMC. And before I move on to some of the more technical aspects of the meeting and the press conference, I do want to focus on one other sort of quote unquote macro question that the chair received during his press conference that I took note of at least.
                                                       And that was a question regarding the employment sector, particularly, and the question was something to the effect of that we're seeing pretty strong employment reports, wages appear to be on the increase given sort of the difficulty or uncertainty in measuring unemployment at this point, how is the Fed viewing employment reports, something like that. And Chair Powell responded by giving a characterization of expecting a very, very strong labor market in the very near future, it was actually the second time you'd said it. I didn't make a note of the first time, but it's the second time he's talking about this expectation for a very strong labor market in the near term.
                                                       He's talked about a lot of job openings, which we know from the Jilt survey, that that's an unprecedented highs right now, a lot of job openings, a lot of unemployed people, and there's frictions there that aren't allowing the two to sort of link up, but he expects those frictions to fade in the near term and that we're going to have a very, very strong labor market soon. And he characterized that labor market as low unemployment, high participation, high wages. Maybe you can explain to me how that's not also the ingredients of wage inflation, which at that point to me is the most important ingredient, at least in more durable, more persistent inflation cycle rather than just transitory inflation. How did you read that?

Dan Belton:                                            Yeah. I think you could make an argument that Chair Powell would view that type of wage inflation as a positive thing, where he talked a little bit about inflation expectations being anchored right around the Fed's goal. I think 10 year break evens were around 230 today, just a little bit above the Fed's objective. And I think given their new mandate about appropriate given where inflation has been recently. So I think Chair Powell would view that as appropriate inflation, as long as it's accompanied by strong growth, which he characterized by those different elements of a strong labor market.
                                                       So I don't think Chair Powell is necessarily concerned with strong inflation of the 2%, 2 1/2 percent ilk. It's more of this runaway inflation that I don't think necessarily you would get if we saw a strong labor market. Keep in mind, we did see a very, very strong labor market that got stronger and stronger in the 10 years following the financial crisis. And we still didn't get that type of runaway inflation that we traditionally have. So I don't think it's necessarily a leap to say that we could get wage inflation that doesn't necessarily lead to the Fed being behind the curve.

Dan Krieter:                                           Yeah, I suppose that might be the nuance that the chairman was going for. I can't shake the feeling that before the press conference, I think I had a higher confidence in the Fed's view on inflation being transitory than I do now. And if that's the case then it seems to me that the case for lower rates, the case for lower spreads, the case for higher equities is weaker now than it was before the meeting. And we can talk a little bit more about credit specifically towards the end. Just want to clean up some more Fed related stuff before transition the conversation to credit.
                                                       I guess the next topic of conversation should be the RRP IOR adjustment. I guess not much to say on this really. We were very conflicted on this going into the meeting. Personally flip-flopped on the issue a couple of times, just because everything the Fed had told us, as far as that they didn't want to do it, my view on it was the Fed would only raise those rates when they had to. But at that point that they had to was rapidly approaching, given RRP volume pickup. And so they gave the five basis point increased to RRP IOR. What does that ultimately matter? I think there was actually a question on that during the Q&A where one of the reporters asked, so do you think this will actually decrease the volumes of the RRP and how did Powell respond?

Dan Belton:                                            Yeah, he said maybe, maybe not, essentially. I thought it was interesting. He gave the primary rationale for it. He said to keep Fed funds within the range and also to support functioning of money markets. I thought that might've been a nod to the fact that you have all of this money parked in money market funds receiving zero basis points of return day after day at the Feds RRP facility. So it was sort of a nudge higher in that rate to give some return to these money funds that are undoubtedly struggling with these $500 billion daily and zero returning assets.

Dan Krieter:                                           Yeah. And that's the important thing. We even said this in our written work, that if the Fed was going to increase these rates, it was because they were concerned with repo rates, even though Fed funds is its official rate. Sure, they said that it was to keep Fed funds well within the range, but we hadn't seen Fed funds drop lower than six yet. And we have a pretty long, and well-established history that the Fed was tolerant of Fed funds at five basis points, or even less than that from lower bound for a matter of weeks or months. So they didn't say it, but I think you're exactly right. The driving force behind this move had to have been concern about the money fund complex. You are starting to hear anecdotal reports and see reports on media outlets that money funds were taking the steps of turning away money to try and keep rates positive, things of that nature.
                                                       That's obviously not what the Fed wants to see. So they made the move. Yeah, Powell said it could have some impact on RRP volumes. He said something like, yeah, you think it would, but it's possible that it won't. I don't see a scenario where it does have any impact on volumes. What's that feedback mechanism? It's still going to be the floor and the floor is still soaks up excess reserves. That's just at what rate they pay for those reserves. And I don't see how this changes the amount of excess reserves in any way. It just changes the rate. So I would expect RRP volumes stay very, very high, but we know now that that floor, which has held very firmly this whole time, it's going to hold at five basis points. So we don't need to worry about negative. So for negative repo, we shouldn't have to worry about money funds turning away money, at least to the same degree they were before. So looking ahead, Dan, if that's what they accomplished with this technical adjustment, is this it? Do you think that there's any reason to think that they'll do this again?

Dan Belton:                                            It'd be surprising. I think the Feds RRP rate has been a pretty strong floor at the bottom end of the range. They've only had to make one upward technical adjustment before this. And that was when the RRP rate was actually five basis points below the floor. So given that the RRP rate is now five basis points above the floor, I don't think we would see downward pressure on Fed funds that's going to get the rate down below the RRP rate. So I would be surprised if we saw another upward technical adjustment.

Dan Krieter:                                           Yeah. I'm with you. I think this was it. I think the Fed just wanted to take away any of that discomfort at zero or any concern that it would go negative. Now it won't. So I'm with you there. Another thing that our readers know that we've been looking at and waiting for rather patiently here is any word or update on the SLR. And the chair fielded a question on the SLR during the Q&A asking specifically for any update or any guidance on that. But didn't get much of an answer. I don't think there's much to discuss here. He said, we're working on it, nothing to share in terms of particulars or timing at this point, though, it did seem to be that Powell was hinting pretty heavily that there's going to be a change coming.

Dan Belton:                                            Yeah. He did make an effort to justify why that might be appropriate. And maybe that's just purely for political reasons. Remember the political backlash against any speculation that the Fed was going to extend the SLR exemption. So he just sort of talked about the virtues of maybe tinkering this rule, who knows how much to read into that. But yeah, he did talk about why it might be appropriate.

Dan Krieter:                                           [inaudible 00:17:37] changes anything. We're all expecting of a rule. We just don't know when it's going to happen. And we don't know what it's finally going to look like. I think my view is that it's going to be Treasuries and reserves, which should ultimately put upward pressure on swap spreads, but there's nothing to either support or refute that notion from today. So SLR is coming at some point, I think your point on it, his comments today being pointed a bit at the political backlash, I hadn't considered that. I like that, but high level, really nothing to take away from that today.
                                                       Well, I guess the last question we could talk about really quickly that was sort of interesting when the reporter asked if the Fed thought that they were trapped out of fear of a taper tantrum. And it was the first time actually that Chair Powell used the word taper for the entire hour long meeting of the Q&A. He didn't say it until the end. And he said we can't be absolutely certain on the timing. And he said something to the effect of we'll do everything we can to avoid an adverse market reaction. But when our macro economic goals have been hit, we will taper. Again, this doesn't probably change much. I think we'd expect him to say nothing else, but I don't know. Did you read that at all as maybe something the market maybe wouldn't love?

Dan Belton:                                            Not really, to be honest. I think everyone knows that tapering is coming, especially given the trajectory that the economy is on. I think it's hard to argue that removal of some amount of this accommodation isn't appropriate. So I don't think the market is under any illusion that it can play the tail that wags the dog in a sense that it could prevent the Fed from tapering despite the economic fundamentals warranting it.

Dan Krieter:                                           Yeah. I agree with you wholeheartedly. Just thought we could at least mention that here before we move on. And actually that question segues nicely to just I want to have a brief discussion on tapering and the impact it could have on credit spreads before we wrap up the podcast today, because I don't think that anyone's expectations for the tapering timeline were altered meaningfully today.
                                                       I think if the consensus is an announcement by the end of this year for implementation in Q1 of 2022, I don't think that got altered today, but if it did get altered, of course it would have to be that those expectations for tapering were pulled ahead. Particularly if we thought the Fed maybe indicated a slightly weaker hold on inflation than we thought going into the meeting. So I guess what I want to get at is do we expect to taper tantrum? It was the focus of the press conference, for sure, at least the Q&A portion of it. So Dan, on the topic of taper tantrum, where do you fall?

Dan Belton:                                            I don't expect to taper tantrum. We've talked about this a little bit. The market seems to now be starting to price to an eventual taper, which is later on this year. I think we will see some market reaction to it, but that's going to be more of a function of the technical impact of this Treasury and MBS supply hitting the market and the market having to digest that and then maybe crowding out to some extent some of the private market borrowing and other assets that are maybe finding a lower price as Treasuries clear the market first. But I think given the state of the economy right now, it's unlikely that there's going to be as severe market reaction, even though ten-year Treasury sold off about 10 basis points today, they're still in the context of 160 or so. So it's hard to make the claim that higher rates are going to prove very detrimental to the economy in the big picture.

Dan Krieter:                                           Certainly at this stage, it's hard to argue with that logic. I take no exception with it. I think you're absolutely right. I can't imagine there's going to be a tapering tantrum, especially since we've already gone through it in the previous cycle. We know what to expect from the Fed, from other central banks. We all know it's coming. Does it coming one or two months earlier, late matter? Probably not really. Sure, there could be some mechanical impact there, an increase in effective supply, the potential of some crowding out. I certainly sympathize with that notion, but at the end of the day, spreads are going to stay very, very low. And actually fundamentally the way that investors assess credit risk is probably just different now. So I'm still in the camp that we could see a near term buying opportunity arise at some point in time, probably late July to August.
                                                       And that rationale is really it's been enhanced after today because even though I believe that inflation will ultimately prove transitory, I think we're going to see some pretty eye-popping numbers here. And I think that the market's going to have a moment of doubt there surrounding the idea that inflation is going to be transitory. And even after the Fed meeting today, they didn't exactly come out very strongly and say, inflation's definitely transitory. A lot of hemming and hawing, a lot of uncertainty, a lot of honesty, which is nice, but it didn't really convey a strong grip on inflation to me.
                                                       So if we do get a little bit of a backup in the summer months around some fears of higher inflation, maybe that comes alongside taper talk during the Jackson Hole meetings. Some seasonal weakness and credit spreads. There's a lot of things intersecting in the summer months in early Q3 that could see a bit of an increase in credit spreads, but it's a buying opportunity. Spreads are going to stay very, very low I think here as long as inflation proves transitory. And I think ultimately we'll still think that regardless of how the Fed sounded at today's FOMC meeting.

Dan Belton:                                            Yeah. Dan, I think that sums it up well. So thanks for listening. We'd love to hear from the listeners. Do you agree, disagree? Any other thoughts, anything we didn't cover, please feel free to reach out.

Dan Krieter:                                           Thanks for listening to Macro Horizons.

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 BMOs marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:                                             This podcast has been prepared with the assistance and 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 suggestion that any investment for strategy referenced herein may be suitable for you.
                                                       It does not take into account to 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 the BMO or any of its affiliates to be considered a commodity trading advisor under the US commodity exchange act. BMO is not undertaking to act as a swap advisor to you or in your best interest in you to the extent applicable who rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.
                                                       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. This podcast does not contain all information that may be required to evaluate any transaction or matter, and information may be available to be BMO and/or it's affiliates that is not reflected herein. BMO and it's affiliates may have positions long or short and affects transactions or make markets insecurities mentioned herein or provide advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

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

You might also be interested in