This article will focus on the Fed’s May meeting where it decided to maintain the federal funds rate between 75 and 100 basis points. The stock market had a slight increase in response to the decision, but that may have been because Apple rallied throughout the day after opening lower. The 10-year bond yield increased about 2 basis points to 2.3180%. The reaction was subdued because there weren’t any surprises in what the Fed did or said in its statement. Yesterday, there was only a 4.3% chance of a rate hike for today’s meeting. The Fed’s statement also did little to change the chance of a rate hike in June. The odds of a rate hike went from 67.6% to 71.8%. This meeting was as in-line with expectations as a Fed meeting can get.
It's tough to make sense of Fed policy in terms of the timing of rate hikes. I don’t understand why the Fed wants to hike in June instead of this month. Since the Fed has decided to ignore the data, there isn’t much support for hiking rates at any specific meeting. The only argument I can think of is that the Fed wants to hike rates gradually.
As I stated, the Fed ignored the weak GDP report, calling it transitory weakness. That’s a forecast which has no evidence to back it up. The Fed is thinking the economy is like a trampoline which slings back higher after going down. However, you must provide evidence in making a near term projection. The economy will eventually grow faster than 0.7%, but there may be a recession in between now and then. As you can see from the chart below, the Citi Economic Surprise index is at -20.60. The Fed is willing to ignore the economic data when making policy if the stock market moves higher. If the Nasdaq was down, the Fed would have been more dovish. This hike in March was the weakest quarter for a hike, in terms of GDP growth, since 1980.
The Fed didn’t discuss what it would do to the balance sheet in this statement. I do not view this decision to avoid the discussion as dovish as I used to. I interpret deciding not to talk about the balance sheet as the Fed saying it has made no change to policy or the timing of the unwind. The current consensus is the Fed will start the unwind process after it raises rates the third time this year in September. Because this meeting didn’t have a press conference, the Fed decided to put off the discussion. It’s better to give all the details at once with a press conference then to leak out some of them over many Fed meetings. This also gives the Fed more time to work out the kinks in the plan which is complex and unprecedented.
As you can see from the chart below, the process will be difficult because the holdings don’t have uniform maturity dates. This doesn’t mean the Fed can’t smooth them out. The Fed can roll over a floating percentage of bonds which are maturing. There is nothing in the guidance which says the Fed will allow 100% of the bonds expiring to mature. When I say the process is difficult, I don’t mean creating a plan and acting on it will be difficult. The difficult part is explaining what it will do prior to taking the action. Usually the market likes to price in future events right away, but there may be a surprising reaction in the bond market or stock market which could cause the Fed to change the initial plans. In theory, the Fed can hike interest rates in between meetings, but the tradition is doing so at meetings. The question remains if the Fed wants to only make balance sheet decisions at meetings or if will do so on the fly, since the unwind will probably be a daily activity.
Adding some confusion to this balance sheet reduction is that the White House wants to lengthen the maturity date on newly issued treasuries. That’s shockingly inconsistent with Fed policy. The Fed unwinding the balance sheet simultaneously with the Treasury issuing long-term bonds possibly with 20-year maturity dates could cause a large selloff in bonds. I’m expecting the balance sheet reduction to lower long dated bonds because it is an uncertain proposition and long bonds are where investors go to express a ‘risk off’ position. I think reaching for long U.S. bonds as a ‘risk off’ trade expression could change if the Treasury started to lengthen the maturity dates of bonds it issues. This would make the supply of treasuries uncertain. Uncertainty is the enemy of long bond investors.
The government thinks there’s a ‘free lunch’ by issuing longer bonds because interest rates are so low, but there’s no ‘free lunch.’ It would already be expensive to switch to longer dated issuances and if interest rates rose, it could be prohibitively expensive. That’s why I don’t buy this plan to increase the maturity of newly issued bonds. In my mind, the only way to increase the average maturity date of government debt would be to lower spending along with issuing longer dated bonds. That would inspire confidence in the government to pay off the debts it is accruing.
Finally, the Fed said 12-month inflation is running close to its 2% goal. The Fed is like a student who tells his parents he got a B on every test when 90% of the time he gets a C or below. As you can see in the chart below, core CPI decelerated to 2% growth in March. In many surveys I’ve reviewed, pricing pressure has deteriorated which leads me to believe further deceleration in core CPI is on the way. The PCE price index excluding food and energy was down 0.1% in March which shows the Fed is not close to its 2% inflation goal, The Fed continued its number fudging by stating consumption growth remained solid even though real PCE only increased 0.3% in March.
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