Weekly Wisdom – August 24, 2022

By Hightower Great Lakes on August 24, 2022

The Fed, in Hindsight

Nearly one year ago, we wrote about the 2021 Jackson Hole Symposium. The key themes were the Fed’s timeline for tapering their asset purchases and interpreting their definition of “transitory.” The Fed is back at Jackson Hole this Friday, and since the 2021 event, many have raised the topic of wavering public trust in the institution.

The Fed made mistakes. One year ago, we were following an increasingly tight labor market with falling unemployment rate. At the same time, GDP was growing faster than pre-pandemic, consumers were flush with elevated savings and inflation was rising.

The Fed continued to stimulate lower rates and manipulate bond markets through purchases for a further seven months, until March 2022. Shortly thereafter, the Fed began aggressively tightening – both raising rates and shrinking their balance sheet (not reinvesting funds after securities mature).

To provide context for the Fed’s bond market manipulation, the Fed was buying $120 billion of bonds monthly at this time last year. That amounted to nearly $6 trillion over two years since the pandemic’s onset – more more than triple the amount purchased after the great recession – and contributed to the Fed’s balance sheet reaching above $8.9 trillion in March/April.¹

The Fed has completed three other quantitative easing (QE) periods since 2008. In December 2008, the Fed lowered the Fed funds rate to near zero and between 2009-2010 purchased $1.75 trillion in assets in response to the great financial crisis.

These purchases constituted about 22% of the market for those assets. The second bout of QE occurred in 2010-2011, and the third bout occurred in 2012-2014.

The Fed explained these QE programs as a response to slow economic activity and unemployment higher than their targets. During the period from 2008-2014, the Fed’s assets increased from $882 billion to $4.47 trillion.²

Chart 1: Fed Balance Sheet Assets (Vertical Lines Represent Beginning of New QE Period)³

The Fed, Today

The extensive easy monetary policy quickly shifting to aggressive tightening policy has implications. The Fed has so far reiterated their commitment to undoing years of downward rate pressure and will now do the exact opposite in order to drive inflation lower.

The Fed is looking to win back public trust and has made statements about their unwavering commitment to fighting inflation until there is “compelling evidence that inflation is moving down,” even at the price of rising unemployment. “

This process is likely to involve a period of below-trend economic growth and some softening in labor market conditions,” said Fed Chair Powell. He also said, “We’ve seen the very beginnings of perhaps a slight lessening in the tightness of the labor market, but it would only be the beginnings.”⁴

Rate increases are accomplishing the Fed’s goal of slowing economic activity, but inflation still remains persistently high. To put it in perspective, new home sales were down -30% y/y in July but the average sales price was still up +18% y/y.

Plus, natural gas is now at 14 year highs, oil has stopped going down, food prices are up 13% y/y and the Core PCE stands at 4.8% – well ahead of the Fed’s 2% target. And the stickier parts of inflation also remain elevated – rents are up 7.4% y/y and wages up 5.2% y/y.

The longer the Fed hikes rates and shrinks their balance sheet (at unprecedented magnitude), the greater risk this places on the economy.

We’ll look for clarity on the Fed’s interpretation of the economy when Powell speaks on Friday from Jackson Hole. Overall, we expect the Fed to maintain their hawkish stance with aggressive tightening policy continuing into 2023, as many Fed board members have already communicated.

Interpreting the Bond Market Signals

According to the St. Louis Fed, most economists agree that the interest rates that matter for stimulating investment and consumption is the medium- to long-term expected real interest rate.

The medium- to long-term expected real interest rates are a function of three components: average expected overnight interest rates, a term and/or risk premium and expected inflation. Real interest rates have climbed positive in recent months, reflecting the higher Fed funds rate, higher risk premium and moderating inflation.

Chart 2: Real Rates Higher⁵

Higher term premium is not reflected in today’s real interest rates, and the Fed’s manipulation is evident in the shape of the yield curve. The Treasury 2/10-year spread has remained consistently inverted since July 5th. Credit spreads have also widened, a hawkish indicator with greater economic risk being priced in.

Chart 3: U.S. Treasury Yield Curve Higher and Inverted⁶

Bond markets have historically been leading indicators for the broader economy. For instance, yield curve inversions tend to precede recessions (by varying lengths of time). With rising yields pressuring long duration assets and increasing economic risk, we think equity markets will continue to fight a choppy, uphill battle against the Fed.

Click here to read last week’s Weekly Wisdom (8/17).

SOURCES

¹ Source: Bloomberg
² Source: St. Louis Fed
³ Source: FactSet (chart)
⁴ Source: The Federal Reserve
⁵ Source: FactSet (chart)
⁶ Source: FactSet (chart)

Disclosure

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