2017/08/16 Commentary: Back to the Fed
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Commentary: Wednesday, August 16, 2017
Back to the Fed
Markets seem a bit subdued this morning because nothing at all has changed since Tuesday’s strong US data. There was not all that much out on the international front this morning out of line with estimates, and reverting to softness were the weaker US Housing Starts and Building Permits. The NOKO situation continues calm (for now) after Kim Jong-un’s predictable decision to hold off on his imminent plan to launch four missiles toward the US Territory of Guam. While Mr. Kim said this is due to his desire to "watch a little more the foolish and stupid conduct of the Yankees" (according to the NOKO KCNA news agency), many people are hoping this means that either in his own right or through the pressure from benefactor China he has finally realized the US retaliatory threat is serious.
US Secretary of Defense Mattis warning that if North Korea fired on US territory it would be "game on" was very explicit. This is part of why we felt the ‘NOKO first strike scenario’ was not a likely outcome (see our WEEKEND: NOKO Crisis Redux post for more on that and alternative scenarios.) Yet that holds the prospect of heating up again as the US and South Korea head toward annual major military exercises from the top of next week.
And speaking of major influences that may become more critical next week, there is also the annual Kansas City Federal Reserve annual Economic Policy Symposium in Jackson Hole, Wyoming. Key among the various communications will be European Central Bank President Mario Draghi’s speech next week Friday (August 25th.) Yet the current spin on that is he will NOT suggest any policy shifts. This will be consistent with the overwrought inferences on removal of accommodation at his late June speech in Sinha, Portugal being reversed in all subsequent ECB communication.
And in any event we will need to deal with another central bank influence first: today’s 13:00 CDT (14:00 EDT; 19:00 GMT) release of FOMC July 25-26 Meeting Minutes. There is anticipation of much discussion of why any further federal funds rate increases are less than warranted or desirable at present. Yet there will also be keen interest in any discussion of the planned reductions in the Fed’s balance sheet, with potential to impact especially both equities and govvies with some influence on foreign exchange.
Authorized Subscribers click ‘Read more…’ (below) to access balance of the discussion. Non-subscribers click the top menu Subscription Echelons & Fees tab to review options. As this is a ‘macro’ assessment, Market Observations remain the same as last weekend’s WEEKEND: NOKO Crisis Redux post that were updated (lower section) after Monday’s Close, and there is no Extended Trend Assessment in this post.
NOTE: Given the likelihood the US economy will now get the structural reform that we (along with Mario Draghi and others) have been loudly complaining was not forthcoming since our dual It’s Lack of Reform, Stupid posts in January 2015, we need to adjust our view that a potential economic and equity market failure is coming. We previously referred you back to our December 8, 2015 post for our major Extended Perspective Commentary. That reviewed a broad array of factors to consider Will 2016 be 2007 Redux? While a continued regime of higher taxes and more regulation (i.e. under Clinton) might have fomented a continued weak or even weaker US economy, the tax and regulation changes proposed by the Trump administration will hopefully still be approved by the Republican Congress and diminish the similar fears we had to what transpired in 2007-2008.
As the Fed was the first to pursue Brobdingnagian balance sheet expansion after the 2008-2009 Crisis, it is natural it will be the first to begin to unwind its major government bond and agency paper position. Yet that is going to merely be the first phase of the broader unwinding of balance sheets that will include almost all major central banks. There was an excellent Financial Times article on this just this morning: Central banks hold a fifth of their governments’ debt (our marked-up version) reviews just how much of a challenge all of this unwinding will represent.
To wit, the six central banks that have engaged in the extensive Quantitative Easing (QE) that was supposed to be a temporary and limited measure to stem the Crisis in 2009 and shortly thereafter “…now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.” It further noted, “Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments.”
And citing the Fed’s dilemma, “More than half of the Federal Reserve’s $4.47tn balance sheet consists of Treasuries, with mortgage-backed securities guaranteed by government agencies such as Fannie Mae and Freddie Mac making up a further 40 per cent.” And it is therefore not excessive for informed observers to pay more attention to the Fed’s balance sheet unwind as a test for what will need to occur elsewhere in the not too distant future.
[As we occasionally do we have provided the actual FT article to allow for our mark-up. Yet we also encourage anyone who does not already have a www.FT.com subscription to secure one. It now offers some very reasonably priced low article access forms.]
It is also why unless there is some sort of major surprise, any further federal funds rate increases will likely have been discussed as being less warranted or desirable at present. That much has been clear from previous speeches by Fed Governor Brainerd and Fed Chair Yellen’s subsequent Congressional testimony. For much more on all that please see our July 27th Commentary: Balance Sheet Chicanery post.
That has quite a bit more background on bond market pricing, the yield curve influence (especially as it relates to major commercial bank needs), and why even any initial Federal Reserve Balance sheet reduction with be “more symbolic than real.” While it was already our assessment in that regard, it was also explicitly noted by Bill Gross (originally of PIMCO fame and now with Janus Henderson) in a very pointed CNBC interview after that Wednesday’s FOMC statement. Gross specifically said the pace of the Fed’s balance sheet reduction “…is akin to something like watching paint dry.”
And so it is that much more important to assess any discussion in the minutes from that meeting which might provide some insight on whether or not that is correct. If so, the market impact will also likely be minimal. However, if there is any sentiment that there could be either an unexpected near-term return to federal funds rate hikes or more aggressive balance sheet reduction, it could foment a sharp market response. We are not suggesting we expect that, yet must be on guard early this afternoon.
There is no Extended Trend Assessment in this post. In spite of the short-term impact of various matters reviewed previous, the Market Observations remain the same as Monday’s update of the last weekend’s WEEKEND: NOKO Crisis Redux post.
Thanks for your interest.
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