The Fed’s “Not Thinking” Singular Focus
Supporting the beaten-down labor market is the Federal Reserve’s “major focus,” not inflation nor risk asset prices. Doing “whatever we can and for as long as it takes.”
Given the furious market volatility and risk asset rally over the last couple months, investors could be forgiven for assuming that the U.S. Federal Reserve has their backs. Following its June monetary policy meeting, Fed Chairman Jerome Powell confirmed as much, and quite explicitly.
“We’re not looking to achieve a particular level of any asset price. What we want is investors to be pricing in risk, like markets are supposed to do. Borrowers are borrowing; lenders are lending. We want the markets to be working. Again, we’re not looking to a particular level,” Powell told a press gaggle following the meeting, at which the Fed’s monetary committee left its key policy rate unchanged, as expected, at the zero-lower bound.
Investors had clearly been pricing in plenty of risk following the market bottom in late March, just as the Fed began announcing a slew of monetary stimulus measures. Together with announced fiscal spending, total stimulus in the pipeline runs north of 40% of GDP, a breathtaking figure.
The massive stimulus is meant, of course, to cushion the economy’s hard coronavirus-induced fall. According to their median forecasts, Fed officials now expect a 6.5% contraction this year, followed by a 5% recovery in 2021 and a further 3.5% expansion in 2022. Further facilitating this not-quite “V-shaped” recovery is the Fed’s forward guidance implying no rate hikes through 2022.
“Not Even Thinking About Thinking About Raising Rates”
“We’re not thinking about raising rates,” Powell told reporters. “We’re not even thinking about thinking about raising rates.” To the contrary, the Fed is “strongly committed” to do “whatever we can and for as long as it takes,” Powell declared, echoing former European Central Bank President Mario Draghi’s “whatever it takes” vow in 2012.
Markets are supposed to be forward looking, so a rebound from the first-quarter selloff is hardly surprising. But it’s hard not to notice that U.S. stock and corporate bond prices are already near pre-pandemic levels, even though the economy isn’t expected to fully recovery until some time in 2022. Ground-level benchmark rates may pave the way back, but don’t necessarily make it easier for rate-hobbled banks to lend when the “Fed and other regulators have pushed lending toward markets, and away from banks,” Thornburg President and CEO Jason Brady points out.
Flat or negative rates in Japan and Europe haven’t done much to conjure animal spirits and revive their economies. Powell didn’t mention negative rates, but he did point out that the Fed has “reviewed the historical and foreign experience with targeting interest rates along the yield curve.” Japan has engaged in outright “yield curve control” since 2016, while the ECB’s main refinancing rate has been stuck at zero since 2016 as well, while its deposit rate has been at zero or negative since 2012.
“Whether such an approach would usefully complement our main tools remains an open question,” Powell said. Yet, so far, the financial repression by the ECB and the Bank of Japan hasn’t proven very effective. Counterfactuals aside, Japan’s real GDP per capita in purchasing power parity has been going down for some time, while the country’s GDP in chained deflators is also down sharply from five years ago and nominal GDP per capita has inched along at a sub-1% compound annual growth rate for years.
Beta-Testing Yield Curve Control?
In subsequent remarks to the Senate Banking Committee, Powell said the Fed has “made absolutely no decision to go forward” on yield curve control. But it’s hard not to wonder whether the Fed is engaging in a trial run. The yield on the 10-year U.S. Treasury has been trading in a tight 0.6% to 0.7% range since mid-April, despite the incredible swings in risk asset markets. After the blow-out May jobs report, it briefly shot up to 0.96%, but quickly fell back to the middle of its second-quarter trading range.
The Fed’s balance sheet expansion seems calibrated, at least optically, toward targeting that 0.6%-0.7% range. (Figure 1) Plenty of factors determine the 10-year Treasury yield, but upwards of $2 trillion in Fed purchases of Treasuries this year has to be the top one. Perhaps equally striking is that, while the 10-year Treasury yield has been “steady as she goes” for a couple months now, the spread between five-year and 30-year Treasuries has blown out by 40 basis points. (Figure 2)
Figure 1: Fed Balance Sheet (in blue) Plateaus as 10-year Treasury Yield (in gold) Flat-lines
Figure 2: Five-year/30-year Treasury Spread Balloons (in gold) as 10-Year Treasury Yield (in blue) Hangs Low
As we previously discussed in The Fed’s Dueling Mandates, the U.S. monetary authority is not only tasked with promoting maximum employment and stable prices, but also “moderate long-term interest rates.” Those three mandates may, at times, be at odds with each other, forcing the Fed to pursue one with higher priority than the others.
“I think our principal focus…is on the state of the economy and on the labor market and on inflation,” Powell said when asked about “a potential bubble blowing that could pop and set back the recovery.” The chairman’s response was explicit: “Now, inflation of course is low, and we think it’s very likely to remain low for some time, below our target. Really, it’s about getting the labor market back and getting it in shape. That’s been our major focus.”
So, the Fed isn’t currently worried about inflation and isn’t targeting asset price levels, as it seemed to after past market swoons, otherwise known as the “Fed put.” It’s instead focused now on restoring the U.S.’s pre-pandemic 3.5% employment rate through an extended period of rock-bottom interest rates that may also target portions of the yield curve.
Positive benchmark interest rates serve a crucial money pricing function and form the basis for discounted cash flow analyses to determine the financial viability of investments. Undercutting that function for extended periods with flat or negative rates hasn’t ginned up economic growth in Europe or Japan. Nor has the U.S.’s experience with lingering low rates created financial market stability reflected in “moderate long-term interest rates.” To the contrary, as business valuations inflate and deviate from underlying economic fundamentals, they have tended to pop at points.
“My takeaway is the Fed has ‘got the back’ of a lot of risk-taking out there. Never mind that previous, similar policy brought us the challenges of 2008, 2011, 2015/16, and perhaps controversially, 2020,” Brady says. “The Fed may believe its toolset can fix everything. Well, the jury’s still out. We have lower growth, more debt and more wealth inequality thanks to higher risk asset prices than in previous decades. I won’t lay this at the door of the Fed, certainly not entirely, but perhaps there is no magic monetary bullet after all.”
Investors would be well advised to assess whether valuations in their portfolios accurately reflect underlying business fundamentals. Efficient capital allocation, downside protection, return on capital and return of capital depend on it.