Fed Moves Back to Center Stage as Transmission Mechanism is Challenged

The Federal Reserve moves to center stage next week.  Outside of the US and Chinese inflation measures, it looks to be a relatively light week in terms of high-frequency economic data. Investors are still ruminating over the surprising jobs report (gain of 2.5 mln jobs vs. forecasts for 7.5 mln loss).  Yes, there were classification problems, and a lower participation rate dampened the unemployment rate. But, the unexpected 290k rise in Canadian jobs seems to lend credibility to the underlying signal that the worst has passed.

The FOMC meeting takes place amid a dramatic run-up in risk assets.  It is manifest in strong rallies in global equities.  In the currency markets, it is expressed as the outperformance of the dollar-bloc and Scandis and the underperformance of the yen and Swiss franc.  Among emerging markets currencies, the three that were the hardest hit in the heat of the panic in March and into April, the Brazilian real, the Mexican peso, and the South African rand have soared since the middle of May (17.6%, 10.4%, and 10.0%, respectively).    Emerging market bonds have seen their premiums retrace more than half of the crisis-induced run-up.  In Europe, peripheral yields have fallen relative to Germany.

Some offer individual drivers for each development, and we mustn't ignore the idiosyncratic-level of analysis.  However, the trees make up the forest, and what makes the forest thrive?   Liquidity.  Governments and central banks have opened up the spigots.  The idiosyncratic analysis can explain how much and in what form, but in aggregate, the sums are large, and if anything, more is coming.  China is recently announced it will boost spending.  Required reserves will likely be reduced further.  The new benchmark, the one-year Loan Prime Rate, is expected to gradually drift lower in the coming months.  Japan unveiled its second supplemental budget and may double the small business loans it buys.  South Korea announced its third supplemental budget, which is so far the biggest.  India unexpectedly cut rates by 40 bp at the end of May.

Three new initiatives from Europe were expected to be forthcoming.  The ECB delivered the first this past week by increasing its Pandemic Emergency Purchase Program by 600 bln euros and extended it to six months to the end of June 2021.  The second initiative is the Targeted Long-Term Refinancing Operation later this month.  If specific targets are reached, and there is no reason to think that they won't be, banks will be able to borrow funds at an incredible minus 100 bp.  Thirdly, Europe continues to debate an EU-level support program, which looks likely to include loans, grants, and guarantees.  A unanimous agreement, which is required, alongside EU Parliament consent, may be difficult to conclude this month.  If there is a 30% chance that the 750 euro package is approved, the expected value is 225 bln.

Germany announced a 130 bln euro fiscal package, as it took a pandemic of historic proportions for Berlin to embrace Keynesian demand management.  While the headline is about 4% of GDP, the actual new funds or what the Japanese call "clear water" is a little more than half.  Still, Germany is positioning for a robust recovery, which appears to set the stage for increased divergence at some point with Europe.   This may be another example of the "K" type of bottom we expect, where pre-existing conditions matter as does the policy response.  Some will emerge in a stronger relative position, and Germany is bound to be one. 

The Bank of England meets during the EU summit (June 18) and is expected to expand its bond-buying program.  However, next week, the focus will be on the FOMC meeting.  The Federal Reserve has shown extensive flexibility in adjusted its programs as needed.  For example, it has reduced the Treasury purchases to $5 bln a day from $75 bln at the peak.  It has also made adjustments to its local government facility recently. 

Pressure is building for the terms of the $600 bln Main Street facility that has just been launched.  The purpose is to help businesses too big for the Small Business Administration facility but too small to benefit from the corporate bond purchases or direct industry support, like the airlines.  The minimum loan is for $500k, and the maximum is $200 mln, and Powell has indicated he is open to broadening limits in both directions.  The terms of the loans may also need to be adjusted if the take-up is low.  However, such announcements are not captive to the FOMC meeting schedule, and it is cited here to illustrate the large-scale support and its flexibility. 

The Fed's balance sheet continues to expand as its lending programs are launched and more than offsets the decline of Treasury purchases.  The Fed's balance sheet bottomed last August around $3.76 trillion.  In the final four months of 2019, the Fed's balance sheet rose by about $310 bln. Over the past four months, it has increased by nearly $3 trillion.   Although it may seem otherwise for short periods, there does not seem to be a robust relationship between the level or change of a central bank's balance sheet and its exchange rate. 

That should come as no surprise.  After all, while monetary factors may be influential some of the time, there are other factors or influences.  The euro extended its rally last week precisely because the ECB indicated it would expand its balance sheet more than it previously stated.  If it had not done so, the euro would have likely been sold in disappointment. Currently, the most compelling explanation of the anomaly of poor economic and geopolitical news and the powerful, relentless rise in risk assets is the aggressive fiscal and monetary policy. At the same time, consumption remains asphyxiated, and investment decisions postponed. 

The FOMC may want to standardize its Treasury purchases, which have been reduced from $75 bln a day to $5 bln as the capital markets normalized.  However, the US yield curve has steepened.  The 2-10 year curve pushed above 70 bp last week, the steepest since Q1 2018.   The typical suspect is inflation or inflation expectations.  A few hours before the Fed's decision on June 10, the May CPI will be reported. The headline rate is probably closer to 0 than half of one percent.  The core rate is around one percent higher.  

Market-based measures of inflation expectations have firmed, but not that much.  The five-year/five-year forward is in the middle of its 160-200 bp two-month range.  The 10-year breakeven is firm around 125 bp, the upper end of where it has been since the crisis began.  At the start of the year, it was in the 160-180 bp range.  

Supply seems a more likely suspect than inflation or inflation expectations.   The Congressional Budget Office estimates the deficit will be around 18% of GDP this year, and that is before the next set of measures that will likely forthcoming in July or August.  The Democrats passed a $2 trillion+ package, which is really just a marker for negotiating purposes.  The White House and the Senate are counter-offering with a $1 trillion package. 

The stronger than expected May employment report saw an immediate reaction in some quarters, arguing this package is no longer needed.  Nevertheless, given the political cycle and the fact that even under if one took the unemployment rate at face value, it remains well above the peak of the 2008-2009 financial crisis, and a premature fiscal cliff may cut short the first signs of a turn.   It seems clear that there were some temporary layoffs and some permanent job losses.  It is far from clear the relative size of either.

Meanwhile, there seems to be growing interest in shifting from buying a fixed amount of Treasuries to purchasing what is needed to defend a target for something besides overnight money.  This is yield curve control. Rather than targeting a quantity of Treasuries as is the case now, it would target an interest rate.  The Bank of Japan's implementation targets the 10-year bond yield in a band around zero.  The Reserve Bank of Australia targets the three-year bond yield at 25 bp, the same as its cash target rate. 

Many do expect the Fed to go to a yield curve control strategy though the timing may not be imminent.  If the Fed concludes as we do that the steepening of the curve is due to real and anticipated supply, it could bring forward the implementation.  Those that expect the Fed to do so anticipate that it would target the 2-5 year part of the curve.  Besides capping the increase in yields, YCC would underscore the Fed's forward guidance about rates staying low for an extended period.  The US five-year yield rose 15 bp last week to is near 45 bp,  the highest in nearly three months. Before the crisis, it was 100-120 bp higher.  The US two-year yield bottomed a month ago near 10 bp.  It has since recovered and is hovering around 20 bp.

The challenge for the FOMC is that market rates rise and remove some of the easing that the central bank has determined is necessary to reach its mandated objectives of price stability and full employment.  The bearish steepening, if it persists, maybe a challenge to the transmission mechanism of Fed policy.  Powell's reaction to these developments will be among the most important parts of his press conference.  Still, the market exaggerates.  A few weeks ago, despite the Fed's repeated denials, the market was pricing in a negative policy rate. Now, it is lifting rates prematurely.

Lastly, the summary of the Fed's economic projections will be of interest.  The base case for a recovery in H2 still seems to be reasonable.  The Summary of Economic Projections is a policy tool and helps shape forward guidance.  The median dot plot for the funds' rate target is likely to remain near zero into at least through 2022.  The amalgamation of individual forecasts may anticipate around a 5% contraction this year, followed by a 4% growth in 2021.   In its April World Economic Outlook, the IMF projected a 5.9% US contraction in 2020 and a 4.7% expansion next year.  

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