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'95 analog revisited, as the hikes end focus turns to the balance sheet, slacker labor models, correlation regime shift, issuance begins
Revisiting the ‘95 Analog
The reaction to Vice Chairman for Monetary Affairs Nominee Philip Jefferson’s Thursday speech entitled Financial Stability and the U.S. Economy was immediate in terms of pricing of the policy path, though a bit delayed in equities and exchange rates. The FOMC leadership views — generally the Chair, Vice Chair for Monetary Affairs and NY Fed President — matter most and with the quiet period beginning Saturday they left little ambiguity that they support skipping the June meeting to allow more financial stability information to accumulate. We also suspect they do not want to hike ahead of a large increase in Treasury issuance, are confident that headline inflation will be below 4% by July and are hearing a preponderance of anecdotal evidence that the demand for labor is cooling. We expect the skip to evolve into a pause at the late July FOMC meeting and be confirmed as the end of the rate hike cycle in September. Assuming 0.3% all items CPI prints for May and June, an annualized rate of 3.4% will leave the policy setting at a real rate of 1.75%.
While this is much lower than the 3% setting at the end of the last aggressive hiking cycle in early ’95, and household and nonfinancial corporate sector debt to GDP ratios are only 10% higher and well below extreme levels (~90%), the government debt to GDP ratio is double the ‘95 level and on an unsustainable path despite the Fiscal Responsibility Act’s 2-year spending caps. More importantly, while the amount of flattening in the benchmark 2s10s Treasury curve was similar in each cycle, in ‘95 the curve bottomed at zero, today the Fed’s balance sheet is a key contributor to a deep inversion that is unsustainable for the banking system, just as Volcker’s hikes and deep curve inversion were for Thrifts (S&L’s). Additionally, in ‘95 the Fed operated in a scare reserves system, today the abundant reserves system and Treasury Department’s struggles to manage their mountain of debt has created liquidity climate change and we may be on the verge of another serious storm.
We have frequently characterized the market’s skepticism concerning the FOMC’s policy projected policy path as a reduction in forecast credibility following the pandemic policy mistakes. When Fed officials speculate an inverted yield curve might reflect market expectations of lower inflation, credibility is further damaged. In April 2022, the initial inversion of the benchmark 2s10s Treasury Curve was driven by a 200bp inversion of the breakeven inflation curve. In other words, a year ago the inversion was attributable to the market correctly forecasting peak inflation, and had that Fed Governor observation been made a year ago it would have been accurate.
Today, the 2s10s real rate (TIPS) curve is 95bp inverted, and this is likely due to two factors. The first is expectations that the equilibrium policy rate is lower than the current setting, in other words, skepticism about ‘higher for longer’. The second factor, and what we’d like to discuss as the Fed prepares to end the rate hike cycle, is the ongoing impact of their balance sheet on the price of the global benchmark investment interest rate, the real 10-year Treasury rate (TIPS yield). Consequently, the answer to why the yield curve is deeply inverted is an overly restrictive rate policy combined with excessively easy balance sheet policy. Little wonder that Governor Bowman is concerned that stabilization of the housing market is impairing the disinflation process. While she is correct in her assessment that shelter inflation is unlikely to return to the 20-year pre-pandemic average of 3%, her solution is to continue to use the rate policy hammer when another tool, the balance sheet, would be far more efficacious.