Sun setting on the tightening cycle
The Fed removed its tightening bias, opening the door to rate cuts.
A busy month of news pertaining to the liquidity markets ended on a high note when the Federal Reserve maintained the target fed funds rate at 5.25-5.50% and pushed the probable first rate hike to late spring at the earliest.
Degrees of confidence
Fed Chair Jerome Powell returned to the word “confidence” many times in his post-FOMC meeting press conference yesterday. He said the Fed has confidence in the authenticity of inflation’s downward trajectory over the last six months, but needs more. Not sure two months will make that much of a difference, but this stance allows policymakers to sneak in a few more months of “higher for longer.” Think of it as an “insurance pause” lest inflation hovers at present levels for a few readings. While the phrase “reduce the target range” appeared amid the extensive changes to the FOMC statement, Powell slammed the door on any chance of easing in March, saying it is not the “base case.”
His pronouncement means March will be a busy meeting, as Powell revealed the future of QT will also be discussed at length. While Powell characterized it as working well, he acknowledged hearing market rumblings about how the reduction of the Fed’s balance sheet might soon negatively impact liquidity in the Treasury market. This doesn’t mean the Fed will adjust the amount of the security roll-off immediately, but certainly suggests trimming it is on the horizon. Powell affirmed that policymakers could reduce the balance sheet and rates in tandem.
Investing in the front end of the Treasury yield curve improved last month as the markets pushed out forecasts for the first cut past March, a development likely to continue after Powell’s comments yesterday. Trades are now more in line with our firm view of 75 basis points of cuts this year, helping us find more value along the curve than when the fed futures trading called for upwards of six cuts. This should be aided by the U.S. Treasury’s quarterly refunding plans released this week that indicate bill supply will likely remain robust.
New birds, same cage
The composition of the FOMC changes each year when the presidents of four regional Fed branches have a hockey-like line change. Occasionally, this can shift the alignment of the 12 voting members, but this time the change will be negligible as none of the new voters hold extreme views. We consider Atlanta’s Raphael Bostic a centrist, Cleveland’s Loretta Mester and Richmond’s Tom Barkin as hawkish, and San Francisco’s Mary Daly dovish. Given the momentum the Fed has in this current cycle, the change won’t make much of a difference.
We, and the greater financial world, thought we’d finally put the London interbank finance rate (Libor) price-fixing scandal behind us when the British Financial Conduct Authority ceased to support it last year. With the Fed’s Secured Overnight Financing Rate (SOFR) now serving as the risk-free benchmark, the Bloomberg Short Term Bank Yield Index (BSBY) emerged in 2021 as an alternative reference rate for transactions in the credit markets. While it had worked well, it was punched in the gut by regulators over the summer and has been used less and less, and Bloomberg will shut it down by November. We and others made the case for it, but to no avail. The irony is that, while regulators such as the International Organization of Securities Commissions (IOSCO) and the SEC say BSBY is not secure enough to base short-term contracts on, market participants are now left with pricing rates at a spread over SOFR, meaning the risk of mispricing loans remains.
Liquidity at large
The world’s major central banks are preparing for their own policy pivots as inflation continues to fall in many developed countries. The Bank of England and the European Central Bank have been holding rates at 5.25% and 4.0%, respectively, with the former reconfirming its stance at its policy meeting this morning. But lately, officials have hinted easing could come this year.
The Bank of Japan’s benchmark rate remains at -0.1%, but it has more conviction that inflation might hit 2% after years of deflation, likely signaling the beginning of the end of its extreme stimulus program. While the People’s Bank of China held rates steady at its January meeting, it injected supply into the system. Later in the month, it cut the amount of cash reserves banks are required to hold in hopes of pushing banks to lend as the country’s economy continues to struggle.