The Fed tried to pull the usual “bait and switch” by talking about an increase of 75 bps, but instead giving the market only 50 bps and acting like it was a “dovish” action.
It was able to create a short squeeze in the equity market, but the bond market saw through the adjustment.
The increase brought the Fed Funds market to 1.00%, which is still historically low.
We’re still in the very early innings of Quantitative Tightening (QT), and the impacts will be far-reaching.
The Fed gave color around how they will start selling down their balance sheet beginning June 1st and accelerating by month 2.
This has many implications in the credit market, which we have begun to see implemented over the last few weeks.
- The Committee intends to reduce the Federal Reserve’s securities holdings over time in a predictable manner primarily by adjusting the principal payments received from securities held in the System Open Market Account (SOMA).Beginning on June 1, principal payments from securities held in the SOMA will be reinvested to the extent that they exceed monthly caps.For Treasury securities, the cap will initially be set at $30 billion per month and, after three months, will increase to $60 billion per month. The decline in holdings of Treasury securities under this monthly cap will include Treasury coupon securities and, to the extent that coupon maturities are less than the monthly cap, Treasury bills.For agency debt and agency mortgage-backed securities, the cap will initially be set at $17.5 billion per month and, after three months, will increase to $35 billion per month.
- Over time, the Committee intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample reserves regime.To ensure a smooth transition, the Committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.Once balance sheet runoff has ceased, reserve balances will likely continue to decline for a time. That will reflect growth in other Federal Reserve liabilities, until the Committee judges that reserve balances are at an ample level.After that, the Committee will manage securities holdings as needed to maintain ample reserves over time.
- The Committee is prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments.
The Fed will turn from a buyer of treasuries and MBS (Mortgage-backed securities) to a net seller beginning next month.
The Fed has been the largest buyer of these assets over the last two years, and now they are going to be selling into the market.
A bank was able to issue mortgages at favorable rates and bundle them into an MBS that could be sold to the Fed without restriction.
This is a significant pivot and mortgage rates are reflecting the shift.
The move higher in mortgage rates is putting renewed pressure on housing affordability, and we have already seen a slowdown in buying.
This is pushing down the homebuyer affordability index in a big way with little to stop the drop.
Powell’s comments also did nothing to calm the inflation fears, as we had a steep shift in the yield curve, with the front-month strengthening while the back month weakened significantly.
This is called the “steepener” trade,, where an investor wants to buy the front of the curve (2-year or 5-year treasury) and sells (shorts) the back-end (10-year or 30-year).
The 20-year doesn’t have much volume.
The solid green line shows where the curve is now, and the shift in the longer duration bonds is a big problem for Emerging Markets.
EMs price their debt off of the 10year treasury, which has moved to levels not seen since 2018.
But it will quickly move through those levels and reach yields not seen since 2011.
We are starting to panic in the market as EM central banks move rates higher than expectations as they try to get in front of additional inflationary pressures.
Many countries are still running deficits that are becoming more expensive to maintain, as they must roll their current debt and issue new debt to cover the budgetary shortfalls.
We have already seen India surprise the market by raising rates ahead of expectations. This comes from the Bank of England raising rates and talking about an increased risk of a recession.
The issues at the EM level as U.S. rates push higher are compounded as they attempt to fight inflation. To do that:
- They raise internal rates to cool off the market.
- Purchase their local currency with foreign reserves (mainly USD).
These actions have a cost.
They increase the cost of debt for local businesses.
The Central Bank has to go out into the market (or Fed Swap Line) to purchase USD to replenish falling foreign reserves.
The need to buy additional USD is increasing as trade slows because many of these nations rely on a positive trade balance to bring in excess USD that is parked in foreign reserves.
Many of these reserves were also used to stimulate the local economies during the pandemic utilizing both monetary and fiscal policies.
This is also a cause of excess inflation that will continue to find its way back into the U.S. markets.
We are importing at a record pace as prices only move higher around the world and are being passed on to the U.S. consumer.
The import surge will slow down as the Chinese lockdowns catch up and companies/consumers alike work off some of the inventory that has been built up is worked off.
The problem remains the weakening leading indicators and the cracks growing worldwide.
We face a big increase in pressure on commodities and wages that have failed to keep pace with inflation.
Prices are reaching new all-time highs, which companies will keep trying to pass on to consumers.
Things are moving in the wrong direction.
And with Powell still not willing to come at inflation meaningfully, the pressure will grow.
Regards,
Freedom Financial News
