Is the Fed unwittingly engineering a Recession?

The Federal Open Markets Committee (FOMC) increased the FED funds target rate yesterday, for the fourth time in 2018, by 25bps to take the Fed Funds Target rate to 2.5%.  Much of this increase was widely expected as the FED had been communicating the future interest rate direction through its “dot plot”, the latest of which from yesterday compared to the Sep 2018 view is given below:

Note: The dot plot is updated each time the Federal Reserve votes on whether to raise or lower interest rates. It plots where each member of the Federal Open Market Committee believes short-term interest rates, specifically the fed funds rate, will be over the next three years.

We can infer from the dot plot that a further hike of up to two times in 2019 is expected which has shifted from the previously held view of 3 hikes for 2019.

The Federal Open Market Committee released on Wednesday, the 19^th December 2018, the following statement (excerpts):

“Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. The Committee judges that risks to the economic outlook are roughly balanced but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2-1/2 percent.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective.”

The Fed ignored repeated calls from U.S. President Donald Trump in the lead up to the decision to refrain from lifting borrowing costs again amid the volatility in financial markets.  In a way, Trump had put the FED in a bind as even if they wanted to pause, it would appear as if they succumbed to the pressure from the White House and that would have undermined FEDS independence in the eyes of market participants and caused serious damage to its reputation.

The markets reacted negatively with stocks across the world declining by ~1.5% to 3% following the rate hike. The Bond yields fell further with 10 years treasury yield now lower than 3m Libor! The bellwether 2-10s UST spreads (difference between yield on US Treasuries of 2 years and 10 years) now 5bps apart! A negative read is a harbinger of recession.

Market participants are sending the Federal Reserve a message that it might be making a policy mistake by raising rates at a time when inflationary expectations are tame.  But it’s not just about the policy rates.

A more burning concern is about the unwinding of Fed’s Balance Sheet, a.k.a. “Quantitative Tightening”. Since October 2017, the FED has been steadily reducing its holdings of Treasuries and mortgage-backed bonds that it bought during the crisis era post the collapse of Lehman Brothers.  The FEDS Balance Sheet has increased from $800m in 2008 to close to $4.5T in Sep 2017.

Post Lehman Brothers collapse, GDP was contracting and the economy was losing hundreds of thousands of jobs each month and the United States economy fell into deep financial crisis.  The Fed funds target rate was already close to zero with no further room to cut rates.

Not wishing to pursue a negative interest rate policy (NIRP) like the ECB, the U.S. FED took unprecedented steps to spur the economy and nine years ago embarked on a Quantitative Easing program buying trillions of dollars of government bonds and mortgage-backed securities to add liquidity into the economy. The Fed’s bond buying, or quantitative easing, pumped trillions of dollars into the banking system to support the economy after the financial crisis. (The Fed bought bonds from pension funds and banks and paid for them by crediting their reserves with the Central Bank). Between 2008 and 2015, the Fed's balance sheet ballooned from ~$900 billion to ~$4.5 trillion. 

Now, with the economy on much stronger position, FED is unwinding its bond holdings and effectively sucking out liquidity from the system. Since Oct 2017, the FED has reduced its Balance Sheet by ~$400bn from $4.5T to ~$4.1T.  The estimated impact of this QT is the equivalent of a ~50bps of rate increase. The Quantitative Tightening (“QT”) or the unwind of FEDS Balance Sheet has picked up at a pace of ~$50bn a month and is having knock-on effects in the overnight money markets, where the demand for short-term cash has been on the rise.

There are two factors at play as a result of FEDs QT:

1. The shrinking B/S is driving tighter liquidity conditions leading to higher short-term rates

1. The impact of QT is resulting in money moving away from financial assets like stocks to cash and bonds (for reserve maintenance) leading to lower yields on Treasuries

It remains to be seen whether the current rate actions and the pursuit of QT at current pace will ultimately trigger a recession. The early signs are pointing to that with the UST 2-10 spreads at 5bps (dropped to 1bp). 
One thing is becoming clear, volatility is like to increase, so brace yourself for a bumpy ride in 2019!
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With the introduction of Basel 3 liquidity regulations, Banks are now required to hold much higher levels of liquid asset buffers in the form of High Quality Liquid Assets (read Cash reserves and Highly rated Bonds) leading to a general increase in demand for Liquid Reserves and US Treasuries.

In many ways, it’s the reversal of the FED actions during the financial crisis when it adopted a combination of QE and rate cuts to stave off the economy entering into a depression. It will be interesting to see what this does to the credit spreads….conventional wisdom says that credit spreads should widen as the liquidity squeeze extends leading to increase in cost of funds for Banks.

Fed officials have discarded the notion that they are to blame for the short-term rate increases.  However, the market participants have a different view and are vocal in their comments that if the Fed doesn’t slow down or stop its unwind, it could end up draining too much liquidity from the banking system, causing excessive market volatility and ultimately undermine its ability to control its rate policies to maintain stability in the financial markets.

How does Quantitative Easing work? 

Through QE, the Central Bank purchases financial assets – almost exclusively government bonds – from pension funds and insurance companies. It pays for these bonds by creating new central bank reserves. The pension funds would sell the bonds to the Central Bank and in exchange, they would receive deposits (money) in an account at one of the major banks. Banks would end up with the new deposit (from the pension fund), and a new asset is created in the Bank’s Balance Sheet– Reserves at the Central Bank.

Quantitative Easing therefore simultaneously increases the:

a)      the amount of reserves at the central bank in favour of banks that can be used for lending by banks; and

b)      the amount of commercial deposits with banks

This in theory supports the credit creation process as only the deposits can actually be utilised in the real economy, as central bank reserves are just for internal use between banks and the Central Bank.  Fed officials contend their unconventional policy actions saved the U.S. from a crisis worse than the Great Depression.

GDP growth has bounced back since 2008 and has held steady near 2 percent over the past few years.

While many economists had opined that QE would lead to a runaway inflation but it has defied such predictions and has remained surprisingly low.  This has further called into question the need for the FED’s rate action in the present time when inflation is stubbornly hovering around 2%.  

The Fed's low-interest rate policy made it inexpensive for the government to continue to borrow and spend. U.S. public debt is near $20 trillion. Investors had hoped for a less aggressive approach after U.S. stocks tumbled into a correction zone amid concern that global growth is slowing.

Many think that the Fed has completely misjudged the situation.  Though they have signalled a less aggressive path for rate hikes in 2019, the quarter-point move on Wednesday and the recent market turmoil doesn’t unduly worry the U.S. central bank. Global stocks are set for their worst quarter since 2011, yet Jerome Powell in his press conference said that “we don’t look at any one market,” and that in the abstract “a little bit of volatility” probably doesn’t leave a mark on the economy.

The feedback into credit spreads as a result of the current sell-off in equities and bonds is yet to take effect and when that happens, there will be a lot more pain to endure and that will impact economic growth.

Besides the Fed’s monetary policy related impact, there are worries of global trade wars, domestic politics and the geo-politics. America and China are planning to hold meetings in January to negotiate a broader trade truce.