Incoming Fed Rate Hikes

Inflation data in the United States came in surprisingly hot, and so rate hike chatter went off the charts. I think the idea of a “surprise” inter-meeting rate hike is silly in the context of modern Federal Reserve operating procedures, but I now see more chance of an initial 50 basis point rate hike in March as an attempt to assert dominance.

Unless inflation cools a lot, the base case has to be that we are looking at 25 basis points per meeting (plus the wild card of a starting 50) for forecast horizons going out a year. The pricing I have seen is consistent with this, so this should not be a surprise to anyone. After the one year horizon, far more uncertainty creeps into inflation/growth forecasts.

Since I do not think anything of interest happened, I will mainly repeat points that are not commonly appreciated.

• What matters most for the rate hike cycle is the terminal rate pricing. Fed members can raise their estimates for long-term policy rates in the “dot plot” in an attempt to influence market pricing, but there is no particular reason for anyone to have much confidence in the Fed’s ability to forecast where they will decide to put rates years in the future. Unless they specifically target term yields, the Fed just reacts to historical data and sets the policy rate.

• They can muck around with Treasury buying/selling (“Quantitative Tightening”). There is considerable uncertainty about the exact effects of Federal Reserve balance sheet expansion, so I expect caution in reversing it. I am skeptical about its effects, explained in more depth below. However, it is impressive that the army of Ph.D.’s at the Fed managed to develop a policy tool that is effectively slower to react to the cycle than fiscal policy.

• The flattening of the curve (chart above) is coinciding with the inevitable “bond market is predicting recession!” stories. My view is that we have a market segmentation issue: bears are throwing all their risk at the front, bulls are buying long tenors, and relative value players are not going to jump in front of a steamroller to pick up nickels. Forwards are converging to the discounted terminal rate, and that terminate rate will move up and down as data hit.

Blow Up the Treasury Market?

We have seen some yappy comments from some of the more outspoken Fed hawks. Roughly speaking, they are mad that the discounted terminal rate is too low. However, the only way to do that is either by raising rate expectations, or the term premium (by definition of those terms). The ability of one Fed speaker to get market participants to change their rate forecasts is debatable. So, do crazy things to destabilise the Treasury market to raise the term premium?

Although that is a strategy, it is a rather bizarre one. Over the past couple of decades, I have been reading self-congratulatory missives by neoliberal economists regarding the reforms they made to lower term premiums. Now, some hawks want to raise them? Well, that’s the kind of consistency you expect from a highly mathematical science.

The problem with discussion of term premia and things like Fed balance sheet policy is that economists use toys models that just pick some economic variables at random. Given the number of crypto-Monetarists in the profession, they look at the Fed balance sheet (“money!”) and ignore literally everything else in the bond market.

The reality is that a Treasury bond is just a source of default risk free duration (DV01 might be a better term, but whatever). Although there are some managers that might be confined to only holding Treasury securities, asset allocators rarely have such restrictions. (The exceptions are entities like trusts, and smaller central banks.) If Treasurys get too expensive versus spread product (including mortgage-backed securities, which are more of a vol risk than a credit risk), they just move their assets to those asset classes to get their DV01 there. The stock of USD duration is large, and we have to keep in mind that issuers can change the duration of issuance.

In other words, a rapid change in Fed policy could move the curve a lot in the short run, but that just will result in asset mix and issuance shifts if the curve appears stupidly priced.

Postscript: Canada Crisis Update

The safest observation I can make is that everything you might read in the American media about the convoy protests is incorrect.

• The Emergency Act is part of a legislative overhaul of The War Measures Act that was last invoked by Trudeau Senior in the 1970s in response to separatist violence in the 1970s. The overhaul was done by the Progressive Conservative Party (yeah, the name is funny, it was that for a reason), and explicitly is subordinated to The Charter of Rights and Freedoms that were brought in by Trudeau senior in the early 1980s. (From what I recall, conservatives viewed the Charter as a liberal-commie plot at the time.) The Emergency Act had not been invoked, but the act that might be considered “martial law” was invoked by the Progressive Conservative government (at the request of Quebec) during the Oka Crisis of 1990. That crisis was a border dispute between the Mohawks and Canadian governments, with roots in treaties pre-dating Confederation. In other words, what is happening is a constitutional nothingburger that bleeding heart “conservatives” are crying about.

• The existence of “money laundering” tells us that governments have always frozen banking assets of criminal organisations. The only thing different is that it is easier to do it more quickly (and puts more burden on the banks to enforce).

• At the time of writing, other protests are winding down, and the authorities are signalling a roll up of the Ottawa protest. The question remains whether the “nonviolent” protest (if we ignore the intimidation, criminal charges, weapons charges, and charges of a conspiracy to commit murder) gets ugly.

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(c) Brian Romanchuk 2022