I am catching up on things post-vacation (new consulting project dropped). I just wanted to make some comments on topics I have run into recently before getting back to some banking texts that I had finished up earlier.
Fed!
The Most Important Fed Meeting Ever happened today, and the Fed remained on hold. Since I am focussing on writing books that are supposed to be somewhat timeless, I do not spend much time on central bank watching. With the disclaimer that I had no forecast, I do not think it is inherently surprising that the Fed did not cut.
The big inflation miss in recent years was politically damaging to the Fed (as well as the government more generally), so it is not going to be excited about the possibility of being perceived as making an inflationary mistake. The economy is muddling along, and it is unclear whether they believe that a few tactical cuts would make a difference.
On paper, the central bank could act more like the random process that shows up in fixed income pricing models. Jump back and forth between cuts and hikes based on vibes and/or data, with the overall trend in rates following the overall perceived trend in the economy. Such a strategy would result in a jumpy policy rate, looking closer to volatile market data in low enough frequency data. In practice, the Fed smooths its interest rate response (“gradualism”). The FOMC lags what they think might need to be done, and once it is clear that they have lagged too far, they start moving rates up/down. The idea is that the pace of rate cuts/hikes will be faster than perceived needs, so they will no longer be lagging within a year or so. This creates a policy rate trajectory that looks like actual results — policy rate being on hold for extended periods, with regular cut/hike paths in between.
On the basis that only too-dovish central bankers get a bad historical reputation with other central bankers, the Fed is happy to lag behind the need to cut rates. As such, rate cuts tend to coincide with recessions — a tendency that created the data that the “U.S. yield curve predicts recession” cling to. Tactical rate cuts within an expansionary period are rare (with COVID-19 helping to preserve that rarity).
Treasury Issuance
I have been seeing grumbling about how changes in Treasury issuance patterns is offsetting Fed Quantitative Tightening (or whatever). This is the silliness you have to expect from commentators discussing anything involving supply and demand factors in the Treasury market.
Stepping back, there are two stories to explain why Quantitative Easing might work (spoiler: it doesn’t, but work with me).
Fed purchases of Treasurys create excess reserves, which is “printing money.” Since everybody just loves the Quantity Theory of Money, this means that manipulating excess reserves drives inflation and/or the economy.
Changes to Fed holdings of Treasurys affects term interest rates via a portfolio rebalancing effects. The idea is that investors in aggregate have a preferred “money”/bond holding ratio, and changes from that target ratio will have an effect on term premia. (E.g., Fed purchases drive down the term premium.)
One needs to be effectively innumerate to believe the first theory (Quantity Theory), but thanks to Economics 101 and internet economics, the effectively innumerate are in the majority. “Printing money” can affect markets courtesy of these people believing it is true. This shows up less in rates markets since being on rates will eventually be costly. However, other, lesser markets like credit, equities or foreign exchange have no mechanism to punish dubious monetary theories, and so “printing money!” may be a viable investment thesis there.
The second theory is plausible, but it has a key problem that the term premium is hard to model (and the existing models stink). And if we did want to take the theory seriously, we would need to quantify all the supply and demand factors in play. We would need to look at duration supply, as well the changing portfolio preferences of investors (e.g., liability matching demand, which depends upon trends in actuarial liabilities as well as regulations).
Of course, central bank-obsessed economists did not want to do the work of quantifying those other factors, so they just looked at central bank purchases of bonds. They then get mad about Treasury issuance patterns when they find out they are not constant.
I saw this during the first American QE experiment. Everybody looked at Fed purchases, and ignored Treasury issuance. I snarfed down all the CUSIP-level data from the Fed and Treasury, and guess what, the Treasury lengthened issuance duration into the Fed purchases. To top it off, there had been some well known papers recently published that were retrospectives on the failure of Operation Twist (where Treasury duration lengthening nullified the plans of the brain trust at the Fed to micromanage the yield curve with purchases).
Despite the increases in telecommunications capabilities, the thousands of Ph.D.’s at the Fed were somehow unaware that there were Ph.D.’s at Treasury who have a mandate to minimise the Treasury’s borrowing costs. Those Treasury Ph.D.’s talk to the market participants on the Treasury Borrowing Advisory Committee (TBAC) regarding investors’ preferences for Treasury duration. Amazingly enough, if the central bank is attempting to push investor duration allocations from their target portfolios, investors will indicate that they want issuance to lean the other way. Doing so would presumably reduce term premia — allowing the Treasury team to meet their objective of minimising funding costs.
(If anyone actually read The General Theory, they would have noticed that Keynes — an accomplished investor — noted that a unitary authority might be able to control the yield curve with supply and demand. However, trying to do so with two groups with incompatible objectives might not work.)
So any time someone complains that Treasury issuance is cancelling out what the Fed is doing with purchases, you need to ask them: what did you expect would happen?
Politics
In a perfect world, I would be able to ignore American politics. Unfortunately, it intrudes upon my Twitter feed. Unlike the previous two elections, this election season has been quite funny. With all the excitement, I can barely remember the attempted shooting at the Republican candidate last year.
This election is about culture war issues that I would sit out as a Canadian. On the macro side, I do not see too much new. My working assumption is that Harris would largely continue Biden’s policy stance, and unless the composition of Congress greatly changes, not too much might change. Trump is a known quantity, which is being vaguely pro-business and anti-tax while doing various micro policies to benefit/punish friends/enemies. Differences would show up in a crisis, but it is hard to predict what crisis will show up.
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