Asset Allocation Bi-Weekly – The Problem of Financial Conditions (May 31, 2022)

by the Asset Allocation Committee | PDF

Among the financial pundit class, there has been a growing call to weaken financial conditionsWhat are financial conditions?  They include credit spreads, the level of interest rates, the level of equities, the level of market volatility, the dollar’s exchange rate, etc.  Weaker financial conditions mean that borrowing costs rise, and the perceived risk of investment increases.  By increasing the costs of investment and borrowing, market participants (households, firms, etc.) will often exert greater caution, and this practice will tend to slow growth in the economy.  Essentially, the argument is that with inflation running “hot,” using weaker financial conditions to slow investment and consumption will eventually lead to less inflation.

However, managing financial conditions isn’t a straightforward process.  Once financial conditions begin to deteriorate, they can almost take on “lives of their own.”  In a sense, financial panics are evidence of rapidly deteriorating financial conditions.  A modest weakening in financial conditions might reduce “frothiness” in markets and lessen risk.  Nevertheless, containing a decline in financial conditions can be challenging.

Although there are several financial conditions indexes, we prefer the one generated by the Chicago Federal Reserve Bank.  This index has 105 variables, including various interest rate spreads, volatility measures, and the levels of several indexes and interest rates.  The index is updated weekly.  A rising index suggests increased financial stress (deteriorating financial conditions).  From 1973, when the index began, to mid-1998, there was a tight correlation between the level of fed funds and financial conditions.  For the most part, policymakers could use financial conditions as a “force multiplier” to enhance policy.  When the policy rate rose, financial conditions worsened in lockstep.  When the policy eased, they rapidly relaxed.

But, after mid-1998, the two data series became almost uncorrelated.  What happened?  A couple of factors likely affected this relationship.  The first was the passage of the Gramm-Leach-Bliley Act, which eliminated the difference between commercial and investment banking.  This bill changed the financial system, leading to more financial activities occurring outside the traditional banking system.  In other words, the non-bank banking system was fostered by this bill.  Why is that important?  To illustrate, instead of borrowing from a bank, firms could issue debt or do collateralized borrowing in a much less regulated environment.  Raising the policy rate didn’t necessarily lead to reduced borrowing because the financial markets have more ways to provide liquidity due to the changes in regulation.

The second factor was greater transparency in monetary policy.  Even in the late 1980s, the FOMC acted in secret.  “Fed watchers” tried to divine if a policy change had occurred by monitoring money supply data or bank reserve changes.  But by the mid-1990s, the FOMC started announcing when the policy rate changed, and over the years, it has been increasingly transparent about its policy expectations.  In general, society tends to treat transparency as a good unto itself.  But by making its policy direction clear, markets could adjust and thus had little to fear from “surprises.”  In the non-bank banking system, participants could use derivatives to insulate their positions from policy changes, rendering them less effective.

So, due to changes in the financial markets and increased openness, the FOMC has lost its ability to use financial conditions as an effective policy tool.  For example, on the above chart, the FOMC steadily lifted rates from 2004 to 2006.  During this time, financial conditions didn’t move.  Then, in 2007-08, when financial conditions deteriorated rapidly, aggressive rate cuts had little ability to improve them.  It took years of “zero-rate policy” and rounds of Quantitative Easing (QE) to finally improve financial conditions to a level in line with the pre-Great Financial Crisis period.

Recent history shows that when financial conditions weaken, it takes aggressive and swift action by the FOMC to reduce it.  In March 2020, financial conditions deteriorated rather quickly, and not only did the FOMC cut rates rapidly, but it implemented a broad intervention into the financial markets to support their function.  In addition, the balance sheet was expanded at a pace not seen outside of wartime.  Clearly, the pandemic was part of the policy response, but widening credit spreads and other signs of financial stress were also part of the Fed’s actions.

Although the call for purposely undermining financial conditions is understandable, the above chart shows it could trigger unforeseen outcomes.  We are no longer in a world where financial conditions deteriorate in lockstep with changes to the policy rate.  Instead, over the past 24 years, these conditions have shown a tendency to ignore policy tightening, only to deteriorate rapidly with little warning.  A modest weakening of financial conditions might be welcome, increasing the potency of tighter policy.  However, a sudden spike, as seen in 2008 and 2020, could be destabilizing, forcing the FOMC to rapidly reverse its current policy path.  Sadly, such events are almost impossible to predict in advance, although we can say that they seem to occur after tightening cycles.

It is possible that 2008 and 2020 may reflect the immaturity of the non-bank financial system, and markets may have evolved to a point where such market events have become less likely.  The backstops offered by the Fed during March 2020 might serve as a blueprint for containing financial crises.  Therefore, allowing financial conditions to deteriorate is less risky.  However, it appears to us the burden of proof lies with proving that tightening won’t “break something.”  And so, we remain vigilant, watching for funding issues that could trigger a run on liquidity and force the FOMC to ease.

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Asset Allocation Bi-Weekly – The FOMC Speaks (May 16, 2022)

by the Asset Allocation Committee | PDF

On May 4th, the FOMC announced its policy changes.  The Fed moved its fed funds target by 50 bps, the fastest increase in 22 years; the last hike of this amount was in May 2000.  In the press conference, Chair Powell scotched the notion of a greater than 50 bps rate hike.  He did, however, suggest that similar 50 bps rate hikes will be likely for at least the next couple of meetings.

One way to look at the future path of policy is to compare the level of inflation to unemployment.  This is the classic Phillips Curve idea; although the FOMC has seemingly jettisoned this concept, history suggests that policy has been aligned with this relationship.

The upper line on the chart shows the level of fed funds along with the target; Haver Analytics has estimated the policy rate target beginning in 1982.  The lower line shows the spread of yearly change in overall CPI and the unemployment rate. From the late 1960s into the early 1980s, inflation regularly exceeded the unemployment rate, forcing policymakers to lift the policy rate aggressively to contain inflation.  These tightening cycles led to four recessions over 12 years.  After that experience, the FOMC took steps to move rates high once the spread between inflation and unemployment approached zero.  This policy stance could be called “preemptive”.

However, in the current expansion, the Fed has allowed inflation to exceed the unemployment rate by a wide margin.  On the above chart, we have made forecasts for data unavailable for April and May (the yellow shaded area on the chart).  We expect inflation to begin slowly falling, but the unemployment rate to remain low.  To normalize rates, the unemployment rate will need to rise above CPI.  The tone of Powell’s press conference suggests the FOMC is moving in the direction of achieving this target at a deliberate pace; it is likely the Fed hopes inflation will fall as supply constraints ease and thus wants to give the economy more time to adjust to tighter monetary policy.

The other major announcement was that the Fed will begin to reduce the size of the balance sheet.  Quantitative tightening (QT) will start in earnest in June.  The impact of changes to the balance sheet remains controversial; the expected outcome from quantitative easing (QE) was to lower long-term interest rates.   Interestingly enough, QT and QE have tended to lift long-term rates, whereas a stable balance sheet led to lower interest rates.

On the other hand, periods of QT tended to narrow credit and mortgage spreads.  On the chart below, periods of QE are in green, and QT in tan.

Finally, the relationship of the Fed’s balance sheet to equities is also controversial.

The S&P 500 often tracks higher during periods of QE and stalls when the balance sheet stabilized…until late 2016.  Equities forged higher even with QT, but the positive relationship between the balance sheet and equities returned during the most recent QE period.  The model would suggest that QT will have a modestly adverse effect on equities.  The biggest risk to equities is likely the business cycle. Recessions tend to bring bear markets in stocks.  But, QT on its own is probably not a bearish event.

So, to recap, tighter monetary policy, which includes higher policy rates and balance sheet reduction, increases recession risk.   Recessions are inclined to affect risk assets adversely. We expect credit spreads to widen and equities to weaken if recession odds rise.  Longer duration yields generally decline, although in periods of elevated inflation, the declines are often simultaneous with the onset of the downturn.   Although we do not expect a recession in 2022, the likelihood in 2023 is rising.

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Asset Allocation Weekly (January 8, 2021)

by Asset Allocation Committee | PDF

Although U.S. equity markets appear richly valued based on historical metrics, relative to interest rates, current values of relative earnings or sales are not extreme.  Thus, the direction of interest rates and, more specifically, the direction of monetary policy, is a key element in equity values going forward.  In other words, when does the Fed raise rates?

Over the past year, the FOMC has changed its reaction function.  Since Volcker, the Fed has tended to tighten policy before full employment is achieved to “preempt” potential inflation.  This policy has led analysts to focus on various forms of the “Taylor Rule,” which attempts to calculate the neutral rate of interest given the level of current inflation, the inflation target, and the level of slack in the economy.  That policy has ended and has been replaced with a policy that promises to keep rates low until price levels above 2% annual growth are sustained.

Of course, the actual path of policy will be determined by the “buy-in” from the members of the FOMC.  Although Chair Powell’s comments suggest he is fully committed to the new policy, it is not clear if it has universal acceptance.  At this juncture, there are no dissents, but if inflation starts to rise, we could see some of the more traditional hawks grow uncomfortable with ZIRP.  Since an uptick in inflation in 2021 is possible, given base effects alone, it does raise the question—will the Fed stay committed to low rates?

Obviously, it would be foolhardy to claim that rates will stay near zero forever, but it would make sense to have some idea of how long we can comfortably expect ZIRP to remain in place.  First, for 2021, based on the composition of the FOMC, we can reasonably expect steady policy.

The above table shows the current members of the FOMC.  The committee consists of seven governors and 12 regional Fed bank presidents.  The governors are permanent voters as is the president of the New York FRB.  Each year, four regional bank presidents also formally vote on policy.  Our table shows the current governors on top and the regional presidents below.  We rate each on our “hawk/dove” scale and have also categorized them by policy inclination.  Moderates and Traditional Hawks rely on standard economic measures to set policy; the Hawks are more inclined to raise rates preemptively, whereas the Moderates tend to have higher tolerance for inflation uncertainty.  Doves tend to only raise rates if the evidence is overwhelming for inflation.  The Financial Sensitives will entertain rate hikes or other austerity measures when financial markets appear to be overheating.  Otherwise, they tend to side with the Doves.  We have also updated our estimates, with Powell and Clarida becoming more dovish.  The addition of Governor Waller and the current roster of regional FRB presidents make it clear that the new FOMC is much more dovish than in 2020.  That would suggest policy will remain steady with a bias for additional easing.

The other factor of note we find important is the relationship of the two-year deferred Eurodollar futures relative to fed funds.  The current implied yield of the deferred Eurodollar futures suggests the market expects steady policy for the next 18 to 24 months.

Under normal circumstances, the implied deferred yield is higher than fed funds.  In periods where the implied yield falls below fed funds, shown by a vertical line, policy easing tends to occur shortly thereafter.  From 2007 into 2013, the level of the implied yield remained stubbornly elevated relative to the fed funds target, suggesting the financial markets didn’t trust the promises of Chair Bernanke to keep rates low.  It wasn’t until early 2013 that markets finally accepted that policy would stay steady (and then Bernanke blew it up by announcing the slowing of the balance sheet expansion in 2013).  Note the current level of the fed funds target and the implied LIBOR rate.  The market completely believes the Fed will keep rates low for at least the next 18 to 24 months.

Overall, with equity valuations high, the key to maintaining these lofty expectations is the level of interest rates.  As long as dovish expectations for monetary policy remain in place, these valuations will likely persist.

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