The central thesis of the last SriKonomics was that Federal Reserve Chairman had lost the central bank’s traditional ability to influence long-dated debt markets through statements and concrete actions. Speaking at the Economic Club of New York on October 19, he conceded that “it’s hard to say exactly what’s going on with long-term yields.” My conclusion in the writeup that went out a week ago was that such diffidence reduces the ability of monetary authorities to prevent a “credit event” following the sharp run-up in interest rates.
Financial market developments over the past week go part of the way toward strengthening that belief. With the Fed observing its “silent period” ahead of the Federal Open Markets Committee meeting next Tuesday and Wednesday, there was no monetary official to provide a note of reassurance after the Chairman had roiled markets with his speech in New York City.
The yield on 10-year Treasurys hit 5.02% Monday morning, reaching the highest level since June 2007 when it got to 5.26%. After a mini-rally early in the week prompted by statements by prominent bond managers that it was untimely to bet against US obligations, the yield still closed the week at 4.85%. The S&P 500 had a worse run. By last night, the index had fallen by just over 10% from its peak this summer, putting it in correction territory.
What explains the small rally in Treasurys combined with the decline in large cap equities? Even market participants who had anticipated a “no landing scenario” — inflation coming down without economic pain — were worried about a recession after the recent rise in Treasury yields. And risk assets are not priced for recession.
There was no relief from the Personal Consumption Expenditure price index numbers released yesterday by the US Bureau of Economic Analysis. The headline number rose by 3.4% in September compared with a year earlier, a pace similar to that in July and August, and remaining well above the Fed’s target of 2%. Any comfort authorities may have taken from the fact that the annual increase in the core index (which excludes food and energy) slowed from 3.8% in August to 3.7% in September was offset by the fact that the month-on-month increase of the core index accelerated from 0.1% to 0.3%.
Yesterday’s data also provided a window into consumer behavior. After adjustment for inflation, personal consumption expenditures increased by 0.4% in September, accelerating from a 0.1% rise in August. 18 months of interest rate hikes by the central bank have not cooled consumers’ ardor to spend on goods and services. That, by itself, would suggest the need for more monetary tightening — not a good signal for equity markets.
Still, expect the Fed, which has become a spectator rather than orchestrator of Treasury market movements, to pause again on hiking rates. At his press conference to follow 30 minutes after the announcement of the rate decision at 2 pm Eastern time on Wednesday, Powell will likely explain that he and his colleagues are still studying the fallout from the increase in the Federal Funds rate from near-zero in March 2022 to close to 5.5% currently.
Don’t expect the Fed to attain nirvana following its deep study. The economy is experiencing the impact of excesses of monetary policy since the 2008 financial crisis and, in particular, of post-covid Fed balance sheet doubling combined with interest rate measures. Massive fiscal expansion in the final months of the Trump administration, and during the Biden administration, have added to inflationary pressures. No amount of in-house research can magically transport the economy toward immaculate disinflation.
That brings us to the intriguing question of what Powell will say at his press conference about recent developments. Since he has already indicated that he cannot explain the gyrations in Treasurys, he may once again attribute higher yields to wider term premiums which, by their nature, are not measurable! That should suffice to get the Chairman off the hook and let him proceed to the next question.
There is little expectation that the volatility in bonds will cause him to suggest an explicit reversal of policy — an end to Quantitative Tightening and a move toward lower interest rates. A policy reversal would cause a rally in risk assets and, in the process, making it even more difficult to bring inflation down to 2%. On the other hand, the recent turbulence in bonds must have sufficiently frightened the Fed into not providing a tough message.
I do not expect benevolent Uncle Jay to say “Uncle” on Wednesday. He needs a credit event to push him to that stance.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
October 28, 2023
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Possible credit events: CRE, another bank failure, credit crunch, CLO market, losses to large pension funds (similar to UK in Sept - Oct 2022)
What is the credit event you think will scare the Fed and start the rate cutting cycle? CRE or do you see anything else on the horizon