U.S. Fed increased interest rates by another jumbo 75 bp, as the market expected. We saw an initial bullish spike in the stock market and a drop in USD reaction to a critical sentence from the Fed statement.
In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial freedom.
What does that mean?
“… the Committee will take into account the cumulative tightening…” so they’re not just saying, “Hey, this last three-quarter of a per cent move in interest rates is gonna have this or that effect to the economy“, but they’re now starting to look at what is the cumulative total impact that everything they have done so far since the start of this year.
They will take into consideration all the money they sucked out of circulation. They have created an enormous balance sheet by “printing money” out of thin air, and now they are sucking that money from the economy. If you don’t know how this works, join my XM Live Trading and Education sessions, and I will explain how that works in detail.
Shortly, Quantitative easing (QE) means that Fed is buying assets from the banks, so that’s how they put money into the economy (increasing the total money supply or quantitative easing). How does this happen? Simply Fed creates money out of thin air and asks the market, “Hey, we want to buy some assets. Do you have some?” Banks, of course, are happy to sell their government debts to the central bank. So, Fed buys their debt and injects money into the economy by paying with fresh new USD. That increases the total money supply, called Quantitative easing, known as “printing money.”
So what happens after Fed injects new money into the system? Suppose the amount of money is huge in a short period with heavy fiscal stimulus. In that case, inflation is inevitable, and when it appears with that power as we’re in now, the Fed may consider monetary policy tightening.
How does monetary policy tightening work? Fed first decided to “print” less money before start rising interest rates. Then they also may consider reducing their balance sheet by letting the debt in their “hands” mature, or they may even consider selling some of the debt to reduce their balance sheet to fasten the tightening process.
Fed offers its assets to the market, and banks buy them. And then, the opposite effect of the QE happens, which is sucking money from the economy (Quantitative tightening). So, when the Federal Reserve decides to reduce its balance sheet, they may sell its assets and get the dollars back, and as a result, fewer US dollars are circulating in the economy.
Let’s have a look at the second part of the sentence. This is big!
“…the lag with which monetary policy affects economic activity and inflation…” – This part is essential to understand; it’s called a Cantillon effect because there is a significant lag between maternity policy and economic activity. Again, the short explanation is that the money is working its way out by affecting the stock market and real estate market, and then long after that, it hits goods and services, and inflation comes. The same is true for the opposite effect. When the central bank tights its monetary policy, the first to react is the stock market, then the real estate market drops and then long after that, it hits goods and services, and deflation appears. So this is how money works its way through the economy.
So, how long can we expect the monetary policy to hit?
In 2020, when Covid-19 hit, the S&P 500 price dropped rapidly by more than 35%, from $3396 to $2184. The CPI number before the pandemic ranged between 2.95% and 1.55%; for the Core CPI, the range was between 2.39 to 1.68. After lockdowns and the economic headwinds, the CPI numbers dropped as follows the CPI was 0.22%, and the Core CPI fell to 1.22%.
S&P 500 recovered to its pre-pandemic losses in less than 5-months. At that moment, the Inflation data was moving around 0.65% for CPI and 1.19% for the Core CPI. As you can see, the lag between the assets and goods & services is significant.
The moment when inflation returned ot its pre-pandemic levels was exactly 1-year after the Covic-19 crash when the S&P 500 was already at stratospheric levels of nearly $4000. This means that when inflation returned to its pre-covid levels, the S&P500 index made over 80% gain from its covid-19 lows.
Let’s have a look at in the chart below:
So what that says about the Fed monetary policy tightening, the market drop below 20% (bear market) and the current elevated inflation numbers?
It is likely the economy to suffer a recession and even potential deflation. Let’s look at the US Treasury market, something I have been talking about in the XM live since the beginning of this year.
The US Treasury yield curve is officially inverted. The 10yr-2yr curve is inverted, and the 10yr-3mo curve is just dropped into negative territory with yesterday’s Fed “jumbo” 75 bp rate hike. This points towards a likely 2023 recession.
Just as importantly, the US Treasury market continues to run into liquidity problems, as we have discussed multiple times in my XM Live Sessions sice beginning of this year and to some extend going all the way back to the expiration of the SLR exemption in spring last year, and now that became the topic on main stream media headlines. Bloomberg had a good one two weeks ago with a number of charts including a measure of liquidity and a measure of volatility
In 2022, the Fed is letting Treasuries mature off its balance sheet. Foreign pools of capital mostly do not buy Treasuries due to the strong dollar (that puts them in defence mode; they stop buying and even start selling Treasuries to defend their currency). US banks, due to supplementary leverage ratio limitations, are also mostly not buying Treasuries.
Those are the three biggest balance sheets for Treasuries, which means as they sell or just stop buying, more Treasuries have to be absorbed by the smaller balance sheets (hedge funds, bond funds, retail investors, and so forth), and this process is disorderly, illiquid, and puts government borrowing costs on an unsustainable path for the long run, due to the high debt-to-GDP levels that they have.
We can back up and note for a moment that bond yields are determined by the market in terms of two components: expected inflation and expected default risk. Corporate bonds in particular can go up or down either because inflation expectations are changing, or because recession risk and the perception around their default risk is changing.
In other words, this sharp rise in US Treasury yields, along with near-record volatility and illiquidity, is not because market expectations of forward inflation spiked this year (quite the contrary).
Does that leave us with an increasing market assessment of default risk? Treasuries?
I would say no, which instead leaves us with a third option: along with hikes on the short end of the curve, there’s not enough balance sheet capacity to hold these long-duration Treasuries. It’s, therefore, a more mechanical problem. Foreign central banks are trimming Treasuries (mainly just not buying more) not because they think they are badly priced but because they are doing it to defend their currencies. Banks don’t necessarily think Treasuries are overvalued; their SLR limits prevent them from buying more. And the Fed is selling Treasuries to tackle inflation by tightening monetary conditions.
There is price-insensitive selling from the most significant balance sheets and not a comfortable amount of balance sheet space elsewhere to absorb those Treasuries. This explosive move in yields, liquidity, and volatility is not about a recent rise in inflation expectations. It’s about a lack of buyers due to specific supply/demand issues that are largely separate from the question of price.
Take, for example, the Oil price back in April 2020, when it went negative. Did the market value Oil at a negative value? Of course, not. We all theoretically like to buy unlimited oil for “free” or at negative dollars per barrel. The real problem was the unprecedented demand collapse due to covid-19 lockdowns, and there wasn’t anywhere to put the supply that was just pumped out.
If the Treasury Department uses this tactic to change the duration profile of its debt, it can extend Treasury market functioning longer. There is over $2 trillion in the Fed’s reverse repo facility, mostly from money market funds. This money would be happy to be in T-bills if more T-bills were issued. The Treasury could buy back off-the-run longer-duration securities and increase its issuance of T-bills, basically doing an “operation twist” to absorb this capital and relieve pressure from longer-dated off-the-run securities. Money market funds and their usage of reverse repo remain one of the few big balance sheets available that have a lot of space, but the catch is that it would only work for T-bills.
My base case is that the Treasury market or an adjacent financial plumbing issue will be the limiting factor for how tight the Fed can be regarding rates, quantitative tightening, and firm dollar policy.
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Let’s get more technical and update the latest trades discussed in the previous articles.
GBPUSD broke the wedge pattern and headed down as expected from the previous analysis
The positive emotions from the U-turn expectations and the new PM Rishi Sunak increased the price to 1.1645. And when the emotions settled down, the market showed signs of exhaustion and completed its ABC corrective structure. And imidiately after that Fed Interest rate decision “helped” the Cable to break down below the daily wedge pattern.
The price has formed an excellent LOB setup on the lower time frame (1-hour chart), which we traded early this morning. The previous setup played well, but unfortunately, the price spike during the Fed rate hike kicked me out of the trade with +50 pips trailing stop. The new setup is also playing well so far. The trade is secured already, and he hopes the price will continue in its south direction.
EURUSD performed better than expected after my recent analysis. The price dropped to 0.9730s, close to the confluence area we discussed in the previous analysis (find the link above).
If the price breaks below the formed daily channel, this will be a technical signal for trend continuation with the same target of 0.9550, aiming for the weekly lows. If the risk-off continues to be the game’s name, we will aim for targets like 0.93 and 0.94 (2001 highs).
After the hawkish Fed yesterday, I don’t expect the price reverses at a robust pace, but to be prepared for any changes, I will secure the position with a trailing stop. And if the price bounces back above 0.9850, then I will consider it a short-term bounce with a potential retest of the parity level.
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