Absolutely magnificent piece. I heard Dave Dredge of Convex Strategies discuss curve steepening on Grant Williams last fall and it stuck in my brain. This article added clarity to my thinking. Thank you.
It's impossible to know the real strategy, if there is one, of the Fed and it's machinations. I would prefer to let the markets determine rates and leave the voodoo-ism on the sidelines. Trying to micro-manage interest rates is beyond silly. Supply and demand is as good as anything in determining natural rates. It's only at the extremes that the Fed should intervene.
I agree that the "real" strategy is hard to surmise - its a weird game of show and pretend and guidance and expectations... real "will they / won't they" vibes.
I totally agree with you in spirit that supply and demand seems like a good place to start (so long as the Fed keeps demand relatively stable). Unfortunately, the trend is towards more intervention and micromanaging, not less. Sadly this is the reality when it comes to monetary policy in our age.
Neither had I to be honest - at least not in the way that I constructed the Long Run-FFR spread vs. 10y2ys. When I put together the chart for the first time I knew there was something there!
Absolutely the most insightful and important article I’ve ever read about the Fed and interest rates. Cements my view of entrenched inflation for the foreseeable future.
Great piece this week! I would be shocked to see them adjust that long-run estimate upwards before the September or December dot plots. Total speculation on my part, but by September few would really argue the 2022 rate hikes haven’t taken effect in the markets. So if inflation and the markets are still showing strength, the Fed might finally be desperate enough to move it up?
Thanks Cole - agree that it would be a shocker to see them change the LRE in the upcoming meetings. The preference will be just to keep nudging the FFR between 5-6% and hoping the data comes in soft in the meantime.
The UK Gilt market has been rather interesting this week and looks to be so going forward. The BoE sold all gilts it bought in the panic, so it will be interesting to see if they're at that level again. IMHO it's the pace things happen which spooks CB's.
Turning to the USA, another reason for the persistent bid to the long end has been the increase in Stripping as Pension Plans lock in overfunded positions.
Thanks Karl, yea I think the UK intervention is actually an interesting case study for a number of reasons - in the footnotes I talk about their unwind of the position as well as the counterintuitive benefit to the GBP.
Any simplistic answer to why the market moves one way or the other will always the insufficient to capture all the details, and certainly this is not the only factor impacting long term rates - but I do think it’s an important one
Good article, and your reasoning regarding the "Long term estimate" is sound, but I think there is an even simpler answer. With the LTE they are simply aiming towards their 2% target and the falling curve simply indicates that they see it coming closer and it shows they are determine to get there.
So I don't think it's any YCC per se but if market see it that way I think it over-interpret the whole thing and contributes to the process of prolonging the normalization.
Definitely could be! But what is the "neutral" rate that gets to the 2% inflation? It's not clear there's a right answer, and clearly the FOMC's opinion has changed over time. I do think there is certainly a finger to the wind happening regardless
Thanks for the writeup! I have one question - the market for long-term treasuries is HUGE. Does that entire market really just follow the soft guidance from the Fed, or is it the market saying this inflation is truly transitory?
Well, the Fed has an enormous amount of control over interest rates and the treasury market, and seem to add something new to their "toolkit" every week. Given these power its not surprising that the treasury market hangs on the words of the Fed.
I think its impossible to separate Fed guidance from the market's response from independent thinking. They all blend together and react off each other. Anything in black and white will not capture the shades of grey, but you have to start somewhere.
We have seen the chaos hit the treasury market before and I'm sure we will see it again. My best guess is that eventually the effects of QT will drain enough liquidity that market functioning begins to break down. Its possible, though less likely, that a surprising monetary policy announcement (such as an increase in the inflation target, or an increase in the Long Run Estimate) could cause a rapid move higher in rates. Of course an independent event like COVID could do the trick too. Though in all those cases, the Fed can always step to intervene. With no constraints on its buying power, there isn't a limit to what the Fed can do to solve the problem. Whether that aligns with their monetary policy goal of fighting inflation is another question.
The tldr; is that monetary policy influences the private sector which then influences monetary policy which influences the private sector ...
The authors discuss at length the Fed being pinned by the private sector in a liquidity trap ... but neglects going into detail about the private market pinning the Fed in an expectations trap.
And what you're describing to me sounds like an 'expectations trap' though of a different sort than the one that happened in the 1970s. Investors en masse expect the Fed to keep long term rates anchored.
An expectations trap is certainly a good way to describe it. It definitely is iterative and reflexive between the market and the Fed and there's no way to really isolate a "cause" and "effect" cleanly.
Though, at the end of the day, the Fed has the unlimited ability to purchase treasuries at any price. That is a tool the market just can't compete with.
True. I'm sure you know this already but I didn't until your comment triggered me to crosscheck. It's not just forward guidance holding down the long end.
The below SOMA holdings visualization tool shows that despite QT happening for the portfolio as a whole ... they are adding to their > 10-year holdings. More data to add the narrative that they're full on doing yield curve control.
I always look forward to your insightful articles.
Thanks Cheri as always! Hopefully the insights don't run dry
Can you make an update about Evergrande and Chinese banks? Haven't heard about that for a while
Definitely worth an update. I'll put it on the list.
Second an identical look at PBOC! Haven't been reading much about it in the zeitgeist recently!
Absolutely magnificent piece. I heard Dave Dredge of Convex Strategies discuss curve steepening on Grant Williams last fall and it stuck in my brain. This article added clarity to my thinking. Thank you.
Thanks Sean, I'm happy to be included in a thought with those gentleman! Glad you took some value from the post.
It's impossible to know the real strategy, if there is one, of the Fed and it's machinations. I would prefer to let the markets determine rates and leave the voodoo-ism on the sidelines. Trying to micro-manage interest rates is beyond silly. Supply and demand is as good as anything in determining natural rates. It's only at the extremes that the Fed should intervene.
I agree that the "real" strategy is hard to surmise - its a weird game of show and pretend and guidance and expectations... real "will they / won't they" vibes.
I totally agree with you in spirit that supply and demand seems like a good place to start (so long as the Fed keeps demand relatively stable). Unfortunately, the trend is towards more intervention and micromanaging, not less. Sadly this is the reality when it comes to monetary policy in our age.
Thanks Gorgo for reading!
Awesome analysis of the Dot Plot re: Fed strategy. It helps simplify analysis of the multitude of market signals. Thank you!
Thanks KM, hopefully someone found it helpful. I think the key insight is the correlation between long-run guidance and the yield curve!
Completely agree. I hadn't read about this correlation anywhere else (and I read a LOT).
Neither had I to be honest - at least not in the way that I constructed the Long Run-FFR spread vs. 10y2ys. When I put together the chart for the first time I knew there was something there!
Absolutely the most insightful and important article I’ve ever read about the Fed and interest rates. Cements my view of entrenched inflation for the foreseeable future.
That seems like a stretch but I appreciate the sentiment! Glad you enjoyed, and please come back next week for more.
Awesome article. Looking forward to your next.
Thanks Shannon!
Great piece this week! I would be shocked to see them adjust that long-run estimate upwards before the September or December dot plots. Total speculation on my part, but by September few would really argue the 2022 rate hikes haven’t taken effect in the markets. So if inflation and the markets are still showing strength, the Fed might finally be desperate enough to move it up?
Thanks Cole - agree that it would be a shocker to see them change the LRE in the upcoming meetings. The preference will be just to keep nudging the FFR between 5-6% and hoping the data comes in soft in the meantime.
I love reading this, you make me ask very valuable questions, thank you for your writings TLBS! Keep it going! Today with extra caffeinated coffee ;)
Shoot now I need to think of something good for next week too! Thanks as always :)
Nice work LBS!
The UK Gilt market has been rather interesting this week and looks to be so going forward. The BoE sold all gilts it bought in the panic, so it will be interesting to see if they're at that level again. IMHO it's the pace things happen which spooks CB's.
https://www.bankofengland.co.uk/news/2023/boe-completes-unwind-of-recent-financial-stability-gilt-purchases#:~:text=In%20total%2C%20the%20Bank%20purchased,portfolio%20of%20temporary%20gilt%20holdings.
Turning to the USA, another reason for the persistent bid to the long end has been the increase in Stripping as Pension Plans lock in overfunded positions.
https://www.bloomberg.com/news/articles/2023-01-28/pension-funds-with-a-historic-surplus-eye-1-trillion-of-bond-buying
cheers!
Thanks Karl, yea I think the UK intervention is actually an interesting case study for a number of reasons - in the footnotes I talk about their unwind of the position as well as the counterintuitive benefit to the GBP.
Any simplistic answer to why the market moves one way or the other will always the insufficient to capture all the details, and certainly this is not the only factor impacting long term rates - but I do think it’s an important one
Highly anticipated best spot on analysis, as always
Thanks Tainpei! glad you find them insightful
Really interesting, this is a novel perspective for me. Will definitely share.
It is a novel perspective for me as well - I'm not sure its foolproof, but there's definitely some good meat on the bones. Thanks for reading!
Good article, and your reasoning regarding the "Long term estimate" is sound, but I think there is an even simpler answer. With the LTE they are simply aiming towards their 2% target and the falling curve simply indicates that they see it coming closer and it shows they are determine to get there.
So I don't think it's any YCC per se but if market see it that way I think it over-interpret the whole thing and contributes to the process of prolonging the normalization.
Definitely could be! But what is the "neutral" rate that gets to the 2% inflation? It's not clear there's a right answer, and clearly the FOMC's opinion has changed over time. I do think there is certainly a finger to the wind happening regardless
Thanks for the writeup! I have one question - the market for long-term treasuries is HUGE. Does that entire market really just follow the soft guidance from the Fed, or is it the market saying this inflation is truly transitory?
Well, the Fed has an enormous amount of control over interest rates and the treasury market, and seem to add something new to their "toolkit" every week. Given these power its not surprising that the treasury market hangs on the words of the Fed.
I think its impossible to separate Fed guidance from the market's response from independent thinking. They all blend together and react off each other. Anything in black and white will not capture the shades of grey, but you have to start somewhere.
Great writing...Question: What would cause the Fed to loose the long end of the curve and does it have a medium to high probability?
We have seen the chaos hit the treasury market before and I'm sure we will see it again. My best guess is that eventually the effects of QT will drain enough liquidity that market functioning begins to break down. Its possible, though less likely, that a surprising monetary policy announcement (such as an increase in the inflation target, or an increase in the Long Run Estimate) could cause a rapid move higher in rates. Of course an independent event like COVID could do the trick too. Though in all those cases, the Fed can always step to intervene. With no constraints on its buying power, there isn't a limit to what the Fed can do to solve the problem. Whether that aligns with their monetary policy goal of fighting inflation is another question.
Your commentary is thought provoking ... and it feels like it's headed in the right direction. It brings to mind this working paper:
"The Natural Rate of Interest Through a Hall of Mirrors"
https://www.federalreserve.gov/econres/feds/files/2022010pap.pdf
The tldr; is that monetary policy influences the private sector which then influences monetary policy which influences the private sector ...
The authors discuss at length the Fed being pinned by the private sector in a liquidity trap ... but neglects going into detail about the private market pinning the Fed in an expectations trap.
And what you're describing to me sounds like an 'expectations trap' though of a different sort than the one that happened in the 1970s. Investors en masse expect the Fed to keep long term rates anchored.
Anyways as always enjoyed reading.
An expectations trap is certainly a good way to describe it. It definitely is iterative and reflexive between the market and the Fed and there's no way to really isolate a "cause" and "effect" cleanly.
Though, at the end of the day, the Fed has the unlimited ability to purchase treasuries at any price. That is a tool the market just can't compete with.
I'm glad you found it thought provoking!
True. I'm sure you know this already but I didn't until your comment triggered me to crosscheck. It's not just forward guidance holding down the long end.
The below SOMA holdings visualization tool shows that despite QT happening for the portfolio as a whole ... they are adding to their > 10-year holdings. More data to add the narrative that they're full on doing yield curve control.
https://www.newyorkfed.org/data-and-statistics/data-visualization/system-open-market-account-portfolio