No Foregone Conclusions: Is Jerome Powell Playing Hard to Get?

It should have been a nothingburger of a Fed meeting. 

At the September FOMC meeting after cutting rates by 25bps, Powell described the Fed’s approach as one of “risk management”, suggesting that its next steps would be extremely data dependent. But with the government shutdown, the Fed is missing the critical economic indicators it needs to justify anything other than a slow, steady pace of cutting 25bps per meeting. So no one was surprised when the Fed delivered a market-consensus rate cut this week of 25 basis points, bringing the Fed Funds target rate range to 3.75-4.00%.  

The Fed also delivered what we believe to be an expected decision to stop Quantitative Tightening as of December 1st.

The precise language the FOMC used in their statement was, “The Committee decided to conclude the reduction of its aggregate securities holdings on December 1”. In his opening remarks of the press conference, Powell clarified by adding: 

If you’re saying, “huh?”, here’s what this means in layman’s terms.

The Fed has been watching for signs of stress in the system indicating that Quantitative Tightening — meaning, the shrinking of the Fed’s balance sheet by not reinvesting the principal from maturing securities it owns — has gone far enough. They wanted to STOP QT before things approach a crisis level.

Now is that time. All the small signals we spoke about in August and September of a potential looming reserve crisis? The Fed was watching those too, and has decided to act.

So what exactly are they going to do? They are going to reinvest the principal from maturing Agency Mortgage Backed Securities (securitized pools of mortgages guaranteed by Fannie and Freddie that the Fed bought long ago to support the housing market and keep rates low) into T-Bills. T-Bills are short dated Treasury securities issued with maturities of 4-52 weeks (i.e., 1-year or shorter).  

The goal here therefore is not just to stop QT. It is to shift the composition of the Fed’s balance sheet from a mixture of Agency MBS and US Treasuries to now focus almost exclusively on Treasuries. Moreover, it is effectively SHORTENING the weighted average maturity of its portfolio, “closer to that of the outstanding stock of Treasury securities”. 

The impact of this is as follows: 

1. It provides a new bid for short term rates, which all else being equal should bring those rates DOWN just like a rate cut would.

2. It encourages the Treasury to issue more government debt in the front end of the curve, where the Fed stands as the ready buyer and where rates will be lower, rather than the long end. Remember: the Fed and the Treasury are separate entities.

3. Theoretically then, if the Treasury decides to shorten the average maturity of its future issuance, that should reduce supply in the long end. By reducing the available supply of long dated bonds, the Treasury may cause long end rates to richen (go down) as the remaining buyers of longer securities scramble to get their hands on whatever’s out there. The Treasury may therefore access lower rates for whatever debt it still does issue out the curve.

In essence, by halting QT in this particular fashion, the Fed is paving the way for lower rates across the yield curve.

All sounds dovish, right? And if you’ve been following us, we’ve been predicting this since the summer (although in perhaps much more dramatic terms 🤪).

Well, that all fell apart with the very first question at the press conference.  Nick Timiaros of The Wall Street Journal asked, “Chairman Powell, are you uncomfortable with how market pricing has assumed a rate cut is a foregone conclusion in your next meeting?”

Powell responded: “Well, as I just mentioned, a further reduction in the policy rate at the December meeting is not a foregone conclusion.”

If I could insert a record screeching to a halt sound effect in this newsletter, I’d do it here. Front end rates immediately sold off (read: moved higher) by 10 basis points as the market hastened to take some certainty out of the equation.

Reporters jumped all over him asking for clarification, and Powell used language discussing the stubbornness of inflation readings and continued risks to the upside on inflation…effectively, all hawkish signals that stopped the market dead in its tracks.  

What’s going on? 

Well, this is the second meeting in a row and frankly part of a larger pattern of Powell disappointing or surprising the market by communicating a different tone in his Press conference than the language of the statement would otherwise suggest.  

My personal take? I think it’s very easy to get a little too excited when you start talking about the Fed’s balance sheet. 

In fact, Steve Liesman from CNBC asked a very leading question later in the press conference about steps the Fed might take to keep the Fed’s balance sheet from shrinking as a percentage of GDP. He’s referring to widespread market speculation that the next step in the Fed’s plan after stopping QT and reinvesting proceeds in T-Bills would be to declare that the Fed’s balance sheet should be in direct proportion to GDP as a backdoor into expanding said balance sheet with future asset purchases.

Read: Quantitative Easing. 

KNOWING that the market might be hunting for breadcrumbs along that future path, perhaps Powell threw a bit of cold water on the prospect for December rate cuts being a foregone conclusion.

By doing so, he disappointed slightly in the near term, but perhaps prevented setting the markets up for inevitable disappointment by getting too excited about the prospect of QE reemerging in the near future.