Pro Perspectives 4/18/22
April 18, 2022
We are a couple of weeks away from the Fed’s May meeting.
At this meeting, they have telegraphed a 50 basis point rate hike. And they have telegraphed the beginning of quantitative tightening.
As we’ve discussed the past couple of weeks: 1) a 50 basis points hike still puts them way behind the curve on the inflation fight. At 775 basis points behind, in the fight, every day that passes they are only adding fuel to the hottest inflation we’ve seen in four decades, … and 2) we don’t have an historical reference point of a successful exit of QE. For the reference points we do have, we find that unknown consequences arise in the quantitative tightening (QT) process, and central banks respond with … more quantitative easing.
The question is, will the Fed even get the opportunity, this time, to start the process of “normalizing” the Fed balance sheet (i.e. quantitative tightening)?
Remember, when they tried in 2017-2019, they broke the overnight interbank lending market. And by 2019, they were forced to restart QE.
This time around, while the Fed has yet to start QT, the interest rate market is already sending some warning signals.
Last week, the 10-year yield did a round trip between 2.84% to 2.64% in 48 hours — on no news. Meanwhile, the 30-year mortgage rate is trading at the widest spread to the 10-year yield, since the March 2020 pandemic-induced economic shutdown. Prior to that, the last time we had seen this wide of a spread was when IndyMac failed in July of 2008 (and the subsequent global financial crisis).
I’m not predicting failures of mortgage institutions, but I’m saying there is a strong likelihood of more intervention coming from the Fed (and other global central banks), rather than less.
Consider this: With the 30-year mortgage now above 5%, we may have (by month-end) one of only four months in the past 50-years, where the month-to-month change in mortgage rates was 1% or greater.
This move in mortgage rates highlights the adjustment that market rates are making, to catch up with inflation. Meanwhile the Fed-determined-interest-rate (the Fed Funds rate) is lagging well behind (and moving at a crawling pace away from zero-interest-rate-policy).
This creates a problem for banks, as they pay interest based on the Fed Funds rate. The average interest rate paid on checking accounts right now is 0.3%. Depositors will start looking for better alternatives (i.e. moving money).
That brings us back to the discussion we’ve had on yield curve control. This is a lever the Fed may pull (following the lead of Japan). They could keep market interest rates from running away.
But as we’ve discussed, market interest rates are a market mechanism. If explicitly suppressed in an already hot inflationary environment, inflation could run wild.
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