Welcome to Thoughts on the Market. I'm Matt Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates in currency markets. It's Tuesday, August 31st at 11:30 a.m. in New York.
Well, the end of August usually brings with it the start of school in the U.S. and, for children who have to go back to school, the end of summer.
The end of August also brings with it the annual Jackson Hole Economic Symposium, an event held by the Federal Reserve Bank of Kansas City, that brings together dozens of central bankers, policymakers, academics and economists each year to discuss an important economic issue facing world economies.
The main event at the symposium was Fed Chair Powell’s speech on monetary policy in the time of COVID. Going into the speech, investors were looking for information on the timing and pace of asset purchase tapering, as well as the timing of rate hikes that might follow.
Here is what Powell said: “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.”
In other words, Powell emphasized that the bar to hike rates is higher than the bar to taper asset purchases. It’s a distinction that most investors had been aware of, but were comforted to hear Powell confirm nevertheless. It’s also a distinction that the Fed tried to get across in 2013, though unsuccessfully.
At the time, then-Chair Bernanke suggested that tapering could begin in the “next few meetings”. However, that was quite a few meetings earlier than most in the market had expected. What followed was a dramatic rise in Treasury yields. And a tightening in overall financial conditions ensued.
As Treasury yields rocketed higher, FOMC participants tried to communicate the idea that tapering wasn’t tightening. And while the message resonated with strategists like me, the knee-jerk reaction in the marketplace developed a momentum that words alone simply couldn’t stop.
From the Fed’s perspective, tapering asset purchases is its way of reducing the amount of accommodation it adds to the economy each month. It’s not actually tightening policy, per se, but rather easing policy bit by bit with each reduction in asset purchases. The Fed usually tightens monetary policy by hiking its short-term interest rate, known as the federal funds rate. The Fed could also allow the size of its balance sheet to shrink in order to tighten policy.
The good news for the Fed is that now, almost a decade later, investors now seem to have embraced this distinction between tapering and tightening. Last week, markets cheered the part of Powell’s speech where he underscored the more stringent test for hiking rates. Both bond and stock prices went up as the prospects for an earlier start to rate hikes seemed to fade. And the value of the U.S. dollar receded.
However, I’d like to point out a wrinkle that markets may have missed last week. Just because the bar to taper is lower than the bar to hike rates doesn’t mean the economy won’t surpass the higher bar just as quickly as the lower one. Remember, it wasn’t that long ago that FOMC participants weren’t willing to put any time frame on the start of tapering.
It also wasn’t long ago that most investors thought tapering would begin early next year. Today, both FOMC participants and many investors are eyeing the first reduction in asset purchases later this year. My point is simply that, just as the Fed grew more confident about tapering more quickly than expected, it may grow more confident about hiking rates more quickly as well.
Another, less comforting point is that, with Powell having drawn a clear line between tapering and rate hikes, the Fed is free to pursue a more aggressive tapering program than in 2014. While the Fed spent 11 months tapering its asset purchases in 2014, it could easily reduce the number of months to 6. If it made its first reduction in asset purchases this November, the Fed could be finished with its net purchases at the end of April next year.
In other words: The economy either moves closer to both tapering and rate hikes, or it moves further away. It’s very unlikely to take one step closer to tapering, and one step further away from tightening. And as the economy moves closer to both tapering and tightening, as we forecast, Treasury yields and the U.S. dollar should continue to move higher.
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