I will be on Bloomberg TV today at 8:30 am to preview the Fed meeting. Inflation continues to trend lower, which is good news for the Fed and markets. But the level of inflation at 7.1% is still significantly above the FOMC’s 2% inflation target. As a result, the Fed today is likely to argue that rates need to remain high for an extended period to ensure that inflation gets all the way back to 2%.
Survey response rates for employment and inflation have declined significantly during the pandemic, and this is introducing substantial measurement errors and uncertainty, see chart below. One such example is the widening gap between the establishment survey and the household survey in the employment report, with the establishment survey showing 2.6 mn jobs created over the past eight months and the household survey showing no job growth over the same period. Whether the economy created no jobs or 2.6mn jobs over the past eight months is obviously extremely important for the Fed and financial markets.
During the pandemic, the Fed expanded its balance sheet by $5trn, and the Fed is now shrinking it by $95bn every month with $60bn in Treasuries and $35bn in mortgages, see the chart below.
The implications for markets of QT are the opposite of what they were for QE. The idea with QE was to lower rates, boost equities, and narrow credit spreads. With the Fed now in tightening mode, the idea with QT is to raise long rates, lower equities, and widen credit spreads. Such a tightening in financial conditions helps increase the costs of capital and ultimately slow down inflation, see also this Fed paper, which finds that shrinking the Fed balance sheet by $2.5trn is equivalent to increasing the Fed funds rate by half a percentage point.
There are a lot of opinions in financial markets about the effects of QT, but the Fed’s view is clear: Even if the effects of QT are the opposite of QE, the negative effects on the economy and markets of QT are smaller than the positive effects of QE simply because QE normally comes quicker and bigger than QT. In other words, the fact that QT is drawn out over a much longer period than QE is spreading out the negative effects over a longer period.
The bottom line is that the Fed, with rate hikes and QT, is tightening financial conditions, and the Fed’s intentions are clear: higher long rates, lower equities, and wider credit spreads. But because these effects are spread out over a longer period than when the Fed is doing QE, the negative effects of QT on markets and the economy are smaller than the positive effects of QE.
For more, see these Fed papers here, here, here, and this paper by Caballero and Simsek.
Last week, Producer Price Index (PPI) data showed a decline in inflation, but not as much of a drop as the consensus had expected. That’s an important theme going into the week ahead, when we’ll be getting CPI inflation data on Tuesday followed by the FOMC meeting on Wednesday. The consensus expects CPI inflation to fall from 7.7% in October to 7.3% in November—still far above the Federal Reserve’s 2% inflation target but moving in the right direction. The Fed has signaled that after several rate hikes of 75 basis points, they only need to raise rates by 50 basis points in December, which represents an important downshift. Meanwhile, in addition to raising interest rates, the Fed is substantially running down its balance sheet. This quantitative tightening (QT) program is expected to cause the amount of risk-free assets in markets to rise steadily in 2023, potentially crowding out demand for other fixed income products while also putting upward pressure on long-term treasury rates.
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The weekly data for office occupancy rates shows that New York City office use after Thanksgiving reached a post-pandemic high of 50% of capacity, see chart below. Our collection of daily and weekly indicators for the US economy is available here.
As the Fed starts to approach the peak in the Fed funds rate, the market narrative is changing from “there is a high level of uncertainty about inflation and how high rates will go” to “inflation has peaked and we have a better idea about where rates will peak during this cycle,” see chart below. This ongoing transition in the market narrative has important consequences for rates, credit, and equity markets, including levels of implied and realized vol.
The Fed has clearly communicated that they want to downshift next week from 75bps to 50bps, and as we approach the peak in the Fed funds rate, we should begin to see capital markets reopen again, and in November there was a significant increase in investment grade refinancings and M&A/LBOs, see chart below.
Our latest credit market outlook presentation is available here.
In the latest episode of “The View from Apollo” our Chief Economist, Dr. Torsten Slok, speaks with Philip Mintz, a Partner and co-head of Apollo’s Real Estate business. Tune in to hear Torsten and Philip’s thoughts on the state of the market today as the Federal Reserve and other key global central banks continue to tighten monetary conditions, changing public and private real estate valuations after massive dislocations in capital markets, their views on distressed investing, and much more.
