Reactions to the September 2021 FOMC - High Quality Credit Spreads

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Dan Krieter:

Hello, and welcome to Macro Horizons High Quality Spreads through the week of September 22nd, reaction to the September FOMC. I'm your host, Dan Krieter here with Dan Belton, as we discuss our takeaways to today's FOMC meeting and what it may mean for credit spreads going forward.

Dan Krieter:

Each week, we offer our view on credit spreads. Ranging from the highest quality sectors such as agencies in SAS, to investment grade corporates. We also focus on U.S. dollar swap spreads and all the factors that entails, including funding markets, cross currency markets, and the transition from live board to sofa. The topics that come up most frequently in conversations with clients and listeners, form the basis for each episode.

Dan Krieter:

So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or email directly at Dan.Krieter K-R-I-E-T-E-R @bmo.com. We value and greatly appreciate your input.

Speaker 2:

The views expressed here, are those of the participants and not those of BMO capital markets, it's affiliates or subsidiary.

Dan Krieter:

Well, Dan, good to be back here recording another one of a reaction to the Fed meeting episodes. Just minutes after the conclusion of the Q&A session. I guess we could start here. Let's start high level. What were just your main takeaways from either the statement, or the press conference? Your general feeling walking away.

Dan Belton:

Yeah. In total, I thought it was a pretty consensus meeting. I thought some of the sources of uncertainty heading into the meeting, fell a little bit on the hawkish side. And you saw the Treasury market react accordingly. I think the biggest mover in Treasuries was the 5s30s flattener. But a couple of the things that I thought were, not surprising, but some sources of hawkishness.

Dan Belton:

First, you had dots. The 2022 and 2023 dots. And heading into this meeting, we knew that it was a possibility that those median dots for those two years, would move higher. It only required I think one or two FOMC members to up their forecasts for the end of 2022 and 2023. And we got that. I think the 2023 dots were a little bit more surprising. We had the median dot at 1% for the end of 2023.

Dan Belton:

Now, whether looking at the median dot makes more sense than looking at any other function of the distribution, I think is another conversation. But you saw the market react to the increase in the median dot. And then of course, the headline. I think the biggest takeaway I had from this meeting, was Chair Powell's comment before the press conference. But after the statement, when he said that it was likely that the tapering process is going to conclude around the middle of next year.

Dan Belton:

And so, likely to me, that implies a November taper announcement starting in December and reducing purchases by 15 billion a month. That's 10 billion in Treasuries and 5 billion in MBS. And that gets you to the end of purchases by the end of June of next year. And then another question in the press conference, kind of pressed Chair Powell about the possibility of a taper announcement in November.

Dan Belton:

And Powell said something to the effect of, "I wouldn't need to see a strong employment report next month, but I'd like to see a very good one as it relates to announcing a taper in November." So I thought he, as close as he could to really strongly hinting a November taper announcement. He did just that.

Dan Krieter:

Yeah. So that's what I walked away with as well. He said that the unemployment goal was, I don't remember the exact words, just about met or something like that. So very strongly hinting that it was going to be a beginning of November taper. And I like the way you characterized it in your response. That anything that was a little bit uncertain, did lean a bit hawkish. I think the end of asset purchased by the middle of next year, comes as a bit of surprise.

Dan Krieter:

The bigger surprise to me was the dots. Our listeners were, no I'm not a huge fan of the dots. But after the hawkish surprise we got at the June SCP, I really didn't think that we were going to have another hawkish surprise in the dot plot. And I was obviously wrong on that. So it seems the Fed is delivering a coordinated hawkish message here. The Treasury market responding as you would expect with the 5s30s flattener.

Dan Krieter:

I guess it's important to note here, that risk assets though, maybe they were off the highs. They didn't seem to hate the message much at all. Equity still set to finish deeply into the green. Whether that's because of the Evergrande news and the way Chair Powell actually characterized Evergrande during the Q&A. Or as a result of the FOMC, that's probably open for debate. But it doesn't seem like risk assets are reacting too negatively to the hawkishness from the Fed. And I guess the question is, should they?

Dan Belton:

Yeah, I think one possibility there is Chair Powell, as he's done recently, he really separated the liftoff from tapering. And he talked about this satisfying the liftoff test. And how the liftoff test had a lot different criteria than the test for starting tapering. He said, "In order to lift off, we would've to see labor market conditions consistent with maximum employment." And so, there's so a lot of slack there.

Dan Belton:

One possibility I think with respect to the reaction in say equity markets is that, while we're marching closer and closer to this taper announcement, rates are going to remain at the zero lower bound, at least according to what Chair Powell said for at least a year now. And so, I think that's one reason that risk assets have been able to digest this message of an imminent taper, but that being not the same as marching closer and closer to liftoff.

Dan Krieter:

Right. And so, in many ways, this is just like the realization of something we've been saying for a while. That ultimately, the pace and timing of tapering, is not really going to matter much for risk assets. We knew it was coming. And this sort of ends up being a worst case scenario. I want to hesitate to use those words, but it couldn't really have gotten much more hawkish than this. The taper starting in November and winding down by the end of next year.

Dan Krieter:

And really, equities our whip sawing around here up and down and up and really not showing much direction here. So it just shows that tapering at least edits announcement, is not going to be a significant driver of risk assets. We're not going to see a quote unquote "taper tantrum" this time around. Now, as we get into the teeth of tapering, in early 2022, and we start to see the market have to start to absorb more treasure supply, I think then you could have an argument for you start to see some pressure on spreads.

Dan Krieter:

But as we talked about last week here Dan, Treasury's going to cut coupon sizes most likely, unless something goes sideways on that front. And that should cancel out the end of asset purchases from a supply that actually hits the end of the market standpoint. And maybe just all the way through. QE just ends up being sort of a non-event and it becomes more about the timeline for when we're going to raise rates. It's hard. I feel like you have the Chair saying one thing and the dots saying another. How do you reconcile that in your head?

Dan Belton:

Yeah. So it's interesting you brought up the coupon cuts. And coincidentally, I think Treasury is expected to reduce coupon auction sizes on November 3rd, which is the date of their our next quarterly refunding announcement. It's also the date of the next FOMC meeting. So we could have on November 3rd, an announcement for a decrease in coupon auction sizes in the morning and then in the afternoon, plans for a decrease in Fed purchases. And they would likely just about cancel out.

Dan Belton:

I think we're expecting an average of $12 billion in reduction per month of Treasury coupon, auction sizes and 15 billion in Fed purchase reductions. So yeah, like you said, that could just about wash out. And I think the timing works out pretty nicely for the Fed. It's unclear if that is just a nice coincidence for the Fed, or if that's something that they preferred to announce on the same date that Treasury is likely to announce a reduction in coupon auction sizes. That remains to be seen. But it certainly softens the blow of a reduction in Fed accommodation.

Dan Krieter:

And then this gets back to a topic we talked a lot about in our last week's episode actually, which is the stock versus flow argument. Because we know the stock of financial reserves, is going to stay extraordinarily high. But the flow is going to slow down and we're going to see, apart from the debt selling ramifications at the end of the year, we're going to see reserves come out of the financial system.

Dan Krieter:

Once that's over, we're going to see reserves actually just be held steady for the first time. And for me, that's where the impact on credit potentially comes. Not that I think there's going to be a widening. I don't think that to be very clear. I just wonder if it begins to sap credit of it's narrowing potential to continue tightening, to theoretically new historical lows at just about six basis points now off the cyclical low here.

Dan Krieter:

It does seem like you need a pretty strong tailwind to keep pushing spreads further and further narrower. And I wonder if the end of tapering, if that's just enough to maybe keep spreads here and prevent them from narrowing further.

Dan Belton:

Yeah. Dan, I think it's a great point and it goes back to what we talked about in our last weekly, which is that it's very possible if not likely, that liquidity conditions are right now about as good as they're going to get. And through that lens, the pace of tapering does matter. It's not a huge factor, but whether the Fed was going to reduce purchases each month, or at each meeting as we talked about in our weekly, has implications for the terminal level of reserves, once the Fed is done purchasing. And that difference is about 200 billion.

Dan Belton:

So not a massive number, but still about 5% difference in the level of reserves from where they are right now. And the Fed indicating that it's going to be tapering a little bit more quickly than in the alternative scenario, I think is just another reason to expect that liquidity, like you said, is not going to cause spreads to blow out here, but it's just going to make the environment more challenging. As the Fed has indicated that it's going to start tapering in November and start doing it likely at a 15 billion per month clip.

Dan Krieter:

While we're on the topic of reserves, I think maybe here's an appropriate time to talk about more of a technical adjustment the Fed made today, which was essentially doubling the capacity of the RRP by doubling the amount each counterparty is allowed to take from 80 to 160 billion. And I don't think this move was overly expected. I mean, we among others on the street, have been saying that eventually they may have to tweak these limits, but it didn't seem like it was as a pressing need at the moment.

Dan Krieter:

We did see Fed funds drift a little bit lower in the range, but it still never breached the eight basis point level. So it didn't seem like there was anything particularly acute and yet the Fed doubles the counterparty limit. What was your read on that?

Dan Belton:

So I took away a couple things from this part of the policy announcement. First, the Fed is pretty willing to adjust these limits, to make that they're not very binding, which raises the question of, why they even have these limits to begin with? But that's a discussion for another time. Secondly, it doesn't seem from the data that we have, that these limits were binding as of the end of August. I think the highest single counterparty took 65 billion as of the end of August. That's below the $80 billion limit.

Dan Belton:

Now, maybe the Fed has seen something in the past couple weeks which has indicated that the 80 billion limit was binding. And it'll be interesting to see tomorrow's take up if that increase is significantly with the higher counterparty limit. Other than that, I don't read too much into this decision by the Fed. I think the Fed is comfortable allowing this RRP take up to continue to increase and that's likely what's going to happen in the near term.

Dan Krieter:

I'm with you that the Fed has no problem seeing the volume increase. The thing I'm having a hard time squaring, is why did they do this? Like you said, there didn't seem to be any pressing need for it. We haven't seen a large counterparty in the 65, at least to our knowledge. And I just don't totally get it. We've seen some speculation that it could be related to the debt ceiling. We have bill pay downs coming and then the potential for some short end investors maybe avoiding bills around the projected X date for the debt ceiling.

Dan Krieter:

I mean, yeah, maybe it doesn't seem like that's a big enough potential flow to me, to be the catalyst for this move from the Fed. So I guess, maybe sometimes the simplest explanation is just most likely to be right. It might as well just increase this now, when there's no need to, rather than get to a point where it's needed. I get that. It's just while we're marching towards tapering, then to now double this, just seemed a bit odd, but maybe I shouldn't read into something that maybe there isn't a whole lot to be read into.

Dan Belton:

Yeah. That's sort of the way that I'm thinking about it. I just don't think there's much of a cost from the Fed standpoint to increasing this counterparty limit. So why not? If there's any thought to do so, why not do it?

Dan Krieter:

Especially if there's some thought that the debt ceiling maybe could be a situation, you're not meeting again until November here, let's just do this now just in case. Yeah. I get it. I'll agree with you there. Okay. Well, let's see. I think we've covered tapering and its impact on credit. We talked about the change at the short-end. Do we want to spend any more time on the dots here?

Dan Belton:

I think we covered most of the dots. The only other thing that I'd say moving away from the Fed funds expectations, unsurprisingly, we had a downward revision in 2021 GDP. An upward revision to unemployment. And then the inflation forecast was revised higher from 3% to 3.7%. None of those things I thought terribly unexpected, but worth mentioning.

Dan Krieter:

I was a little surprised by the dots, but again, I don't think they hold too much predictive power for what's actually going to happen in the economy, or even necessarily signaling what's going to actually happen to the path of the Federal funds rate to be honest. So for me, as long as the increase is small and it seems that the increase was small, I'm not going to read too much into the dots, even if it was a bit surprising.

Dan Krieter:

And it does seem like that's going to be the case here, that the market's going to shrug that off at least for the most part. So, I mean, those are the three main topics. So we can look now at more of the notes from Q&A. I think there were some kernels in there that are worth discussing. We don't have to spend time on this. But a lot of the Q&A was dedicated to some of the trading accounts for the Federal Reserve presidents, which maybe made this Q&A session a little less instructive, because there were at least three or four questions on the topic that, not going to have much impact on markets.

Dan Krieter:

But one question, maybe the one from the Q&A that I found the most interesting, was the chair was asked about the unemployment goals that relates to raising for the first time. And specifically was asked about Black unemployment. And I think this is the first time that he's actually been asked directly, if he's going to target different unemployment rates for different segments of the population.

Dan Krieter:

And that's something that I've been thinking about, as it relates to the evolution of the way the Feds talked about unemployment particularly, given the impact that the pandemic has had on, on unemployment. That, that was something that could lead to the Fed maybe having a different decision function relating to unemployment and the Federal funds rate in the current cycle versus historical ones.

Dan Krieter:

And I think he gave a bit of a non-committal answer, but basically said that they won't be targeting any one segment of unemployment, that they look at unemployment holistically and there're multiple measurements. And that generally, all those metrics of unemployment should move together so it won't be watching just one. How did you read that?

Dan Belton:

Yeah. I had the same takeaway. I wasn't surprised by his answer. And most of the time when the Fed shares asked about any specific employment metric, they tend to sort of sidestep the question by saying, "We look at the labor market broadly and so we don't look at just any one metric, such as the Black unemployment rate." But you're right. It has been something that the Fed has talked a lot about, especially in the aftermath of the pandemic. And it's a metric that certainly has gotten more weight with respect to Fed policy, I would think.

Dan Krieter:

But the key takeaway, and I'd like to know if you agree or not, is that it doesn't seem like the Fed is going to be approaching unemployment much differently this time through, as relates to how they have in similar cycles in the past. Another interesting topic he got in the Q&A, was a question that sort of tried to draw a parallel between the Evergrande situation and corporate defaults in the U.S. Kind of two important things to take away from here.

Dan Krieter:

First, he talked about how the Evergrande situation seemed to be highly specific in China. He did not seem to have much concern of it rolling over to the U.S. And I think that's obviously the consensus view, but nice to hear the Chair of the FOMC say that. The main mechanism is through confidence channels and things of that nature, where we wouldn't expect to see any contagion here.

Dan Krieter:

But then perhaps more interesting for our purposes, he talked a bit about the corporate default rate. And talked specifically about how they were in his words, very concerned about the amount of corporate leverage leading into the pandemic. And that's something we were talking about a lot in 2019, the amount of corporate leverage, something Yellen and harped on at the time and Paula alike, talking about concern about too much leverage in corporate sector.

Dan Krieter:

He then talked about the pandemic arriving and then being very concerned about a thick default wave. Obviously when you have highly leveraged corporations being cut off from earning streams, that you'd expect some massive defaults. We didn't ultimately see that. Powell correctly credits the CARES Act and the actions of the FOMC at the time. And then that was this sort of extent of his answer. He didn't really seem to directly address leverage in the corporate sector now, which isn't appreciably lower than it was in 2019.

Dan Krieter:

Now, obviously it went up and now we've seen some de-leveraging depending on the way you're looking at corporate leverage here, it's going to be right around 2019 levels though. Maybe higher, maybe a little bit lower. So on the one hand, he says, "We were concerned about corporate leverage levels back in 2019, which are very comparable to the way they are now." And I got the impression he wasn't concerned about corporate leverage now. What was your take?

Dan Belton:

Yeah. It certainly seemed that way. He talked about, like you said, the immense concern that the Fed had, about corporate leverage back in 2019 and the beginning of 2020 as the pandemic started. He did seem to imply maybe not as literal as I was taking it, but he did seem to take on the attitude that we're out of the woods with respect to corporate leverage. Like this is just a thing of the past. We were worried about it in 2019, he made it seem like we're less worried about it now.

Dan Belton:

I thought that was interesting. I thought that was a good point that I didn't really fully pick up on, but you're right. Corporate leverage is not significantly lower than it was in 2019. And then interestingly, just that we're talking about it now, tomorrow on Thursday that Fed Z.1 data is out and that's sort of the most official metric of corporate leverage in the system. So that's something to keep an eye on.

Dan Krieter:

I would say there're differences between now and 2019 regarding corporate leverage. Even if leverage on a gross basis is similar to where it was back then, the liquidity condition now are just not the same as they were back then, with obviously abundant reserves now and RRP at 1.2 trillion, are going to go higher now theoretically with a higher counterparty limit. But versus where we're in 2019, which is where were looking at scarce reserves. We had a sulfur spike and we were looking at needing a repo facility, which we ultimately got first in the form of emergency repo measures. And then now a permanent facility for future episodes like this.

Dan Krieter:

So just looking at the way that central banking and monetary policy has changed in the past 20 years, with the era of QE and negative rates around on the world and things of that nature, perhaps looking at corporate leverage, or debt in an economy in general, whether that's consumer leverage, or industrial leverage, maybe we have to start looking at things in terms of leverage, as it relates to reserves in the financial system. Beside differently, are there enough reserves to allow for that leverage to keep the system going?

Dan Krieter:

Because we have similar amounts of leverage in the system now versus 2019. Back then we were concerned, now we're not. Maybe at least one of the contributing factors there, is just the amount of reserves in the system. So something to keep an eye on. Obviously, that's a longer term trend, much longer term trend. But something I've personally been thinking a lot more about, when I'm trying to think of the path for credit spreads, or what could be the next catalyst to a significant widening, I think preserve supply, the amount of money in the financial system, is perhaps even more an important indicator now and more important than we even realize.

Dan Belton:

Yeah. And it's not dissimilar from, instead of looking at balance sheet leverage, or debt as a proportion of equity, or total assets. If you looked at something like interest coverage ratios. Right? As a function of all of these reserves in the system, interest rates are now lower. And even though corporations hold a lot more debt on their balance sheets, they're much better equipped to cover these interest costs.

Dan Belton:

And I think that's sort of the similar thing to what you're saying, where even though leverage ratios are at the high end of where they've been historically right now, interest coverage ratios are not. These corporations are because of this Fed accommodation, are well able to service their debt that's outstanding.

Dan Krieter:

Another great point. And just to put a bow on the conversation. Assuming leverage isn't going to drop significantly from here, I wouldn't expect it to. We've probably seen the majority of de leveraging we're going to see. When we do, if we've asked forward a couple years, when we get to an environment where the Fed's raising rates and money supply is shrinking, corporate leverage is going to be an area of concern again. And maybe that's stayed in the obvious. But it's just worth mentioning here to end the conversation.

Dan Krieter:

Let's see. I didn't have too much else. He was asked a question on the Vice Chair position, talking about Randy Quarles term ending on October 13th. Didn't have a lot on offer. No guidance whatsoever on any terms of replacement. Obviously, we wouldn't expect that. The only thing I had was that, Chair Powell seemed to say that he would still honor the expectation, or however you want to word it, that the Vice Chair guides the FOMC on regulation matters. I don't know. Kind of shrug for me. What did you get anything on the Vice Chair discussion certainly effect that we're watching.

Dan Belton:

Yeah, I thought it was somewhat interesting. I think it's important to keep in mind that Chair Powell's term is up, as well as the Vice Chair for supervision. So I thought it was somewhat interesting, that Powell said something to the effect of, "The Vice Chair gets to set the regulatory agenda and really owns that area of the Fed." Where you could interpret that as, Chair Powell remember appointed Fed Chair by a Republican and a Republican himself who oversaw a Fed that was doing a lot of deregulation under Randall Quarles as the Vice Chair.

Dan Belton:

Chair Powell was saying today that, whoever is appointed the next Vice Chair for supervision, is going to be fully in charge of the regulatory aspects of the Fed. I thought that was not surprising again, but something that he might have been saying as a sort of wink, wink to President Biden.

Dan Krieter:

Oh, great point. And one I didn't even really realize. The wink, wink to President Biden there. But it does just another breadcrumb to expect that we're going to have more regulation in the financial system, when we do have a new Vice Chair. Something that will likely not be good news for credit spreads upon realization. It's a 2022 story I think, but one that is coming.

Dan Krieter:

He was asked a question on, whether or not Quarles still set the regulatory agenda until he was replaced? I don't remember his exact answer. I remember feeling like it was sort of non-committal, just wrapped up in the, we have no information on that for you today. I ultimately don't really think it matters much. I don't think they're going to push forward any major regulation during a lame duck session for Quarles. So I didn't read much into that. I don't know Dan. That's about everything I took away from the Q&A. Did you have anything else in your notes?

Dan Belton:

No, I really didn't. I thought the most important things were Powell's comments right before the press conference. And then I thought the Vice Chair for supervision discussion, was somewhat interesting. Otherwise, it was a pretty consensus meeting I thought.

Dan Krieter:

Yeah. I agree. Free wood ride down the middle of the fairway. And assuming you don't want to talk in more detail about the trading activities of various Fed presidents, why don't we wrap it up with this? Obviously, we're constantly focused on credit spreads here. Did your view on credit spreads change at all after the Fed meeting? If so, how? And if they didn't, what's your expectations?

Dan Belton:

No, today I think reinforced a lot of what we've been thinking and writing about with respect to credit spreads moving forward. Which is that, conditions are going to remain pretty accommodative in the near term. And then later on in 2022, as the Feds tapering starts to really impact markets, as the Fed allows Treasuries and MBS to clear the market without its support, that's when things are going to start to get more challenging for credit spreads. So expect credit spreads to hit their tights around the end of this year, maybe in November, December of this year. And then I think things are going to get a little bit heavier for credit.

Dan Krieter:

Okay. Well, we're in agreement on that. And I think we can wrap it up there. Thank you everybody for listening to this episode of Macro Horizons High Quality Spreads. And we'll see you back here again next week.

Dan Belton:

Thanks for listening to Macro Horizons. Please visit us at BMOcm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at Daniel.Belton B-E-L-T-O-N @bmo.com. You can listen to this show and subscribe on Apple Podcasts, or your favorite podcast provider. This show is supported by our team here at BMO, including a FICC macro strategy group in BMO's marketing team. This show has been edited and produced by Puddle Creative.

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